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perfect capital mobility

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Consider a group of open economies; assume perfect capital mobility;
(a) Assume there is a Leader country. All other countries (referred to as the Follower countries) fix their exchange rates vis-à -vis the Leader country. Discuss the effectiveness of monetary policy in the Follower countries.
(b) If the Leader country reduces its money supply to fight inflation, what must the Follower countries do to maintain their fixed exchange rate? What is the effect on their economy? What would happen in the Follower countries if they did not change their money supply?

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(a) Assume there is a Leader country. All other countries (referred to as the Follower countries) fix their exchange rates vis-à -vis the Leader country. Discuss the effectiveness of monetary policy in the Follower countries.

Expansionary monetary policy in a follower country with pegged exchange rate regime has no effect in the exchange rate and output. The increase in M would lead to lower interest rates and, therefore, a more depreciated currency and higher output. However, the ...

Solution Summary

Expansionary monetary policy in a follower country with pegged exchange rate regime is examined.

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IS-LM-BP

Consider the IS-LM-BP model of an open economy with sticky price levels in local currency, perfect asset substitutability, perfect capital mobility and static expectations. The economy is in both internal and external equilibrium initially.

(a) Explain why the BP curve is a horizontal line at i = i*, where i is the domestic nominal interest rate and i* is the foreign nominal interest rate.

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(c) Suppose now that the domestic government reduces its money supply, M.

i. What are the initial effects of this monetary policy on the goods market, the money market, the foreign exchange market and the balance of payments of the domestic economy? Which curve(s) will shift?

ii. What is the adjustment mechanism under a fixed exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.

iii. What is the adjustment mechanism under a flexible exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then
compare the new equilibrium with the initial equilibrium.

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