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 not yet affect current production capacity. External factor income flows net out at zero.

Most 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 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 if and 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.

1. 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.
2. 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) Derivethemoneymultiplierandexplaintheconditionsunderwhichitmightbe S

expected to remain constant, allowing the central bank to target M .

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.

Q2:

A small Asian economy runs a current account deficit and it is subjected to a capital flight. Its central bank has abandoned its fixed exchange rate regime. Initially, assume its labour market clears, retaining full employment. The central bank fully offsets the financial outflow by running down official foreign reserves (R) sufficiently to prevent the home long yield from rising.

1. a)Usediagramstoillustratetheeffectsofthisshockanditspolicyresponseon overall economic performance.
2. b)Use a sketch of the balance sheet of the central bank to aid in your use of the diagrams to assess the effects on the nominal money supply, MS, the price level, PY, and the nominal exchange rate, E. Briefly explain your results.
3. c)Useyoursketchofthecentralbank'sbalancesheettodiscusshowitcan "sterilize" the R to avoid any unattractive consequences for overall economic performance.
4. d)Indicate whether a monetary contraction or a monetary expansion is needed and explain why.

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Q3:

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 e

expected future income, Y . Its central bank targets the price level, PY.

1. a)Usediagramstoillustratetheeffectsofthiscombinedpessimismshockonthe current account, the interest rate the real exchange rate the nominal money supply and the nominal exchange rate.
2. b)Inferthechangesinthevolumesofconsumption,savingandinvestment within the home economy, and briefly explain why these changes occur.
3. c)Notingthedirectionofthechangeinthepricelevel,explaintheeffectson employment and GDP if the nominal wage is fixed.
4. 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.
5. e)Explain why a nominal monetary expansion is the best policy response, if it is possible to implement, and what alternative would be helpful if it is not.

Q4:

In the face of pessimism shocks, a central bank finds that conventional monetary policy is effective but insufficient because short maturity bond yields approach zero.

a) Explain, using a bond price formulation, how short maturity debt is comparatively vulnerable to negative yields and what types of shocks are needed to bring them about.

b) Discuss why it is that yields do not go negative by more than small margins. c) Explainwhatalternativesfacecentralbankswhoseshortratesarenearing

zero but who seek to further increase liquidity.

d) Use diagrams to help explain how unconventional monetary policy (or quantitative easing) can bring about an inflation, or at least, reduce contractionary deflation.

e) BrieflydiscusstheconditionsunderwhichsuchUMPcouldcauseaninflation that would expand employment and GDP.

Q5:

In a near zero-short-yield financial environment, and confronted with a pandemic, the government shuts down its entertainment services sector and enforces the shutdown by law.

1. a)Explain whether this shock arises from the supply or demand side of the economy.
2. b)Discuss the possible effects on financial markets. For example, would you expect yields and asset prices to rise or fall, and why?
3. c)Discusswhethergenericexpansionaryfiscalandmonetarypolicycouldbe effective in avoiding a subsequent recession.
4. d)Considering the zero short-yield environment, explain what types of policies would best address the economic effects of the shutdown.
5. e)If the government implements the policies you recommend, irrespective of the mix of instruments they embody, explain whether some monetary expansion might always be helpful during the shutdown and recovery period.