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homework3spring2007 - Economics 302 Spring 2007 Homework#2...

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Economics 302 Spring 2007 Homework #2 Due Tuesday, March 13 Homework will be graded for content as well as neatness. Sloppy or illegible work will not receive full credit. 1. Cowtopia is a small economy in the North. It produces milk with a standard (constant returns to scale) Cobb-Douglass production function with capital share½ (this is alpha). The technology level, A, is 10; the capital stock, K, is 100, and labor, L, is 400. The households in Cowtopia have aggregate demand for milk which is a linear function of disposable income. In particular, C = 250 +.75(Y-T). The government spends 700 each year and runs an annual deficit of 200. Finally, domestic firms have aggregate investment demand I = 1000-50r; while the world interest rate is 5%. Initially, Cowtopia’s economy is closed to the outside world. a. What is the equilibrium real interest rate? Include a graph to explain the market clearing condition. Now, suppose that Cowtopia receives advice from the IMF (The International Monetary Fund) to open its economy to the outside world.
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