Question

short answers

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)

Domestic inflation is positive, foreign inflation is zero. Rise in inflation implies that export of country has become less competitive. Less competitive export would bring down export earnings and further it will depreciate currency value. Now depreciation of currency value must be countered to keep exchange rate fixed.

Real Exchange rate = Nominal Exchange rate ( Price in Foreign Country / Price in Domestic Country)

Real exchange of country would fall. Keeping exchange rate fixed, government would release foreign currency in open market or in other words, it will sell foreign exchange in open market. In this way, supply of foreign exchange shall increase and domestic currency supply would be mopped up.