10. You may have seen the term “capital flight” in news articles about developing countries. Capital flight occurs when foreign investors, often spooked by political instability, lose confidence in a country’s assets and decide to sell them. This phenomenon is particularly concerning to the many developing countries that rely on foreign direct investment, which we discussed in Chapter 14.

a. Using Exhibit 15.13, show how capital flight—a reduction of demand for a country’s assets at every interest rate—would affect the real exchange rate.

Assume that the domestic credit market (panel (a))

doesn’t change, so that the real interest rate is held fixed (for example, the capital flight is caused by political instability). Explain why capital flight is represented by a rightward shift of the curve in panel (b). Then explain how this rightward shift in panel

(b) coincides with a movement along the curve in panel

(c) and, therefore, a fall in the real exchange rate.

b. Suppose the local government maintains a fixed exchange rate by changing the domestic interest rate.

Faced with capital flight, how would the government need to change the interest rate to maintain its exchange rate? Explain using the charts from part (a)

of this problem.