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 that has been recessed with very low short maturity yields has embarked on a period of unconventional monetary policy (UMP), causing a significant enlargement of its central bank's balance sheet. It is now subjected to a financial optimism shock that takes the form of a rise in the expected, risk adjusted, net rate of return on installed capital, r_c^e and a rise in expected future income, Y^e. Its central bank targets the price level, P_Y.

1. Assuming no further changes in the nominal money supply, use diagrams to illustrate the effects of this combined optimism shock on the yield on long maturity instruments, the current account, the real exchange rate, and the nominal exchange rate.
2. Infer the changes in the volumes of consumption, saving and investment within the home economy, briefly explaining your results.
3. Describe any change this would require in its central bank's operations. In particular, discuss the two options the central bank would have to control the undesirable effects associated with the economic resurgence. Would the yield on short maturity assets, necessarily need to change? If so, in what direction?