These questions address 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.

Q1:

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, rce and a fall in expected future income, Ye. Its central bank targets the price level, PY.

a) Use diagrams to illustrate the effects of this combined pessimism shock on the current account, the interest rate the real exchange rate the nominal money supply and the nominal exchange rate.

b) Infer the changes in the volumes of consumption, saving and investment within the home economy, briefly explaining your results.

c) Noting the direction of the change in the price level, explain the effects on employment and GDP if the nominal wage is fixed.

d) Retaining the rigidity of the nominal wage, briefly discuss the implications of this shock had the central bank targeted the nominal exchange rate

E, as in many Asian developing economies.

Q2:

The economy is subjected to the same pessimism shocks as in Q2, above.

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.