A country initially has achieved both external balance and internal balance.

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QUESTION:

A country initially has achieved both external balance and internal balance. The country prohibits international financial capital inflows and outflows, so its financial account (excluding official reserves transactions) is always zero because of these capital controls. The country has a floating exchange rate. An exogenous shock now occurs—foreign demand for the country’s exports increases.

a. What shifts would occur in the IS, LM, and FE curves because of the increase in foreign demand for the country’s exports if the exchange-rate value of the country’s currency were to remain unchanged?

b. What change in the exchange-rate value of the country’s currency actually occurs? Why?

c. As a result of the exchange-rate change, how does the country adjust back to external balance? Illustrate this using an IS-LM-FE graph. How does all of this affect the country’s internal balance?


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