Home is a small open economy with perfect (financial) capital mobility. Initially, it is in its long-run equilibrium and domestic assets and foreign assets are prefect substitutes. Recently, the United States reformed its tax system and lowered taxes. Many believe that this kind of development might have negative impacts on the Home economy and people worry that the negative impacts include the following:
Change the world interest rate (Hint: you need to figure out what happens to the world interest rate when the U.S., a large open economy, lowers taxes).
Lower both consumer and business confidence in the Home economy.
Use the long-run classical model of an open economy to evaluate the people’s concerns mentioned above on the Home country’s output, consumption, investment, net exports, real exchange rate, and price level. Explain and support your answer by ONE loanable funds market diagram and ONE foreign exchange market diagram. (15 points).
Based on your answer in part (a), is there anything the central bank (of the Home country) can to if it wants to offset the effect of the change in risk premium on the country’s real interest rate? Explain. (5 points).
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