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.

An economy is subjected to a pessimism shock that takes the form of a fall in the expected, risk adjusted, net rate of return on installed capital, rc e and a fall in expected future income, Ye. Its central bank targets the price level, PY.

a) Explain why a nominal monetary expansion required.

b) Then imagine that the central bank increases the monetary base, MB, but pessimism in households causes more cash to be held in hand and in financial institutions induces them to hold more money in reserve, the two effects being sufficient to prevent any change in the nominal money supply (the "pushing on a piece of string" case). Under these circumstances discuss the effects of the shock on employment and output when the nominal wage is rigid in the short run.

c) Given that the expansion is not possible via conventional monetary policy, briefly discuss the alternatives facing the government and the central bank.

d) If the central bank adopts UMP, use diagrams like those in Q3, above, to illustrate the effects of the resulting monetary expansion and discuss the conditions under which this will result in an expansion in employment and GDP.