(a) Suppose that future total factor productivity (TFP) increases (e.g., because it is expected that a new invention will become available in the future). Which are the effects of this shock on the...

Small Open Economy Model

Consider the Small Open Economy model studied in class. Answer the following questions by assuming that the purchasing power parity (PPP) holds.

Extracted text: (a) Suppose that future total factor productivity (TFP) increases (e.g., because it is expected that a new invention will become available in the future). Which are the effects of this shock on the equilibrium values of the real interest rate and output? Use the equilibrium diagram for the current goods market to answer this question. (b) How will the composition of output be affected by the future TFP shock described in Part (a)? Show that the future TFP shock increases the current account deficit. (c) Suppose that the government of this small open economy wishes to reduce the current account deficit. To achieve that goal, the government plans to change the level of current public spending (i.e., G, using the notation we applied in class). Should the government increase or decrease current public spending? Justify your answer using a new equilibrium diagram for the current goods market. (d) the government changes public spending in order to reduce the current account deficit (as analysed in Part (c)). What would be the effects of this policy on the Assume that the country has a flexible exchange rate regime, and that nominal exchange rate and on the domestic price level? Justify your answer using the equilibrium diagram for the current money market.