Explain how a floating exchange rate might alter the link between increased borrowing and the level of reserves, since a balance of payments deficit will have different implications for reserves under fixed and floating rates.

ASSIGNMENT

In this question you will need to show your grasp of the Polak model by analysing the effect of an increase in government borrowing. A good answer will explain the four identities in the model before discussing the behavioural assumptions to show the likely implications of an increase in government borrowing for domestic credit, and the consequent impact on the balance of payments and hence on international reserves.

In your answer clearly explain the adjustments that follow increases in domestic credit and hence explain why government borrowing (and therefore the fiscal deficit) is always one of the performance criteria specified by the IMF when establishing conditionality for its lending programmes. You may wish to support this conclusion by referring to country examples of such conditionality.

Note that you are asked to critically examine the theoretical links in the model.

You are also asked to discuss the role played by the exchange rate. This will require you to explain how a floating exchange rate might alter the link between increased borrowing and the level of reserves, since a balance of payments deficit will have different implications for reserves under fixed and floating rates.

Your assignment must be properly referenced.