Exercise 8 Consider a small, open economy that decides to establish parity between their currency and the dollar, but where the greater part their international trade is done with Europe.

a. Consider a short-term horizon, where prices for goods do not vary. If the dollar depreciates in relation to the euro, what happens to the trade of this economy with countries that have adopted the euro as their currency?

Chapter 3 • The Foreign Exchange Market 57

b. Continuing the assumption of dollar depreciation, how should the financial account balance for this country change? What happens if international investors are not willing to invest in this country? How should their central bank act to avoid losing the parity with the dollar?

c. Assume that, even though the dollar parity remains stable, investors believe the exchange policy of this country is not credible. What monetary policy should be adopted so that exchange rate parity is maintained in face of the credibility problem? Explain the mechanism associated with you answer.