A) Central African Republic uses a fixed exchange rate regime where the domestic currency, the CFA franc, is pegged to Euro. The CAR government is currently debating a large decline in its spending level. However, the officials lack verifiable data on the asset markets of the economy, as such, they are not sure if the AA curve is very steep or rather flat. a) Analyze and compare the effects of such a spending cut graphically and verbally for two possible scenarios i) a steep AA curve and ii) a flat AA curve. In your comparison, explain what would happen to the following for CAR: short run equilibrium income, interest rate, the net exports, the level of capital inflows and the level of foreign exchange reserves at the central bank. Make sure you explain the mechanism(s) behind your results. b) In your own words, explain the two possible reasons why the CAR economy might have a steep AA curve rather than a flat one.
B. Suppose a central bank that follows a fixed exchange rate signals that they might devalue the domestic currency as the FX reserves of the bank, although enough to withstand the current level of pressure for months, is not at very high levels. Using a second-generation currency crisis model, explain how the sudden devaluation news can trigger a currency crisis. In your answer, explain the basic mechanism of the second-generation model. Also explain why a first-generation model cannot perfectly capture such a scenario.