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Capital Inflows and Monetary Policy Regimes
Consider a small, open economy with a flexible exchange rate that experiences a sudden surge in foreign investment due to newfound optimism about its tech sector. This leads to significant upward pressure on its currency. Analyze how the role of the exchange rate and the ultimate impact on the domestic economy would likely differ under two distinct scenarios:
- The central bank operates with a credible, publicly announced inflation target.
- The central bank has no explicit policy anchor and its commitment to price stability is not well-established.
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A small, open economy with a flexible exchange rate faces a severe negative shock to global demand for its primary export. How does the role of the exchange rate in adjusting to this shock differ if the central bank has a credible inflation target versus if it has no explicit policy anchor?
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