The paper needs to be answered showing all necessary diagrams and calculations. Further instructions are on the paper.
Suppose the world consists of only one pair of open economies, country A and country B, and these countries only trade with each other. Country A only produces food whose output is measured in standard units, where one unit of YA is equal to 1,000 kilograms of food. Country B only produces clothing in standard units, where one unit of YB is equal to 100 kilograms of clothing. The table below provides some selected information about the economies of these countries. Keep your answers to at least4 decimal places.
Production function: YA = 3xK0.50L0.50
Capital stock: K = 1000
Labour supply: L = 1000
Production function: YB = K0.50L0.50
Capital stock: K = 900
Labour supply: L = 900
Consumption function: C = 500 + 0.70(Y-T)
Consumption function: C = 150 + 0.65(Y-T)
Investment function: I = 400 – 25r
Investment function: I = 200 – 50r
Gov’t sector: G = 500 & T = 501
Gov’t sector: G = 110 & T = 110
Net export function: NX = 850 – 925ε
Real money demand = = 0.65Y – 200r
Nominal price level = 1.2
Real money demand = = 0.9Y – 200r
Nominal price level = 1.04
Use the long-run classical model of an open economy to answer the following questions. Both countries have perfect financial capital mobility and no risk premium.
Hint: Since there are only two open economies, both are large open economies.
a) Determine the long-run equilibrium level of food and clothing production. (4 points)
b) Suppose absolute purchasing power parity holds for these countries. For each country, determine the long-run equilibrium levels of:
The trade balance;
The domestic nominal money supply;
The real exchange rate (in the usual orientation # of foreign per domestic, εFC/DC);
The nominal exchange rate (in the usual orientation of # of foreign currency per domestic currency);
The domestic real rate of interest (in percentage points, so if r = 3, this is interpreted as 3%);
The real wage rate of labour and real rental rate of capital;
The unemployment rate; and
Output per worker.
Support your answer with one set of diagrams, one for the (Country A) loanable funds market and one for the (Country A) foreign exchange market. Which country has a better standard of living? (11 points)
c) Suppose the government of country A decides to it would like to move to balanced trade by altering the level of government spending on goods & services. Is this possible? If so, redo parts (a) and (b). Explain in words which country has a better standard of living & why. (15 points)
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