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      Question

      In a small open economy with imperfect capital mobility,

      MPS = 0.25, MPM = 0.15, and interest sensitivity of capital flows φ = 0.4. A foreign country raises its interest rate by 2 percentage points. If the domestic economy maintains its interest rate unchanged, the resulting BOP position and required policy response are:
      A BOP surplus due to capital inflows; domestic interest rate must fall to restore equilibrium Correct Answer Incorrect Answer
      B BOP deficit on capital account; domestic interest rate must rise by (MPM + MPS)/φ × ΔBOP to restore equilibrium Correct Answer Incorrect Answer
      C BOP deficit due to capital outflows; the BP curve shifts upward by Δr* = 2%, requiring domestic rates to rise to maintain BOP equilibrium Correct Answer Incorrect Answer
      D The BOP is unaffected since imperfect capital mobility insulates the domestic economy Correct Answer Incorrect Answer

      Solution

      BP curve slope = (MPM + MPS)/φ = (0.15 + 0.25)/0.4 = 1.0 (positively sloped — imperfect capital mobility). When r* rises by 2% and domestic r is unchanged: foreign assets become relatively more attractive → capital outflows → capital account worsens → BOP deficit. The domestic r must rise by exactly Δr* = 2% at every income level to restore BOP equilibrium. Graphically, the BP curve shifts vertically upward by 2%.   Why others are wrong:
      • (A) — Higher foreign r* causes OUTFLOWS, not inflows.   • (B) — The formula (MPM+MPS)/φ is the BP slope, NOT the required interest rate rise. The required rise is simply Δr* = 2%   • (D) — Imperfect mobility ≠ zero mobility. Only a vertical BP (perfect immobility) would insulate the economy.

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