Question

A number of citizens in Donia, a small country, randomly decide to buy bonds from the government of Genovia, a country next to Donia. What happens to the real interest rate, real exchange rate, trade balance, NCO, and nominal exchange rate in Genovia? Use graphs in your answer.

In the future, a number of citizens in Donia randomly decide again to buy more bonds from Genovia. Now, Donia’s NCO function is extremely reactive to changes in interest rates. What happens to real interest rate, real exchange rate, trade balance, NCO, and nominal exchange rate in Donia? Use graphs in your answer.

Even farther in the future, the price-level in Donia randomly increases. What happens to the real interest rate and real exchange rate in Genovia? Explain your answer.

Answer 1

When residents of Donia buy bonds in Genovia thenmoney will go out, supply of Donian currency increases and it depreciates, demand for Genovian currency goes up and it appreciates . There is net capital outflow (NCO) from Donia and Net capital inflow in Genovia

Let us assume that Donia has Euro as a currency and Genovia has dollar. As supply of Euro shifts right then its value goes down 0.85 to 1.2

Ascurrency of Donia depreciates its products will become cheaper in world market andf exports will increase but imports will be expensive and hence imports will decrease in Donia, improving its trade balance.

Appreciating currency will decrease exports from Genovia and its imports will rise and hence its trade balance will deteriorate.

As money is going out from Donia there will be rise in interest rate in Donia to stop this.

If price levels in Donia go up then its exports will be less and imports will be more and its currency will depreciate and interest rates will go up to reduce capital outflow.