Suppose a small, relatively poor country decides to pursue trade and financial sector liberalization, opening up its economy to international transactions with the rest of the world in goods, services, factor services and assets. Assume it will follow a flexible exchange rate regime.

a) What are the benefits and potential costs for this country of opening up to trade?

b) If you observed this country initially experience current account deficits and capital account surpluses when it opened up to trade, would you be surprised and why (or why not)? Under what conditions would the deficits be “sustainable”?

c) What would you expect to happen to the prices of tradable goods that the country produces when it opens up to trade and why?

d) What would you expect to happen to the rates of return to the assets of this country and why?

e) Suppose that, initially upon opening up to trade, the country experiences a balance of payments deficit that is attributable to a current account deficit that is inadequately funded by foreign lenders. Why might foreign investors be wary of holding the assets of this country? What would you expect to happen to the nominal exchange rate of this country and why?

f) What would you expect to happen to the current account and capital account of this country as a result of the nominal exchange rate movement you have described?