Financial Derivative And Risk Management

a. Consider the Mundel-Fleming (M-L) model with a fixed exchange rate. The exchange rate S is defined as x units of domestic currency for 1 unit of foreign currency, hence,a rise in S implies a depreciation of the domestic currency.

In the diagram below, insert labels for the vertical axis, the horizontal axis, the downward sloping line and the upward sloping line. Add the line that indicates the balance of payments (BP), assuming that cross-border capital mobility is limited,and the BP is in surplus (BP>0). How would the BP line change if capital mobility increased?

b. The balance of payments is defined as: CA (current account) + K (net capital flows,excluding changes in the central bank's foreign exchange reserves). The exchange rate is fixed and the BP (as defined) is in surplus. How does this affect the central bank's foreign exchange reserves and the money supply?

c. What could the central bank do to avoid a change in the money supply? Describe the central bank's actions.

d. Consider the main assumptions and policy conclusions of the Monetary Approach to the balance of payments and the Mundell-Fleming model. Which has become obsolete? Which is still relevant today?



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