Consider a world economy consisting of Home(H) and Foreign (F). Each of these countries produces a single good that is both consumed domestically and exported. Let Foreign output be the numeraire and let p be the relative price of the H produced good. Assume full employment in both countries, so that H produces a fixed output Y and F produces a fixed output Y ∗
. Let E be the Home expenditure in terms of its own good and let E ∗
be the Foreign expenditure measured in terms of the foreign good. We will treat E as a parameter of the model, while E ∗
is endogenous. Assume that consumers have Cobb-Douglas utility functions with fixed expenditure shares. Let α be the share of expenditure of Home consumers on the Foreign produced good and let α ∗
be the share of expenditure of Foreign consumers on the Home produced good. Assume further 1−α>α ∗
(i.e., the expenditure share of Home consumers on the Home produced good is greater than the expenditure share of Foreign consumers on the Home produced good). World income equals world expenditure, and goods markets clear. Now, suppose E falls. (a) What will happen to p ? (b) What will happen to the trade balance of Home, denominated in units of the Foreign good (i.e., to p(Y−E) )?