Consider the policy assignment problem for a country with flexible exchange rates. In this case, the policy instruments become government spending (G) and interest rates (i).
a. In a diagram, derive the internal balance (IB) and external balance (EB) curves (with G on the horizontal axis and i on the vertical) and show why each has the slope that it does. Assuming that the EB curve is steeper (it is!) identify the two regions where policy directions are consistent and the two where they aren’t.
b. How would you solve the assignment problem? Why did you make this choice?
c. Using your solution show how an economy escapes from an initial situation of recession and CAB deficit. What would happen if you reversed the assignment?