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 fixed exchange rate and defends it using official intervention. The country does not sterilize. An exogenous shock now occurs—foreign demand for the country’s exports increases.
a. What is the slope of the country’s FE curve?
b. What shifts occur in the IS, LM, or FE curves because of the increase in foreign demand for the country’s exports?
c. What intervention is necessary to defend the fixed exchange rate?
d. As a result of the intervention, how does the country adjust back to external balance? Illustrate this using an IS-LM-FE graph. What is the effect of all of this on the country’s internal balance?