Question

Assume that you have fixed exchange rates and a SOE with perfect capital mobility. Assume that you start from an external imbalance (take the case that r in the internal equilibrium is higher than what it should be). Describe the adjustment to external equilibrium.

Answer 1

Context: Fixed exchange rate, small open economy, full capital mobility

Fixed exchange rate: The central bank announces an exchange and maintains it by buying or selling of foreign currency.

Small open economy: The economy cannot influence world interest rates, it takes it as given.

Full capital mobility: If the world interest rate is higher than domestic interest rate, capital will flow out of the country to take advantage of higher returns else where. And vice versa.

Now there is internal balance but no external balance.

Internal balance: Output is equal to potential output.

External balance: Domestic interest rates are equal to world interest rates.

Here, no external balance. The domestic interest rates are higher than the world interest rates. Therefore, there is foreign exchange following into the economy as foreign investors look to invest in the domestic economy to take advantage of the higher interest rates. As a result, the demand for domestic currency increases. There are appreciationary pressures on the domestic currency. As there is fixed exchange rate in the economy, the central bank will intervene in the foreign exchange market to prevent the intervention. It does so by buying foreign exchange and selling domestic currency. This increases the net foreign assets, the size of the central bank's balance sheet increases and therefore the money supply increases.

As money supply increases, interest rates decrease. This process will continue till the domestic interest rate equals the world interest rate. Thus, external balance will be achieved.

However, this process will distort internal balance and push actual output beyond potential output.