Question 2

2. Due to the high political uncertainty in the United States during the Trump Presidency, many investors saw the developing world as safe haven for investment, moving their funds out of the United States. However, with the recent election of Joe Biden who has promised to stabilize the U.S. economy and reduce political uncertainty, some economists are arguing that there will be a massive outflow of capital from the developing world back to the United States. A. Explain, with the help of appropriate diagrams, how such capital flow reversals will affect output and the real exchange rate in Utopia, a representative developing country with strong trade and investment ties with the United States. Assume that the flow of capital out of Utopia is partially driven by worsening political uncertainty in Utopia. (5 points) B. Suppose the Utopian Government has a fixed exchange rate regime in place, maintained by appropriately manipulating the domestic interest rate. Given the improved political outlook in the United States and the threat of capital flowing back to the United States, how should the Utopian Government adjust domestic interest rates to maintain stability in the value of the domestic currency? Explain, using appropriate diagrams. (5 points) C. Given your answer in part B, what should the monetary policy stance in the U.S. be, if the objective is to boost output and employment in the U.S. in the short run? Explain how this policy would be successful, assuming U.S. investors see Utopia as the only alternative investment destination other than the domestic economy. (5 points)