The question addresses the short run effects of financial shocks and policy responses on the overall economic performance of a small open economy that initially runs a current account deficit. They refer to a length of run over which the productive capital stock is fixed, determined by previous investment. New investment creates expenditure on current GDP but does yet not affect current production capacity. External factor income flows net out at zero. All require diagrams that represent the domestic financial capital market and the market for foreign exchange, interlinked by the balance of payments (BoP = CA + KA = 0), and the money market, interlinked in turn with the financial capital market by the interest rate. Unless otherwise stated, assume there is no expected inflation (e = 0, so the nominal and real yields on long assets are equal, i = r), and assume at the outset that all markets clear, including the labour market, and hence the nominal wage, W, is flexible. Revise these assumptions only when instructed.

A small Asian economy runs a current account deficit and it is subjected to a capital flight. Its central bank has abandoned its fixed exchange rate regime. Initially, assume its labour market clears, retaining full employment. The central bank fully offsets the financial outflow by running down official foreign reserves (R) sufficiently to prevent the home interest rate from rising.

a) Use diagrams to illustrate the effects of this shock and its policy response on overall economic performance.

b) Use a sketch of the balance sheet of the central bank to aid in your use of the diagrams to assess the effects on the nominal money supply, MS, the price level, PY, and the nominal exchange rate, E. Briefly explain your results.

c) Use your sketch of the central bank's balance sheet to briefly discuss how it can "sterilize" the R to avoid any unattractive consequences for overall economic performance.