Please add as much detail as possible (tough grader).
1 Trade
Consider a world with three equal-sized economies (A, B, and C) and three goods (clothes, cars,
and computers). Assume that consumers in all three economies want to spend an equal amount on
all three goods. The value of production of each good in the three economies is given below:
Table 1: Value of Production
A B C
Clothes 10 0 5
Cars 5 10 0
Computers 0 5 10
1. What is GDP in each economy? If the total value of GDP is consumed and no country
borrows from abroad, how much will consumers in each economy spend on each of the goods?
2. If no country borrows from abroad, what will be the trade balance in each country? What
will be the pattern of trade in this world (ie. which good will each country export and to
whom)?
3. Given your answer to part (2), will country A have a zero trade balance with country B? with
country C? Will any country have a zero trade balance with any other country?
4. The US has a large trade deficit. It has a trade deficit with each of its major trading partners,
but the deficit is much larger with some countries (eg. China) than with others. Suppose the
US eliminates its over all trade deficit (with the world as a whole). Do you expect it to have
a zero trade balance with every one of its trading partners? Does the especially large trade
deficit with China necessarily indicate that China does not allow US goods to compete on an
equal basis with Chinese goods?
1
2 The Open Economy
Consider the following open-economy IS-LM model. Suppose that foreign income is Y
∗ = 1 and
that both foreign and domestic prices are fixed at 1 (P = P
∗ = 1). This implies that the real
exchange rate is equal to the nominal exchange rate ( = E). Furthermore, assume that the
expected nominal exchange rate is equal to the foreign rate of return (Ee = 1+i
∗
). Finally, assume
that the domestic money supply is equal to one (MS = 1).
Consumption:
C = 2 + 0.75YD
Investment:
I = 0.2Y − 0.25i
Government expenditure:
G = 2
Taxes:
T = 4
Exports:
X = 0.75Y
∗ − 0.2
Imports:
Im = 0.75Y + 0.25
Money demand:
Md
P
= Y − i
1. Using the uncovered interest parity condition, write the nominal exchange rate as a function
of the domestic interest rate.
2. Using the LM relationship and the uncovered interest parity condition above, express the
nominal exchange rate as a function of domestic output.
3. Using your answers above, solve for the equilibrium domestic output. Show your work.
[HINT: this will be a number.]
4. Solve for the equilibrium domestic interest rate and the equilibrium exchange rate. Show
your work.
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