An Asian economy runs a current account surplus and it is subjected to a surge in

capital inflow. Assume its labour market clears, retaining full employment. The

central bank fully offsets the financial inflow by raising official foreign reserves (R)

sufficiently to prevent any change in the long maturity yield at home.

a) Use diagrams to illustrate the effects of this shock and its policy response on

overall economic performance.

b) Use a sketch of the balance sheet of the central bank to aid in your use of the

diagrams to assess the effects on the nominal money supply, MS, the price

level, PY, and the nominal exchange rate, E. Briefly explain your results.

c) Use your sketch of the central bank's balance sheet to briefly discuss whether

unattractive consequences could arise and how the central bank can "sterilise"

the R to avoid these.