Suppose that country A has the same general tastes as the US and trade

Question

US and trade exclusively with the US. Suppose further that govenment of coutry A arbitrarily a law doubling all domestic incomes in A and doubling the price of all dosmetically produced goods and services.

A. Assume FIXED excahgne rates.

what happens to the IS curve in A why?

B. What does the central bank in A have to do to maintain the exchange rate? why?

C. What is the final result of this bank action?

Answer 1

A:

Nominal incomes are doubling or real?

Since prices on domestically-produced goods/services doubled - then domestic economy will switch to import (and US will tend to export more to get higher profits due to difference in price-levels). NX will fall thus IS will tend to shift leftward. Capital inflow into country A will grow.

But because of arbitrary increased incomes IS suppose to shift right. So these two effects might offset each-other. High gap between nominal exchange rate and real will emerge. High imports into "A" will increase demand for US currency and will increase supply of "A" currency on international exchange markets.

All in all I believe that most part of increase in income will go to pay imports rather than on domestic goods/services, exports will fall too (due to increased domestic prices), thus demand for "A" currency will fall.

Fall in exports and increase in imports will tend to depreciate "A" currency. I expect IS will shift left as net result.

B:

Central bank will need to initiate strong contractionary monetary policy, and pay much from it's reserves to maintain fixed exchange rate, partially reasons for such actions are described above. But in general central bank of "A" will be very busy by buying-out it's money from foreign exchange markets to keep fixed exchange rate (not for too long - without attracting additional financing, through taxes, tariffs, quotas, but it will also require strong control against shadow economy and border-control).

C:

Depletion of reserves - but it will not allow it and will devalue it's currency very soon - if other solutions are not initiated (external financing) - of course it' not illegal to go bankrupt/default or do charity. But main result expected depletion of reserves, big debt, etc. - If relevant rational measures are not taken in appropriate time.

P.S. these all are only first-wave effects, many secondary chains will have place too.