A country initially has achieved both external balance and internal balance. International financial capital is highly but not perfectly mobile, so the country's FE curve is upward sloping and flatter than the LM curve. The country has a fixed exchange rate and defends it using official intervention. The country does not sterilize. As a result of the election of a new government, foreign investors become bullish on the country. International financial capital inflows increase dramatically and remain higher for a number of years.
a. What shift occurs in the FE curve because of the increased capital inflows?
b. What intervention is necessary to defend the fixed exchange rate?
c. As a result of the intervention, how does the country adjust back to external balance? Illustrate this using an IS-LM-FE graph. What is the effect of all of this on the country's internal balance?