These questions address the short run effects of financial shocks and policy responses on the overall economic performance of an 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 questions 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 real long maturity yield, r. Unless otherwise stated, assume there is no expected inflation (^e = 0, so the nominal and real long maturity yields are equal, i = r), and assume at the outset that all markets clear, including the labour market, and hence that the nominal wage, W, is flexible. Revise these assumptions only when instructed.

An economy runs a current account surplus.There is full employment and a flexible nominal wage, so its GDP is fully determined in the clearing labour market in the short run. A previous period of export driven expansion has encouraged financial capital inflow, both of which have caused its real exchange rate to appreciate. To control any unattractive domestic implications of this, the country's central bank, which targets the nominal money supply, M_S, wishes to contract it.

1. Define the real exchange rate in terms of the price level and the nominal exchange rate, taking care to list the units of each variable. Then, without using more than your definition in support, briefly explain why an export expansion that raises the terms of trade, combined with a capital inflow, might appreciate the real exchange rate and why this would have caused the central bank to consider monetary contraction.