1.

Explain what will be the qualitative effect of the following events for the external
balance of a country.
a. Large deposits of uranium discovered in the country.
Capital flows due to external investments would occur, and imbalances in the current
account would be generated, leading to large deficits.

b. The world price of the main export good (copper) rises permanently.
In principle this would generate a surplus in the current account, however, the cost of copper
mining must not exceed the benefits in order to maintain this surplus.

c. The world price of the main export good (copper) rises temporarily.
A current account surplus is generated.

d. There is temporary increase of the world price of oil (the country is an exporter).
A surplus is generated in the current account of the exporting country taking into account the
costs of the investment, as these cannot exceed the benefits, and on the other hand a deficit
is generated in the importing country.

2. Suppose that the central bank of a small country with a fixed exchange rate is faced
by a rise in the world interest rate R*. What is the effect on its foreign reserve
holdings? What is the effect on its money supply? Can those effects be offset through
domestic open-market operations?

This means that the demand for the domestic currency decreases, and its value falls in the
foreign exchange market. As a result, the central bank's foreign reserve holdings will
decrease, as it needs to sell more of its currency to maintain the fixed exchange
This country will retain less foreign reserves on high interest rates, and due to this increase
in interest rates there will be a massive outflow of capital. Also its money supply will be
reduced and therefore the central bank will buy bonds and due to this there will be a
reduction in foreign central banks, as foreign exchange reserves and other assets are
converted into bonds.

3. How does fiscal expansion affect the current account under a fixed exchange rate?

Fiscal expansion under a fixed exchange rate tends to initially lead to increased imports and
a deterioration of the current account. Initially, higher government spending boosts
aggregate demand, which can lead to higher consumption and increased imports.The
central bank's intervention may mitigate this effect, but if the government spending increase
is sustained, the current account is likely to face a deficit. Additionally, the central bank's
intervention to maintain the fixed exchange rate can mitigate the initial rise in interest rates
and help stabilize the economy, but if the increase in government spending is sustained, the
current account is likely to experience a deficit. Furthermore, the central bank’s intervention
may result in a depletion of foreign exchange reserves and could create upward pressure on
interest rates over time, as the money supply increases.
4. Suppose a country with floating exchange rates has a current account deficit that
its government considers too large. Explain how fiscal policy could be used to reduce
the current account deficit. Does this action help or hinder its goal of maintaining low
unemployment?

To address a current account deficit in a floating exchange rate system, a government can
implement contractionary fiscal policy, which involves reducing government spending, cutting
transfer payments, or increasing taxes. According to Paul Krugman's International
Economics, this policy leads to a decrease in aggregate demand, shifting the DD curve
leftward.
As aggregate demand falls, GNP decreases, which results in lower income levels and,
subsequently, a reduction in imports. This is crucial because a decline in imports can help
improve the current account balance. Additionally, with lower demand for money, interest
rates typically fall, leading to a depreciation of the domestic currency. A weaker currency
makes exports more competitive internationally, further aiding in the reduction of the current
account deficit.
However, the effects of contractionary fiscal policy come with trade-offs. While it can
effectively reduce the current account deficit, it often leads to higher unemployment, as we
commented in class. As government spending decreases and aggregate demand contracts,
firms may cut back on production and lay off workers, resulting in rising unemployment rates.
Thus, while contractionary fiscal policy can be a tool to improve the current account balance,
it can hinder the goal of maintaining low unemployment.

5. Explain why capital flight, spurred by the expectation of a currency devaluation,

can be a self-fulfilling prophecy. If an expected currency devaluation inspires capital
flight, explain what might happen if investors expect a currency revaluation.

Capital flight can become a self-fulfilling prophecy when investors anticipate a currency
devaluation. When investors expect a devaluation, they rush to sell domestic assets for
foreign assets, increasing demand for foreign currency. This behavior pressures the
domestic currency, leading to actual devaluation, especially if the central bank is depleting its
reserves to maintain a fixed exchange rate.

Conversely, if investors anticipate a currency revaluation—due to positive economic

signals—they will increase demand for domestic assets, leading to capital inflows and
currency appreciation. This shift can bolster the country’s foreign reserves, alleviating
concerns about a balance of payments crisis. Thus, investor sentiment plays a crucial role in
influencing exchange rate dynamics, potentially triggering or mitigating crises.