Consider a small open economy that maintains a fixed exchange rate and is charac
ID: 1191092 • Letter: C
Question
Consider a small open economy that maintains a fixed exchange rate and is characterized by imperfect capital mobility. Suppose that it's domestic goods market is continually affected by unpredictable changes in private absorption. In such an environment, will the level of domestic real GDP tend to be the more stable if the central bank follows a policy of sterilizing of of not sterilizing capital flows in and out of the domestic economy? Explain. Consider a small open economy that maintains a fixed exchange rate and is characterized by imperfect capital mobility. Suppose that it's domestic goods market is continually affected by unpredictable changes in private absorption. In such an environment, will the level of domestic real GDP tend to be the more stable if the central bank follows a policy of sterilizing of of not sterilizing capital flows in and out of the domestic economy? Explain.Explanation / Answer
Answer,
In the case where a small open economy that maintains a fixed exchange rate and is characterized by imperfect capital mobility and is having domestic goods market which is continually affected by unpredictable changes in private absorption. In such an envioronment the level of GDP would tend to be more stable (only upto a certain extent) when the central bank of the economy follows the policy of non sterlizing capital flows in the economy. By adhering to such a policy the central bank allows for least possibility of domestic money supply being affected, thus to a certain extent countering the unpredictable changes in private absorbtion.
Keynesian economists believe that domestic demand is also a function of domestic supply, thus borrowing the argument of Keymesians and with above mentoned economic route the central bank would be able to stabilize domestic real GDP to a certain extent only. 'To a certain extent only' because not sterilzing would have consequences on external economy indicators, such a exchange rate.