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1. Provide brief answers for the following questions:
(b) Suppose that country A and Country B maintain a fixed exchange rate between themselves. If inflation in country A is 3% and in B is 1%, what would happen to the trade balances between these two countries? Could these countries maintain their fixed exchange rates forever? Why or why not?
(c) Under perfect capital mobility, what would occur if the interest rate on dollar-denominated bonds amounts to 6.1 percent and the interest rate on euro-denominated bonds adjusted for changes in the exchange rate is expected to be 5.0 percent? Explain.
(d) You are the economics advisor of Sweden, a country that is not a member of the European Union but trades quite a bit with EU countries and with whom there is a high degree of capital mobility. Suppose that the members of the European Union enact a large tax cut financed by a large increase in their deficit. What should happen to exchange rates in Sweden? What should happen to their trade balance?
(e) Refer to (c), if you are very interested in keeping the Swedish exchange rate constant at the rate it was before the EU tax cut, what specific policy would you recommend to do this to keep your currency from becoming overvalued or undervalued?
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