Please answer each question True, False, or neither and explain the reasons for
ID: 1212336 • Letter: P
Question
Please answer each question True, False, or neither and explain the reasons for your answers. Use graphs and/or equations in your explanations whenever possible.
Assume that a country has been running a current account deficit. A sudden stop in capital flows under a fixed exchange rate requires an end to the current account deficit and creates a recession. [AA-DD-XX curves for extended model with initial current account deficit. Write the equation for interest rate parity including a risk premium]
Explanation / Answer
A current account deficit is financed by capital inflows from surplus countries, resulting in a surplus representing inward foreign investment. It’s all good — as long as investors don’t lose their nerve. When they do, there is a “sudden stop” in capital inflows and the current account is forced into balance. In a fixed exchange rate or common currency system this causes a wrenching economic adjustment: in a (potentially) floating rate system it causes a disastrous depreciation of the currency, which the central bank may be unable to arrest. Both can be accompanied by debt default.