Consider a small open economy that maintains a fixed exchange rate. Explain what
ID: 1191366 • Letter: C
Question
Consider a small open economy that maintains a fixed exchange rate. Explain what effects a reduction in the interest rate that prevails in world financial markets would have on each of the following domestic variables after the economy has adjusted to a new equilibrium: a. Real GDP b. The domestic interest rate. c. The central bank's stock of foreign exchange reserves d. The real exchange rate e. The current and nonreserve financial accounts of the balance of payments Consider a small open economy that maintains a fixed exchange rate. Explain what effects a reduction in the interest rate that prevails in world financial markets would have on each of the following domestic variables after the economy has adjusted to a new equilibrium: a. Real GDP b. The domestic interest rate. c. The central bank's stock of foreign exchange reserves d. The real exchange rate e. The current and nonreserve financial accounts of the balance of payments a. Real GDP b. The domestic interest rate. c. The central bank's stock of foreign exchange reserves d. The real exchange rate e. The current and nonreserve financial accounts of the balance of paymentsExplanation / Answer
The exchange rate is the price of foreign currency in terms of home currency. The international trade between two countries allows exchange of goods and services. This exchange between two countries involves the exchange of paper money or currency. To conduct the trade one trading partner need the currency of other. The exchange rate determines how much home currency will need to purchase a basket of good that is priced as one unit of foreign currency.
The current account measures all the exports and imports in merchandise goods and services, investment income and unilateral transfers. The capital accounts measures the loans to and from foreigners and investment of domestic consumers abroad. The official reserve is the transaction of official reserve to maintain the pegged exchange rate regime. Under flexible exchange rate the official reserve is zero.
There are two ypes of exchange rate ragime a country can follow: fixed or pegged and flexible exchange rate ragime. Under fixed exchange rate ragime, the value of the country's currency remains fixed against another currecy, or a basket of currency, or any valuable metarial such as gold.
The currencies are bought and sold in the foreign exchange market. The equilibrium price of foreign currency is determined through the demand and supply of home currency in the exchange market. If the price of the foreign currency relative to home currency rises, that is now it needed more of the home currency to purchase one unit of foreign currency, the home currency depreciates. On the other hand, if the price of the foreign currency relative to home currency falls, that is now it needed less of the home currency to purchase one unit of foreign currency, the home currency appreciates.
Under perfect capital mobility the capital is free to move between country. The supply of capital is unlimited at the world inerest rate. An decrease in world interest rate will move capital from home country to the world market. There will be increase in capita inflow to home market. The capital inflow will appriciate domestic exchane rate. Therefore, there will be excess demand of domestic currency in the exchange market. The central bank to keep the exchange rate fixed will buy some foreign currency and sell domestic currency. This will increase the foreign exchange reserve held by the cental bank. The increase in money supply will increase the LM curve. This will decrease the domestic interest rate to be equated with world's interest rate and increase real GDP given the IS curve.
Therefore, a reduction in the interest rate that prevails in world financial markets would have following effects on each of the following domestic variables after the economy has adjusted to a new equilibrium:
a. Real GDP will increase.
b. The domestic interest rate will decrease.
c. The central bank's stock of foreign exchange reserves will increase.
d. The real exchange rate is fixed.
e. The current account will decrease and nonreserve financial accounts of the balance of payments will increase.