Macroeconomics Individual Assignment
1. Assume an economy that imports intermediate inputs and pursues a fixed exchange rate system is hit by capital flight. Carefully describe the immediate impact of capital flight on bond prices and the share price of a firm that has dollarized liabilities and cash-flows that are denominated in domestic currency. A fixed exchange rate is only sustainable if a country's central bank can maintain that rate over time with only modest interventions in the foreign exchange rate and if there are sufficient reserves for such intervention. Capital flight occurs when money rapidly flows out of a country, due to an economic event that disturbs investors. This leads to excess demand for foreign currency and if the country cannot acquire additional reserves then it will run out of foreign reserves. The only alternative is to devalue its currency. A lower currency value will raise the price of the imported intermediate inputs goods in the domestic currency. For a firm that has debt denominated in a foreign currency, their principal and the interests to be paid will soar because of the devaluation. The firm’s rate of return will decline as company profits and dividends drop and consequently, its share price will decline. Inflation and interest rates will increase as prices rise. As interest rates go up, the bond values will go down. 2. Carefully explain how an economy can experience a rally in the bond market as it enters deeper into a recession. In such a situation, what will happen to the valuation of a foreign-owned firm that holds only financial assets?
A recession is a period of general economic decline; typically defined as a decline in GDP for two or more consecutive quarters. A recession is typically accompanied by increased unemployment, decreased consumer and business spending. People’s incomes fall in a recession, so the amount they save also decreases. The demand for credit by business generally...
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