3. Consider a small country, Neverland trading with the rest of the world in perfect capital markets. Suppose Neverland has a floating exchange rate. Your CEO, Capt. Hook needs your help-please discuss what is the impact of each of the following events on the exchange rate for the Neverland Doubloons (ND). (All you have to do is evaluate what happens to the currency and why).
a) The governor of the Central Bank of Neverland, Ms. Tinker Bell raises domestic interest rates, while world interest rates remain constant. (1 pt)
b) Ms. Tinker Bell also announced today that Neverland's economy was the fastest growing economy (GDP growth) in the world, stemming from a large current account surplus. (1 pt)
c) Your CEO, Capt. Hook strongly believes that in the long run, the ND will depreciate if Ms. Tinker Bell maintains this higher interest rate for a very long time. Do you agree? (1 pt) Suppose Neverland had a fixed exchange rate, and is committed to keeping it fixed through open market operations (i.e. the central bank buying and selling currency to keep it fixed.)
d) If Ms. Tinker Bell raised domestic interest rates now, what will happen to the exchange rate? What should your CEO, Capt. Hook expect Ms. Tinker Bell to do? Will it impact your company's operations in Neverland? (2 pts)
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