Problem 3. Spillovers and International Transmission of Shocks

Panama (Home) is a small open economy that pegs its exchange rate to the US (Foreign) dollar. Assume that shocks/policies of Panama have no impact on the US economy as it is a small country. We assume that investment in Panama only depends on the real interest rate2 so that when rates rise investment falls and vice versa. Formally, we can write I = I(R), I 0 (R) < 0. We will say that a shock is transmitted positively from the US to Panama, whenever outputs of the US and Panama move in the same direction in response to that particular shock. A shock is transmitted negatively if the outputs of the US and Panama move in opposite direction. Furthermore, assume that all shocks analyzed below are temporary.

(a) Using the AA-DD framework, show the effect a US monetary expansion (R ) on output, interest rates, money supply, and the exchange rate in Panama. Do US monetary shocks transmit positively or negatively to Panama?

(b) Do the same exercise but with shocks to US aggregate demand (Fiscal shocks, etc.). Do US aggregate demand shocks transmit positively or negatively to Panama?

(c) Repeat part (a) under this scenario.

(d) Repeat part (b) under this scenario.

(e) Suppose that the goal of US monetary policy is to stabilize US output: when US aggregate demand increases (declines) beyond the natural level, US monetary authority contracts(expands) the money supply. You also observe that aggregate demand shocks in the US and in Panama are correlated. In other words, when the US experiences an increase (decline) in its aggregate demand, Panama tends to experience an increase (a decline) in its aggregate demand as well. Would a pegged exchange rate regime have a stabilizing effect on Panamas output? What if aggregate demand shocks in the US and Panama are uncorrelated (either move in opposite directions or do not occur at the same time)?

(f) List the possible factors that might make the spillover effect stronger or weaker. (e.g. openness, degree of trade with the US, etc) Explain how those factors affects the above answers.