A small open economy runs a current account deficit. Its central bank maintains a floating exchange rate regime. Initially, at least, the money supply is adjusted to target the GDP price, P_Y. New information induces pessimism on the part of households about their future income and on the part of investors about the future rate of return on capital. Both now anticipate future deflation.

a) Assuming, initially, that the labour market clears, explain with the help of diagrams the effects of this shock on the performance of financial markets (long maturity asset prices and yields).

b) Further explain the likely changes to the country's current account, as well as to its real and nominal exchange rates. Then explain whether the central bank must engineer a monetary expansion or contraction.

c) Now pessimism in households and firms induces them to hold more cash in hand and corresponding pessimism in financial institutions induces them to hold more money on reserve. Use the concept of the money multiplier to discuss the further implications for the required monetary adjustment.

d) A point is reached where the short interest rate is at its zero lower bound, leading (initially at least) to rigidity of the money supply, MS. Briefly discuss the effects of the shock on financial market performance, employment and output when the nominal wage is rigid in the short run.