Consider the following model of a small open economy:
C = Ca + 0.8(Y - T)
Ca = 260 - 10r
T = 200 + 0.25Y
Ip = 300 - 30r
G = 460
X = 400 - 3e + 0.1Yf
M =210 + 2e +0.1Y
Ms/P = 200
(M/P)d = 0.4Y - 48r
Where X = exports, M = imports, e = the real exchange rate=50, Yf = foreign income = 2000 and all other variables are as defined in your textbook. Assume that prices are fixed and that the equilibrium interest rate is equal to the world interest rate in part (a)
Question 1: What is the equilibrium income and interest rate in this economy?
Question 2: Suppose foreign incomes rise to 3000 and the interest rate is allowed to temporarily diverge from the world economy's interest rate? What happens to the value of net exports? (show calculations in practice).
Question 3: Suppose the exchange rate is flexible. If economic policy makers would like to avoid a change in the real exchange rate due to the increase in foreign income, what policy option should they pursue? Explain using the IS -LM curves.