(Solution Document) Assume that the world works according to the Classical model. In a small open economy, output is produced according to the production function Y =...

Assume that the world works according to the Classical model. In a small open economy, output is produced according to the production function Y = 40K 0.5 L0.5 , with K = 16 and L = 25, consumption is equal to C = 50 + 0.75(Y ? T ), and the investment function is I = 160 ? 5r. You know that taxes are T = 0 and that the world real interest rate is 4% (r? = 4). The public authorities of this country decide to decrease government spending G from $100 to $60.

In all the questions below, explain your answers and show all your work.

1. What will happen  in the domestic loanable funds market of this country after the decrease in government  spending  is implemented?  Will the domestic supply  of loanable  funds change?  Will the domestic demand  of loanable  funds change?

d.  What will happen  to the real  exchange  rate of this  country  after  the decrease  in  government spending  is implemented?  Will  domestic  goods become  relatively  cheaper  or more  expensive  with respect to the goods produced  in the rest of the world?

e.  Assume that this country decides to forbid capital  mobility and  trade with  the rest of the world. In other  words,  this  country  decides to become a closed economy.  Assume that G is maintained  at the value  of G = $60.  How will the domestic  real interest  rate change  after  this  country  decides to become a closed economy?


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