Economics question 4

H. Impact of an exogenous shock - fixed exchange rates A small country, Alpenstein prohibits international financial capital flows, so FA=0. Alpenstein has a fixed exchange rate regime and defends it through official intervention; it does not sterilize. An exogenous shock occurs: Alpenstein's large trade partner falls into a recession and cuts its demand for Alpenstein's goods a. Add the BP curve to the graph below - what is the slope of the BP curve? Does the BP curve depend on the interest rate anymore? Yes or no LM IS Y b. Give the equation for the Y-intercept of the BP curve as Y= (use the fact that the BP curve is reduced to CA = 0 when FA = 0). Does this intercept change when exogenous export changes? Yes or no Show on your graph what happens to the BP curve as a result. c. what intervention, if any, is necessary to keep the exchange rate fixed. d. What is the effect of the exogenous shock on the IS curve? (explain) What is the effect on the level of income? Increase or decrease Give the equation for the old level of income and the new level of income in terms of the current account. e. How does Alpenstein adjust back to external balance? Show all the shifts, if any, on the IS-LM-BP graph above

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