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 Asian economy runs a current account surplus and it is subjected to a capital flight. Assume its labour market clears, retaining full employment. The central bank fully offsets the financial outflow by running down or reducing the rate of increase of official foreign reserves (R, orR) sufficiently to prevent any change in the long maturity yield at home. The nominal wage is rigid downward.

1. For the case in which the central bank does nothing more than sell foreign assets and use the proceeds to purchase domestic currency, use diagrams to illustrate the effects of this shock and its policy response to discuss the effects on the real and nominal exchange rates and whether the net effect is expansionary or contractionary of domestic output and employment. Use a sketch of the balance sheet of the central bank to aid in this assessment.Complement your diagrams and the balance sheet with explanatory text.