uppose the central bank of a country is worried about the economy overheating so it enacts a contractionary monetary policy (reducing the money supply): 2A. Assuming the country has a fixed exchange, illustrate the effects of the contractionary monetary policy with both an IS-LM-BOP graph and a foreign exchange market graph for the foreign currency, explaining which curve(s) shift and why. Explain the effects on GDP, interest rates, and the current account and capital account.
2. Suppose the central bank of a country is worried about the economy overheating so it enacts a contractionary
2A. Assuming the country has a fixed exchange, illustrate the effects of the contractionary monetary policy with both an IS-LM-BOP graph and a foreign exchange market graph for the foreign currency, explaining which curve(s) shift and why. Explain the effects on
2B. What would the central bank have to do to maintain the fixed exchange rate? Illustrate this on the foreign exchange graph in 2A. (You do not need a new graph).
2C. Define sterilization and explain what the central bank would have to do to sterilize the intervention. Show on your graphs the GDP, interest rate, and exchange rate with sterilized intervention (label as point 1 on the graphs from 2A).
2D. Suppose instead the central bank does not sterilize the intervention. Explain what would happen and illustrate the effects on both the IS-LM-BOP graph and foreign exchange market graph, explaining why the curves shift and the effects on GDP, interest rates, and the current account and capital account. (You can use the same graphs but label your graphs carefully with the new point labeled as 2).
2E. Explain the Trilemma. How is the Trilemma related to your answer in 2D?
2F. What would happen if instead of intervening to hold the exchange rate fixed, the central bank allows the exchange rate to change to eliminate the disequilibrium? Illustrate the effects on both a foreign exchange graph and an IS-LM-BOP graph (use new graphs) explaining which curves shift and why. Explain what happens to the exchange rate, GDP, interest rates, and the current account and capital account.
2G. Suppose this country is Germany in the early 1990s when there was a fixed exchange rate between Germany and Britain. Explain why Germany’s contractionary monetary policy created problems for Britain, what Britain did in response, and why this contributed to Britain’s decision not to adopt the Euro as its currency. (No graph is required for this question.)
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