Q:Use the assets market model with imperfect substitutability to depict a sovereign debt crisis.

a. Explain and show carefully how you model (i.e. what variable is changing) to depict this crisis. What happens to the exchange rate?

b. What would happen if the central bank wants to intervene in the foreign exchange market to curb the increase in the exchange rate? Show through a diagram and explain what happens to international reserves and interest rates.

c. In practice sovereign debt crisis are associated with drops in output. Show carefully through a figure of the DD-AA model that our model fails to deliver this prediction. Explain how would you change the model to bring it closer to reality?