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 has full employment and a flexible nominal wage, so its GDP is fixed in the short run. Following a period of expansion, its central bank is targeting the nominal money supply, MS, and wishes to contract it.

a) Draw diagrams to represent the domestic financial capital market and the foreign exchange market, interlinked by the balance of payments (BoP = CA +KA =0), and the money market, interlinked with the financial market by the interest rate (e = 0 so i = r). Offer brief explanations as to how the diagrams are interlinked and culminate in the determination of the nominal exchange rate.

b) Sketch the balance sheet of the central bank and briefly describe how it will bring about the monetary contraction, detailing the role of the short maturity interest rate.

c) Derive the money multiplier and explain the conditions under which it might be expected to remain constant, allowing the central bank to target MS.

d) Use your market diagrams to indicate which variables are affected by the monetary contraction and, in particular, how this affects the price level, PY.

e) Explain whether this monetary contraction would be expansionary or contractionary (of employment and GDP) in the short run if the nominal wage, W, were rigid.