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ECON 521: OPEN ECONOMY MACROECONOMICS

FALL 2015

MARK MOORE

PROBLEM SET 5 SOLUTIONS

DUE: MONDAY, NOVEMBER 30, 2015, IN CLASS

1. Sudden Stops/Debt Crises

a. Consider an SOE with a fixed exchange rate. Suppose there is a sudden stop in capital inflows, modeled here as an increase in the risk premium on domestic assets. Show the effect in an IS-LM-UIP model.

SOLUTION: UIP shifts right, so the currency tends to depreciate at the current interest rate. The central bank must defend the fixed exchange rate by buying domestic currency and losing FOREX. The money supply falls, and LM shifts up until the interest rate reaches the point on the new UIP curve consistent with the fixed exchange rate. Output falls.

b. Consider an SOE (small only to ignore the effects on the world interest rate) with a flexible exchange rate (and able to borrow in its own currency). Suppose initially is below the natural level and the economy is at the zero lower bound. Consider a sudden stop (in this case a selling of domestic government debt), again modeled as an increase in the risk premium on domestic assets.

i. Show the effect on the economy in an IS-LM-UIP model.

SOLUTION: Let p be the risk premium. UIP is E=Ee(1+i*+p)/(1+i). An increase in the risk premium tends to create a depreciation of the currency (E increases), which, given fixed prices, creates a real depreciation and increases the current account. The IS curve shifts right and output increases.

ii. In these circumstances, is it reasonable to expect the that central bank would be willing to buy

domestic bonds to forestall a crisis? How does this expectation affect the likelihood of a debt crisis?

SOLUTION: Yes, with low output and the economy constrained by low output, there’s no reason for the central bank to be worried about inflation. It’s reasonable to expect that the central bank would buy domestic bonds in the event of panic selling of them. Thus, there’s not reason to panic...