2. Suppose the U.S. Federal Reserve is gradually reducing its money supply to raise its

interest rate over time. The higher rate of return in the U.S. causes investors to selling

foreign currency and purchase dollars, causing capital to flow out of emerging (non

U.S.) economies and into the U.S. Consider the implications for an emerging economy.

(a) Suppose there is free capital mobility. If the emerging economy pegs its currency

to the U.S. dollar, what happens to the interest rate in the emerging economy

over time (increase, decrease, stay the same, or can't determine)? What happens

to output as a result?

(b) The emerging economy would like to stabilize output in the short-run through

monetary policy but has run out of reserves of U.S. dollars. What are the two

specific policy options available (be precise, and use one sentence for each option)?