Consider a country with a flexible exchange rate, and which initially has a current account surplus of zero. Then, suppose there is an anticipated increase in future total factor productivity.
(a) Determine the equilibrium effects on the domestic economy in the case where there are no capital controls. In particular, show that there will be a current account deficit when firms and consumers anticipate the increase in future total factor productivity.
(b) Now, suppose that the government dislikes current account deficits, and that it imposes capital controls in an attempt to reduce the current account deficit. With the anticipated increase in future total factor productivity, what will be the equilibrium effects on the economy? Do the capital controls have the desired effect on the current account deficit? Do capital controls dampen the effects of the shock to the economy on output and the exchange rate? Are capital controls sound macroeconomic policy in this context? Why or why not?