Exercise 7 Based on the economic model developed in Section 8.4:

a. Compare the behavior of the exchange rate when facing shocks on the current account when assets are perfect substitutes and when there is no substitutability whatsoever between them. Explain your answer.

b. Based on the relation of external balance (EB), presented in Section 8.4, explain how exchange rate depreciation affects the NIIP of the domestic economy. How would your answer change if the domestic economy had foreign liabilities denominated in foreign currency? Explain.

c. Consider the case where the assets are imperfect substitutes. Assuming that the economy was initially in steady-state equilibrium, what is the impact of a permanent negative shock on the terms of trade? Explain your answer. On a graph, present the old and new equilibrium, including a graph with the NIIP trajectory immediately after the shock for the case when ΛR  ðð@ΛðRe

; vÞÞ=@Re

Þ is large and for the case when ΛR is small.

d. Considering the case of assets that are imperfect substitutes in an economy initially in steady-state equilibrium, what is the impact of a permanent shock on the preferences of the domestic economy residents that leads them to increase their demand for domestic assets? Construct a graph with the NIIP trajectory and the exchange rate immediately after the shock for the case where ΛR is large and for the case where ΛR is small.