Question

Open Economy – Two Large country problem

USA Initial Conditions

C^d = 310 + 0.4(Y-T) – 200r^w
I^d = 120 – 200r^w
Y = 1000
T = 200
G =275

China Initial Conditions

C^d_F = 480 + .4(Y_F – T_F) – 300r^w
I^d_F = 255 – 300r^w
Y_F = 1500
T_F = 300
G_F = 300

a) (5 points) What is the equilibrium real interest rate that clears the international goods market? Show all work.

b) (5 points) Compare the level of absorption in each country to the income generated in each country. Is the US spending beyond its means? Is China the lender? Explain using real numbers! Draw two diagrams side by side, with the USA on the left and China country on right. Locate this initial equilibrium as points A on both diagrams (there are four point A’s, two on each diagram). Be sure to label diagrams completely labeling the trade deficit/surplus on each graph, etc. (10 points for correct and completely labeled diagram)

c) (5 points) Now let the US conduct expansionary fiscal policy so that G rises by 300 to 575. We assume that the government spending multiplier (ΔY/ΔG) is 1.5, consistent with the multiplier estimated by the White House economists. Re-calculate the new equilibrium real interest rate that clears the international goods market and the associated new levels of desired savings and investment for each country and label these new equilibrium points on your existing diagram as point B. Please show all work.

d) (5 points) What has happened to the US’s trade balance and why?

e) (5 points) Are these results consistent with the US going to AA, the proposition put forth by Fareed-Zakaria in the Colbert clip? Why or why not?  

f) (10 points) Explain what would happen to the trade balance for the US if China experiences a recession (i.e., China's output falls), all else constant. Please be specific as to what would happen to US absorption and why. Note, this discussion is worth 10 points. Feel free to support your answer with a diagram or two.

Answer 1