Small Open Economy
12. Consider a small open economy with fixed prices and wages. Consumption de- mand depends positively on disposable income and investment demand depends negatively on the domestic interest rate i. Government spending and taxes are exogenous. Net exports NX are negatively related to income Y and the nominal exchange rate E, where E is the foreign price of domestic currency. The demand for money M"/P = L(Y, /) is positively related to income Y and nega- tively related to the interest rate /. Capital mobility is perfect, and balance of pay- ments equilibrium requires / = /", where /" is the foreign interest rate. Throughout this question, assume the government's policy is to fix the exchange rate. Initially. the current account is in balance. Suppose there is a decline in demand for the country's exports owing to a reces- sion in the world economy. (a) [6 marks] Illustrate the effects of this shock using the IS-LM-BP diagram. What foreign exchange market intervention is required to support the fixed exchange rate, and what are the consequences for the domestic economy? Once a point of internal and external equilibrium is reached, explain why the country will run a current-account deficit. (b) [2 marks] Once the point of equilibrium is reached in part (a), is it necessary to have an ongoing foreign-exchange intervention? Explain the implications for the feasibility or infeasibility of maintaining the fixed exchange rate. Now suppose that capital flows depend on the difference between the domes- tic interest rate / and the expected return on foreign bonds adjusted for expected changes in the exchange rate, that is, i" -(AE/E), where AE denotes the expected change in the nominal exchange rate. Capital mobility is perfect, so the BP line remains horizontal, but now has height i" - (AE/E). In external equilibrium, un- covered interest parity (UIP) holds: i = i" - (AE/E). (c) [2 marks] Explain the rationale behind the uncovered interest parity equation. (d) [4 marks] Suppose participants in the foreign exchange market lose confidence that the government will maintain the fixed exchange rate and come to expect the exchange rate will depreciate. What are the effects of this in the IS-LM-BP diagram? What action does the government need to take to maintain the fixed exchange rate? (e) [2 marks] Imagine the government cares not only about the exchange rate, but also about the level of national income. Could the loss of confidence in the fixed exchange rate be rational? Explain. In light of the difficulties of maintaining the fixed exchange rate, the government decides to impose capital controls that block all capital inflows and outflows. The BP line now represents the points in the diagram where CA = 0. (1) [4 marks] After the export demand shock, analyse whether the government can use capital controls both to maintain the fixed exchange rate and to avoid a recession without running out of foreign exchange reserves
