Question

Y = 5,000

C = 1,000 + 0.3(Y - T)

I = 1,500 - 50r

T = 1,000

G = 1,500

where Y is total income (GDP), G is government spending, C is aggregate consumption, I is the investment function, T is government taxes and r is the real interest rates in percent.

b. Jupiter Island is a small open economy (with perfect capital mobility) in the world economy described above, though not involved in the technological innovation. Use the classical model of a small open economy to show and explain the predicted long-run effects of a technological innovation abroad on Jupiter Island's interest rates, investment, exchange rate and trade balance.

Answer 1

Since Jupiter is small economy open country with no technological innovation, hence its exports become less popular and its domestic saving Y-C-G remains unchanged.

Since we assume Y is determined by capital and labor, and consumption will only depend on disposable income.

Secondly government spending is fixed exogenous variable, also investment will not change since its small open economy and is dependent on world interest rate.

Now since neither if savings nor of investment change, the Net exports also called as S-I doesnot change.

Thus decreased popularity of economy will cause exports curve to shift inwards slightly. Net exports however remain same but real exchange rate depreciates. This depreciation of currency gives boost to net exports by making goods cheaper therefafter and as results trade balance remains same.