QUESTION 5

Economics

5. M-F fixed exchange rate problem A small country, Pecunia, under a fixed exchange rate regime reached equilibrium (IS- LM intersection) along with external balance (on the BP line). Pecunia trades a lot with the rest of the world. Pecunia's central bank does not sterilize, but it fears inflation. In addition, Pecunia only allows limited access to its capital market while its citizens need authorizations to invest abroad. The government plans to use fiscal policy (more specifically government spending) to ease the inflationary pressures on its economy. a. Spell out the policy carried out by the government. b. Use a graph slowing the IS-LM-BP to illustrate the impact of the policy - point a is the starting equilibrium. Show the shifts (if any) of the 3 curves IS-LM-BP resulting from the fiscal policy adopted. c. Break down the effect into two stages: i name the impact of the Y fiscal policy alone point b ii, name the final equilibrium point c. i. What can you say about the balance of payments at point b. ii. Compare the level of income at a, b, and c