Major shocks occasionally strike a country's economy. List the types of shock that may occur and discuss the effects of these exogenous changes on a country that has a floating exchange rate.

What will be an ideal response?

POSSIBLE RESPONSE: There are two types of internal shocks that can affect a country's economy, domestic monetary shocks and domestic spending shocks. There are two types of external shocks, international capital-flow shocks and international trade shocks. Domestic monetary shocks shift the LM curve. A sudden decrease in money demand resulting from a decreased desire to carry cash balances for precautionary purposes is such an example. If the monetary shock tends to expand the economy, then the domestic currency depreciates, further increasing domestic product. Domestic spending shocks alter domestic expenditure and shift the IS curve. The effect of this kind of shock on the exchange rate and, therefore, domestic product and income, depends on the relative slopes of the LM and FE curves, because it matters which changes more: international capital flows or the country's current account. International capital-flow shocks shift the FE curve and occur because of changes in investors' perceptions of economic and political conditions in various countries. For instance, an adverse shock to international capital flows, leading to capital outflow from our economy, can occur if there is a sudden increase in foreign interest rates. The capital outflow puts downward pressure on the exchange-rate value of the country's currency and the currency depreciates. The depreciation improves the international price competitiveness of the country's products. The improvement in the current account tends to increase its domestic product. International trade shocks cause the value of the country's current account balance to change and shift the IS and FE curves. A sudden decline in foreign demand for our exports or an increase in our taste for imported products would constitute such a change. An adverse international trade shock reduces both the current account and the country's domestic product and income. As the current account worsens, the overall balance of payments tends to go into deficit, and the country's currency depreciates. The improvement in price competitiveness leads to an increase in the country's exports and a decline in imports. The current account improves, putting the overall payments balance back to zero. Domestic product and income rise back toward their original levels, reducing or reversing the initial effects of the adverse international trade shock.