Problem:
Consider the IS-LM-BP model of an open economy with sticky price levels in local currency, perfect asset substitutability, perfect capital mobility and static expectations. The economy is in both internal and external equilibrium initially.
(a) Explain why the BP curve is a horizontal line at i = i*, where i is the domestic nominal interest rate and i* is the foreign nominal interest rate.
(b) Define respectively the internal equilibrium and external equilibrium of the economy.
(c) Suppose now that the domestic government reduces its money supply, M.
i. What are the initial effects of this monetary policy on the goods market, the money market, the foreign exchange market and the balance of payments of the domestic economy? Which curve(s) will shift?
ii. What is the adjustment mechanism under a fixed exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.
iii. What is the adjustment mechanism under a flexible exchange rate regime? Illustrate and explain which curve(s) will shift during the adjustment, and then compare the new equilibrium with the initial equilibrium.