Poorland uses the P but cannot issue debt in its own currency. Instead it must raise its debt is denominated in Richia $s. Currently, the outstanding issue is R$10bn while Poorland GDP is P 100bn, while the exchange for the P in terms of the R$ is E = 1. Poorland then experiences a recession. If its central bank does nothing then GDP will fall 1%, and the exchange rate will fall to E = 0.9. If the central bank cuts rates, GDP can be stabilised (no fall) but the exchange rate will fall to E = 0.8. Alternatively the central bank can raise rates, exacerbating the fall in GDP to 2% but fully mitigating the fall in the exchange rate (i.e. still have E = 1). The GDP falls are one off losses (i.e. the GDP the falling year is independent of what happens this coming year), and the exchange rate moves are expected to be permanent. What is the central banks optimal policy (it cares only about economic losses)? Comment..

1. Poorland uses the P but cannot issue debt in its own currency. Instead it must raise its debt is
denominated in Richia $s. Currently, the outstanding issue is R$10bn while Poorland GDP is P
100bn, while the exchange for the P in terms of the R$ is E = 1. Poorland then experiences a
recession. If its central bank does nothing then GDP will fall 1%, and the exchange rate will fall to
E = 0.9. If the central bank cuts rates, GDP can be stabilised (no fall) but the exchange rate will fall
to E = 0.8. Alternatively the central bank can raise rates, exacerbating the fall in GDP to 2% but
fully mitigating the fall in the exchange rate (i.e. still have E = 1). The GDP falls are one off losses
(i.e. the GDP the falling year is independent of what happens this coming year), and the exchange
rate moves are expected to be permanent. What is the central banks optimal policy (it cares only
about economic losses)? Comment.