For each part of the question, support your answer by one demand-supply diagram
ID: 1173752 • Letter: F
Question
For each part of the question, support your answer by one demand-supply diagram for DC. Each sub-part of the question is not related to the other part. a) Recently, both Home and Foreign engage in a trade war. Home imposes tariffs on aluminum and steel from Foreign while Foreign imposes tariffs on agricultural products from Home. What happens to the country’s exchange rate, financial account, and current account? Explain (and assume capital account is always equal to zero). (No need to discuss the BOP adjustment process). (10 points) Note: The countries adopt flexible exchange rates. b) The country adopted a fixed exchange rate and its current account and financial accounts are in balanced. Suppose there are rumours that the government might default on its debt in the future; as a result the risk of holding domestic assets increases. What happens to the country’s official reserves? Explain. (10 points)
Explanation / Answer
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Answer-
a) As per the question both home and foreign countries are engaged in a trade war and because of this there are restrictions imposed on import and export of certain goods.Home imposes tariffs on aluminium and steel from Foreign while Foreign imposes tariffs on agricultural products from Home. Because of this there will be no impact on the exchange rate because the exchange rate can only be impacted by government policies, monetary policies and the base rate exchange system. However there will be change in the financial account there are reduced Exports and the home country will have to import more at a higher price which will increase its cost and reduce its profit. The current account will be impacted negatively as the fiscal deficit will increase by decrease in exports and rise in imports.
b)The country adopted a fixed exchange rate and its current account and financial accounts are in balanced. Suppose there are rumours that the government might default on its debt in the future; as a result the risk of holding domestic assets increases. Because there is a rumour that the country may default on its obligations most of the foreign investors will try to withdraw their investments from the country and they will withdraw in form of foreign exchange thereby reducing foreign currency in the country. And due to reduction in foreign, the reserves of the country will be depleted because of the conversion factor.
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