International Monetary Econ

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6. In the second-generation model of exchange rate crises, assume that the benefit of maintaining an
exchange rate peg is equal to 4% (measured in output gap terms). Examine each of the following cases,
assuming the economy experiences a recession. For each case, illustrate the IS‒LM‒FX model and
determine whether the country will (1) peg, (2) float, or (3) peg or float, depending on the peg’s credibility.
On your diagrams, indicate relevant shifts in the curves.

1) If the country defends the exchange rate peg, the output gap is equal to 5%. If the peg is not
credible, the output gap is equal to 8.5%. Will investors view the peg as credible in this case?

2) If the country defends the exchange rate peg, the output gap is equal to 1%. If the peg is not
credible, the output gap is equal to 1.5%. Will investors view the peg as credible in this case?

3) If the country defends the exchange rate peg, the output gap is equal to 3.5%. If the peg is not
credible, the output gap is equal to 5.5%. Will investors view the peg as credible in this case?

4) Illustrate the previous three cases using a diagram. In which case do multiple equilibria arise, and
why? Why don’t investor expectations affect outcomes in the other two cases?

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