Consider a small, open economy (Honduras) with perfectly mobile capital and a fi
ID: 2495822 • Letter: C
Question
Consider a small, open economy (Honduras) with perfectly mobile capital and a fixed exchange rate. The newly-elected government hopes to improve Honduran economic performance by stimulating business investment spending there. And, the government’s adding tax incentives for businesses and easing of various rules and regulations has, in fact, caused businesses to buy more equipment and build more factories and warehouses.
Describe what happens to each of these five items and explain why:
to the Honduran exchange rate
to imports to Honduras
to exports from Honduras
to the Honduran money supply
to the Honduran capital account (KA)
to consumption
to investment
Explanation / Answer
When a country with fixed-exchange rate allows perfect capital mobility costlessly, inside and outside it, then its central bank loses independency because the central bank must intervene every time to adjust the money supply to maintain the exchange rate at predetermined level.
When business spending is stimulated, IS shifts, interest rate rises and output rises in tandem. This increase in interest rate causes capital inflows, and appreciation of the currency. Central bank intervenes, conducts open market purchases and buys bonds against domestic currency. In this way, liquidity in domestic market increases, money supply is increased, interest rate falls and exchange rate is restored, though the output increased multiple times.
The results are:
Nothing to the Honduran exchange rate (fixed)
Rise in imports to Honduras in short-run when currency appreciates
Fall in exports from Honduras in short-run when currency appreciates
Rise in the Honduran money supply when Central bank intervenes
Increase in the the Honduran capital account (KA) in the short-run when domestic interest rate rises
Rise in consumption
Rise in investment