1. The World Bank is concerned about depreciating currencies in developing countries (typically SOEs). What fiscal...

1. The World Bank is concerned about depreciating currencies in developing countries (typically SOEs). What fiscal policy should the Bank advise large foreign countries (that have influence on the world market of loanable funds) to implement in order to reverse the exchange rate depreciation (want ↑e) of the SOEs? For simplicity, assume that the SOE is Mexico and that the large foreign country is the U.S.. The exchange rate e = US$/Peso. Answer the following questions.

a. According to the Mundell-Fleming model, what is the American fiscal policy that should be implemented to promote an appreciation of the Peso? What would happen to the world interest rate (r*) as a result of this policy choice? Explain carefully.

b. Would the change in r* create a net capital inflow (NCI) or a net capital outflow (NCO) for Mexico? Explain using the equation below.

CF = (Amount Mexico lends to U.S.) – (Amount U.S. lends to Mexico)

(Mexico’s holdings of U.S. assets) – (U.S.’s holdings of Mexican assets)

CF = [A] - [B]

c. Would the NCI or NCO appreciate or depreciate the Mexican US$/Peso flexible exchange rate ( e)? Explain by determining the changes in the demand and the supply of pesos on the foreign exchange market. No graph is needed.

2. Would a protectionist trade policy be effective at increasing income under a fixed exchange rate system? Explain and illustrate your answer with an IS*- LM* graph. Make sure to explain the interaction that takes place between the arbitrageurs and the central bank.

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Rahul Sunny answered 1 week ago

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