Explain the assumptions that you have made in deriving your answer.

Question 1(a) Critically evaluate the following statement:

“All foreign borrowing will increase a nation’s net foreign debt” (4 marks)

(b) Whether a current account surplus must be offset by a financial account deficit depends on whether the nation has a fixed or flexible exchange rate regime. Explain. (4 marks)

(c) If an Australian resident buys a newly issued share of stock in the U.K. oil giant British Petroleum (BP), how will this be recorded in Australia’s balance of payments? (2 marks)

Question 2

Utilising the intertemporal model, illustrate and explain how the following shocks will influence the current account of a small economy. Assume the economy initially experiences a current account surplus.

(a) An increase in the world interest rate (2 marks)

(b) A temporary increase in current income (2 marks)

(c) An expected reduction in the price of exports. (4 marks)

(d) An increase in the preference for current, as compared to future, consumption. (2 marks)

Question 3

(a) Assume the one period rate of interest on domestic government securities is 5% and the rate of interest on foreign one year government securities is 5.5% with the current exchange rate being 1.45A$/US$.

(i) What are the one period forward exchange rate and the expected percentage change in the exchange rate over the period? Explain the assumptions that you have made in deriving your answer. (4 marks)

(ii) What would you conclude about domestic and foreign expected inflation rates over the period? Justify your answer. (2 marks)

(b) Compare how a reduction in the domestic nominal rate of interest will influence the exchange rate in the short run under the monetary model and sticky price model. (4 marks)

Question 4

Making use of appropriate diagrams, compare the impact of a reduction in the value of the domestic currency on the trade balance of a small economy below full employment under the elasticities and absorption approaches. (10 marks)

Question 5

(a) Assume an economy is in internal balance but not external balance. Externally, it is experiencing a current account surplus. Also assume that the IB schedule is flatter than the EB schedule. Explain how and why an attempt to restore external balance will disrupt internal balance and what policy would be used to restore external balance. (4 marks)

(b) Assume an economy is in external balance but not internal balance. Internally, it is experiencing inflation.Also assume that the IB schedule is steeper than the EB schedule. Explain how and why an attempt to restore internal balance will disrupt external balance and what policy would be used to restore internal balance. (4 marks)

(c) Critically comment on the following statement.

“The internal balance schedule is downward sloping as an increase in the real exchange rate causes a decrease in the level of government expenditure.” (2 marks)

Question 6

With reference to IS LM BP analysis for a small economy, answer the following questions and provide the required explanation:

(a) Assuming perfect capital mobility, examine the effect that an increase in the level of government spending has for the domestic economy. Consider both the case of a fixed and flexible exchange rate. (5 marks)

(b) Assuming zero capital mobility, examine the effect that an increase in the money supply has for the domestic economy. Consider both the case of a fixed and flexible exchange rate. (5 marks)

Question 7

(a) “A floating exchange rate can insulate a country from foreign trade disturbances, while a fixed exchange rate can insulate a country from internal monetary disturbances.” Explain.

(4 marks)

(b) “If an economy is experiencing a tendency towards a Balance of Payments deficit its real exchange rate will have to increase”. Compare and contrast the way that this is brought about under a fixed and a flexible exchange rate regime. (4 marks)

(c) Why could a system of flexible exchange rates be inflationary? (2 marks)