Question

Short answer: Answer each of the questions in Section B. Answers should typically be no more than 2-3 sentences in length.

1. Suppose domestic inflation is positive (? > 0), foreign inflation is zero (? ? = 0), and the central bank is operating a fixed exchange rate (%?e = 0). What, if anything, will happen to the real exchange rate? Be sure to explain in words what is going on.

2. In the context of the Solow model, explain briefly how the current level of capital k affects the change in the level of capital from today to tomorrow (i.e., if k were higher, in what ways would that affect ?k). Be sure to explain all of the effects.

Answer 1

1. Real exchange rate=nominal exchange arte*(PForeign/Pdomestic). Since inlation in domestic country is positive. This mean that there will be an appreciation of domestic currency. This will lead to outflow of capital from country and thus central bank will intervene to prevent appreciation by selling foreign currency and buying domestic currency.

2. If current level of capital stock is higher then it would mean country is operating with higher level of capital then required this means it would adjust its capital at slower rate . so the change in capital tommorow would be less.