Question

Question 1 Political Instability Small open economy with floating and fixed exchange rates

Suppose that the Thailand adopts floating exchange rate regime. Assume that, political instability in Thailand increases its risk premium (interest rate differentials).

a. Use the Mundell-Fleming model to graphically illustrate the short-run impact on the exchange rate and level of output of this increased country risk. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new short-run equilibrium values.

b. What happens to real interest rates, investment, IS curve, real output, employment, etc, in Thailand?

c. Would you recommend any policy for the government of Thailand in order to minimize the consequences of this crisis? Why or why not?

Now suppose that the exchange rate is fixed by the Central Bank and political instability in Thailand increases its risk premium (interest rate differentials).

d. Use the Mundell-Fleming model to graphically illustrate the short-run impact on the exchange rate and level of output of this increased country risk. Be sure to label: i. the axes; ii. the curves; iii. the initial equilibrium values; iv. the direction the curves shift; and v. the new short-run equilibrium values.

e. What happens to real interest rates, investment, IS curve, real output, employment, etc, in Thailand?

f. What does Thailand’s government have to do to keep the exchange rate at the fixed level? Is this sustainable? What are the consequences of this policy?

g. Suppose that the system collapses and there is a major devaluation of Thailand’s currency. Describe the consequences on the Thailand’s economy of this devaluation h. Which policy would you suggest to the government of Thailand in order to minimize the consequences of this crisis? Explain.

Answer 1