Korean won () has been following a fixed exchange rate regime against the US dollars ($) since 1965. Assume that Bank of Korea (i.e., the central bank of Korea) has been following a fixed exchange rate regime which has been 1200/$ on 29 February 2020 when Korea was already hit by COVID-19 pandemic. From 19 March 2020, 50 trillion worth of financial support package was introduced in Korea to provide financial support for small merchants and small and medium-sized enterprises (SMEs) affected by COVID-19. Thereafter, during the same month, the exchange rate suddenly jumped to 1250/$. During this period, the US was not heavily hit by COVID-19 yet (important hint: assume the domestic currency is Korean won ()).

(A) Use graphs to explain in detail (i) how the exchange rate is over- or undervalued, (ii) how the Bank of Korea can intervene in the foreign exchange markets to correct this problem, and (iii) what can happen if the Bank of Korea fails to correct this problem and why. [25%]

2. (B) Assume that the Korean government has implemented controls over the capital flows during this financial crisis. Explain in detail the advantages and disadvantages of these controls. [5%]

3. (C) Thereafter, the US was heavily hit by the COVID-19 and provided several corresponding fiscal rescue packages. Accordingly, the exchange rate on 31 December 2020 became 1085.65/$. For the interest parity condition to hold between 19 March 2020 and 31 December 2020, what should have been the theoretical US interest rate during this period (although it may have been different from the actual US interest rate)? Assume that the Korean interest rate was 0.5% throughout this period. Show all your work. [5%]