Chapter 17: Fixed Exchange Rates and Foreign Exchange Intervention Multiple Choice Questions 1.

Why is the reserve center in the reserve currency fixed rate system asymmetric? A. The reserve center fixes its exchange rate against the reserve currency, and all other countries are subject to that rate. B. Other countries fix their exchange rate to the reserve currency, and there is no exchange rate left for the reserve center to fix. . The center country has to intervene all the time and regulate the balance of !ayments. ". The center country never has to intervene and bears none of the burden of financing its balance of !ayments. #. Both B and ". Ans$er% # &. 'm!erfect asset substitutability assumes that A. the returns on foreign and domestic currency bonds are the same. B. the returns on foreign and domestic currency are different. . the returns on foreign and domestic currency are influenced by ris(. ". Both B and #. sterili)ed intervention !roves to be un!roductive. Ans$er% " *. Benefit+s, of the gold standard include A. asymmetry. B. ma(ing real values of national monies more stable and !redictable. . limiting money creation. ". Both A and . #. Both B and . Ans$er% #

-.

Which of the follo$ing are true, based on the .onetary A!!roach to the Balance of /ayments? A. 'f the demand for money increases, a budget sur!lus $ill result, and the money su!!ly $ill have to decrease to maintain e0uilibrium. B. 'f the demand for money increases, a budget sur!lus $ill result, and the money su!!ly $ill have to increase to maintain e0uilibrium. . 'f the demand for money increases, a budget deficit $ill result, and the money su!!ly $ill have to decrease to maintain e0uilibrium. ". 'f the demand for money increases, a budget deficit $ill result, and the money su!!ly $ill have to increase to maintain e0uilibrium. #. According to the .onetary A!!roach, money mar(et e0uilibrium does not have to be maintained if the balance of !ayments is not in e0uilibrium. Ans$er% B

1.

By fixing the exchange rate, the central ban( gives u! its ability to A. adjust taxes. B. increase government s!ending. . influence the economy through fiscal !olicy. ". de!reciate the domestic currency. #. influence the economy through monetary !olicy. Ans$er% #. By fixing the exchange rate, the central ban( does not allo$ the foreign exchange mar(et to determine the exchange rate. With the exchange rate fixed, the central ban( cannot adjust the money su!!ly using .onetary /olicy.

2.

3iscal #x!ansion under a fixed exchange rate has $hat effect+s, on the economy? A. The money su!!ly decreases. B. Out!ut decreases. . The exchange rate increases. ". The exchange rate decreases initially but then returns to its original !oint. #. Out!ut is unchanged. Ans$er% ". 3iscal ex!ansion under a fixed exchange rate shifts the "" schedule out$ard, thereby causing an increase in out!ut and a decrease in the exchange rate. 4o$ever, $ith an accom!anying out$ard shift of the AA schedule, out!ut increases, and the exchange rate shifts out$ard. This shifts the exchange rate out$ard to its initial !oint.

&

5.

When a country6s currency is devalued, A. out!ut decreases. B. out!ut increases. . the money su!!ly decreases. ". the money su!!ly increases. #. Both B and ". Ans$er% #. When a currency is devalued, out!ut and the money su!!ly ex!and as the economy6s e0uilibrium shifts out$ard.

7.

A system of managed floating exchange rates is A. a system in $hich governments may attem!t to moderate exchange rate movements $ithout (ee!ing exchange rates rigidly fixed. B. a system in $hich governments use flexible exchange rates. . a system in $hich governments are forbidden from attem!t to moderate exchange rate movements $ithout (ee!ing exchange rates rigidly fixed. ". a system in $hich governments need to reach a !rior agreement among them before they may attem!t to moderate exchange rate movements $ithout (ee!ing exchange rates rigidly fixed. #. 8one of the above statement is true. Ans$er% A A. B. . ". #. 1. Barbados !egs its exchange rate to the 3rench franc. !egs its exchange rate to the British !ound. !egs its exchange rate to the 9.:. dollar. !egs its exchange rate to the ;erman ".. "oes not !eg its currency.

Ans$er% A. B. . ". #. &. :enegal !egs its exchange rate to the 3rench franc. !egs its exchange rate to the British !ound. !egs its exchange rate to the 9.:. dollar. !egs its exchange rate to the ;erman ".. "oes not !eg its currency.

Ans$er% A

A. B. . ". #.

*. .orocco !egs its exchange rate to the 3rench franc. !egs its exchange rate to the British !ound. !egs its exchange rate to the 9.:. dollar. !egs its exchange rate to a bas(et of currencies. "oes not !eg its currency.

Ans$er% " A. B. . ". #. -. We study the system of fixed exchange rate because most exchange systems are not clean floats but dirty floats. regional currency arrangements use fixed exchange rates. many develo!ing and countries in transition use fixed exchange rates. they are lessons of the !ast for the future. All of the above statements are true.

Ans$er% # A. B. . ". #. 1. Argentina, Bulgaria, hina, and 4ong <ong managed their exchange rates under a fixed exchange rate regime. under a flexible exchange rate regime. under a managed floating exchange rate regime. under a currency board exchange rate regime. 8one of the above.

Ans$er% " A. B. . ". #. 2. Australia and /oland managed their exchange rates under a fixed exchange rate regime. under a flexible exchange rate regime. under a managed floating exchange rate regime. under a currency board exchange rate regime. 8one of the above.

Ans$er% B 11. A central ban(6s international reserves include A. any gold that it o$ns. B. any silver that it o$ns. . any gold that it o$ns and foreign and domestic assets. ". any silver that it o$ns and foreign and domestic assets. #. only foreign and domestic assets. Ans$er%

12.

The liabilities side of a central ban( include A. de!osits held by the !rivate ban(s. B. currency in circulation. . de!osits held by the !rivate ban(s and currency in circulation. ". de!osits held by the !rivate ban(s and currency in circulation. #. de!osits held by the !rivate ban(s, foreign assets, and currency in circulation. Ans$er%

15.

Which one of the follo$ing statements is most true? A. Any central ban( !urchase of assets automatically results in an increase in the domestic money su!!ly, $hile any central ban( sale of assets automatically causes the money su!!ly to decline. B. Any central ban( !urchase of assets results in an increase in the domestic money su!!ly, $hile any central ban( sale of assets causes the money su!!ly to decline. . Any central ban( !urchase of assets automatically results in a decrease in the domestic money su!!ly, $hile any central ban( sale of assets automatically causes the money su!!ly to decline. ". Any central ban( !urchase of assets automatically results in a decrease in the domestic money su!!ly, $hile any central ban( sale of assets automatically causes the money su!!ly to increase. #. 8one of the above statement is true. Ans$er% A

17.

Which one of the follo$ing statements is the most true? A. 'f central ban(s are not sterili)ing and the home country has a balance of !ayments sur!lus, any associated increase in the home central ban(6s foreign asset im!lies an increased home money su!!ly. B. 'f central ban(s are not sterili)ing and the home country has a balance of !ayments sur!lus, any associated increase in the home central ban(6s foreign asset im!lies a decreased home money su!!ly. . 'f central ban(s are not sterili)ing and the home country has a balance of !ayments sur!lus, any associated increase in the home central ban(6s foreign asset im!lies an increased home money demand. ". 'f central ban(s are not sterili)ing and the home country has a balance of !ayments sur!lus, any associated decreased in the home central ban(6s foreign asset im!lies an increased home money su!!ly. #. 8one of the above statement is true. Ans$er% A

1=.

Which one of the follo$ing statements is most true? A. 'f central ban(s are not sterili)ing and the home country has a balance of !ayments sur!lus, any associated increase in a foreign central ban(6s claims on the home country im!lies a decreased foreign money su!!ly. B. 'f central ban(s are not sterili)ing and the home country has a balance of !ayments sur!lus, any associated decrease in a foreign central ban(6s claims on the home country im!lies a decreased foreign money demand. . 'f central ban(s are not sterili)ing and the home country has a balance of !ayments sur!lus, any associated decrease in a foreign central ban(6s claims on the home country im!lies a decreased foreign money su!!ly. ". There is not a clear connection bet$een the t$o. #. 8one of the above. Ans$er%

&>.

9nder fixed exchange rate, in general, A. the domestic and foreign interest rates are e0ual, ? @ ?A. B. ? @ ?A B +#e C #,D#. . 8one of the above. ". # is e0ual to one. #. One of the above. Ans$er% A

&1.

9nder fixed exchange rate, in general $hich one of the follo$ing statements is the most accurate? A. The follo$ing condition should hold for domestic money mar(et e0uilibrium% .sD/ @ E+?A, F,. B. The follo$ing condition should hold for domestic money mar(et e0uilibrium% .sD/ @ E+?, F,. . The follo$ing condition should hold for domestic money mar(et e0uilibrium% .dD/ @ E+?A, F,. ". The follo$ing condition should hold for domestic money mar(et e0uilibrium% .s @ E+?A, F,. #. The follo$ing condition should hold for domestic money mar(et e0uilibrium% / @ E+?A, F,. Ans$er% A

&&.

Which one of the follo$ing statements is the most accurate? A. 9nder a fixed exchange rate, central ban( monetary tools are !o$erless to affect the economy6s money su!!ly. B. 9nder a flexible exchange rate, central ban( monetary tools are !o$erless to affect the economy6s money su!!ly or its out!ut. . 9nder a fixed exchange rate, fiscal !olicy tools are !o$erless to affect the economy6s money su!!ly or its out!ut. ". 9nder a fixed exchange rate, central ban( monetary tools are !o$erless to affect the economy6s money su!!ly or its out!ut. #. 9nder a dirty float exchange rate, central ban( monetary tools are !o$erless to affect the economy6s money su!!ly or its out!ut. Ans$er% "

&*.

Which one of the follo$ing statements is the most accurate? A. 9nder a fixed exchange rate, central ban( monetary tools are !o$erless to affect the economy6s money su!!ly. B. 9nder a flexible exchange rate, central ban( monetary tools are !o$erless to affect the economy6s money su!!ly or its out!ut. . 9nder a fixed exchange rate, fiscal !olicy tools are !o$erless to affect the economy6s money su!!ly or its out!ut. ". 9nder a flexible exchange rate, central ban( monetary tools are !o$erful and do affect the economy6s out!ut. #. 9nder a dirty float exchange rate, central ban( monetary tools are !o$erless to affect the economy6s money su!!ly or its out!ut. Ans$er% "

&-.

9nder fixed rates, $hich one of the follo$ing statements is the most accurate? A. .onetary !olicy can affect only out!ut. B. .onetary !olicy can affect only em!loyment. . .onetary !olicy can affect only international reserves. ". .onetary !olicy can not affect international reserves. #. 8one of the above statements is true. Ans$er%

&1.

9nder fixed rates, $hich one of the follo$ing statements is the most accurate? A. 3iscal !olicy can affect out!ut, em!loyment, and international reserves at the same time. B. 3iscal !olicy can affect only em!loyment. . 3iscal !olicy can affect only international reserves. ". 3iscal !olicy can affect only out!ut and em!loyment. #. 8one of the above statements is true. Ans$er% A

&2.

Which one of the follo$ing statements is the most accurate? A. 3iscal !olicy has the same effect on em!loyment under fixed and flexible exchange rate regimes. B. 3iscal !olicy affects em!loyment less under fixed than under flexible exchange rate regimes. . 3iscal !olicy affects em!loyment more under fixed than under flexible exchange rate regimes. ". 3iscal !olicy cannot affect em!loyment under fixed exchange rate but does affect out!ut under flexible exchange rate regimes. #. 8one of the above statements is true. Ans$er%

&5.

Which one of the follo$ing statements is the most accurate? A. 3iscal !olicy has the same effect on out!ut under fixed and flexible exchange rate regimes. B. 3iscal !olicy affects out!ut more under fixed than under flexible exchange rate regimes. . 3iscal !olicy affects out!ut less under fixed than under flexible exchange rate regimes. ". 3iscal !olicy cannot affect out!ut under fixed exchange rate but does affect out!ut under flexible exchange rate regimes. #. 8one of the above statements is true. Ans$er% B

&7.

Which one of the follo$ing statements is the most accurate? A. A devaluation occurs $hen the central ban( lo$ers the domestic currency !rice of foreign currency, #, and a revaluation occurs $hen the central ban( raises #. B. A devaluation occurs $hen the central ban( raises the domestic currency !rice of foreign currency, #, and a revaluation occurs $hen the central ban( lo$ers #. . "evaluation occurs $hen the domestic currency !rice of foreign currency, #, is raised, and a revaluation occurs $hen # is lo$ered. ". A devaluation occurs $hen the central ban( of the foreign country raises the domestic currency !rice of foreign currency, #, and a revaluation occurs $hen the central ban( of the foreign country lo$ers #. #. 8one of the above statements is true. Ans$er% B

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Which one of the follo$ing statements is the most accurate? A. "e!reciation is a rise in # $hen the exchange rate is fixed, and devaluation is a rise in # $hen the exchange rate floats. B. "e!reciation is a decrease in # $hen the exchange rate floats, and devaluation is a rise in # $hen the exchange rate is fixed. . "e!reciation is a rise in # $hen the exchange rate floats, and devaluation is a rise in # $hen the exchange rate is fixed. ". "e!reciation is a rise in # $hen the exchange rate floats, and devaluation is a decrease in # $hen the exchange rate is fixed. #. 8one of the above. Ans$er%

*>.

Which one of the follo$ing statements is the most accurate? A. A!!reciation is a rise in # $hen the exchange rate floats, and revaluation is a fall in # $hen the exchange rate is fixed. B. A!!reciation is a fall in # $hen the exchange rate floats, and revaluation is a fall in # $hen the exchange rate is fixed. . A!!reciation is a fall in # $hen the exchange rate is fixed, and revaluation is a fall in # $hen the exchange rate is flexible. ". A!!reciation is a fall in # $hen the exchange rate floats, and revaluation is a rise in # $hen the exchange rate is fixed. #. 8one of the above. Ans$er% B

*1.

Which one of the follo$ing statements is the most accurate? A. "evaluation reflects a deliberate government decision. B. "e!reciation reflects a deliberate government decision. . "evaluation reflects a deliberate government decision, and de!reciation is an outcome of government actions and mar(et forces acting together. ". "e!reciation reflects a deliberate government decision, and devaluation is an outcome of government actions and mar(et forces acting together. #. "evaluation and de!reciation have the same meaning and the same causes. Ans$er%

*&.

Which one of the follo$ing statements is the most accurate? A. ?evaluation reflects an outcome of government actions and mar(et forces acting together, and a!!reciation reflects a deliberate government decision. B. ?evaluation reflects a deliberate government decision, and a!!reciation is an outcome of government actions and mar(et forces acting together. . ?evaluation reflects a deliberate government decision, and a!!reciation is an outcome of government actions. ". ?evaluation and a!!reciation have the same meaning and the same causes. #. 8one of the above. Ans$er% B

**.

9nder fixed exchange rate, $hich one of the follo$ing statements is the most accurate? A. "evaluation causes a decrease in out!ut, a decrease in official reserves, and a contraction of the money su!!ly. B. "evaluation causes a rise in out!ut, a rise in official reserves, and an ex!ansion of the money su!!ly. . "evaluation causes a rise in out!ut and a rise in official reserves. ". "evaluation causes a rise in out!ut and an ex!ansion of the money su!!ly. #. "evaluation causes a rise in official reserves and an ex!ansion of the money su!!ly. Ans$er% B

*-.

9nder fixed exchange rate, $hich one of the follo$ing statements is the most accurate? A. "evaluation causes a rise in out!ut. B. "evaluation causes a decrease in out!ut. . "evaluation has no effect on out!ut. ". "evaluation causes a rise in out!ut and a decrease in official reserves. #. "evaluation causes a decrease in out!ut and in official reserves. Ans$er% A

*1.

9nder fixed exchange rate, $hich one of the follo$ing statements is the most accurate? A. "evaluation causes a reduction of the money su!!ly. B. "evaluation has no effect on the stoc( of money. . "evaluation causes an ex!ansion of the money su!!ly. ". "evaluation causes a reduction in out!ut. #. "evaluation causes a reduction in official reserves. Ans$er%

1>

*2.

The main reason+s, $hy governments sometimes chose to devalue their currencies is +are,% A. devaluation allo$s the government to fight domestic unem!loyment des!ite the lac( of effective monetary !olicy. B. devaluation im!roves in the current account. . devaluation increases foreign reserves held by the central ban(. ". All of the above. #. 8one of the above. Ans$er% "

*5.

"uring the ;reat "e!ression of the 1=*>s, A. the nominal interest rate hit )ero in the 9nited :tates. B. the real interest rate hit )ero in the 9nited :tates. . the nominal interest rate hit & !ercent in the 9nited :tates. ". the real interest rate hit & !ercent in the 9nited :tates. #. the nominal interest rate hit one !ercent in the 9nited :tates. Ans$er% A

*7.

At negative nominal interest rates, $hich one of the follo$ing statements is the most accurate? A. /eo!le $ould find money strictly !referable to bonds. B. /eo!le $ould find money strictly !referable to bonds and bonds therefore $ould be in excess su!!ly. . /eo!le $ould find money strictly !referable to bonds and bonds therefore $ould be in excess demand. ". /eo!le $ould find money strictly !referable to bonds and the bonds mar(et $ould be in e0uilibrium. #. 8one of the above statements is true. Ans$er% B

*=.

Which one of the follo$ing statements is the most accurate? A. A government cannot esca!e from a li0uidity tra! by fixing its currency6s exchange rate at a sufficiently de!reciated level. B. A government can esca!e from a li0uidity tra! by fixing its currency6s exchange rate at a sufficiently a!!reciated level. . A government can esca!e from a li0uidity tra! by fixing its currency6s exchange rate at a sufficiently de!reciated level. ". A government cannot esca!e from a li0uidity tra! by fixing its currency6s exchange rate. #. 8one of the above. Ans$er%

11

->.

'n 8ovember &>>1, the Ban( of Ga!an re!orted that A. the overnight interest rate $as only H>.>>- !ercent. B. the overnight interest rate $as only 1.>>- !ercent. . the overnight interest rate $as only &.>>- !ercent. ". the overnight interest rate $as only *.>>- !ercent. #. the overnight interest rate $as only >.>>- !ercent. Ans$er% #

-1.

Which one of the follo$ing statements is the most accurate? A. T$o assets are !erfect substitutes $hen investors don6t care ho$ their !ortfolios are divided bet$een them. B. T$o assets are !erfect com!lements $hen investors don6t care ho$ their !ortfolios are divided bet$een them !rovided both yield the same ex!ected rate of return. . T$o assets cannot be !erfect substitutes even $hen investors don6t care ho$ their !ortfolios are divided bet$een them !rovided both yield the same ex!ected rate of return. ". T$o assets are !erfect substitutes $hen investors do care ho$ their !ortfolios are divided bet$een them !rovided both yield the same ex!ected rate of return. #. 8one of the above statements is true. Ans$er% A

1&

Essay Questions 1. Why :tudy 3ixed #xchange ?ates?

Ans$er% 3our main reasons% IManaged Floating C /resent monetary system is hybrid of !ure fixed and floating rate systemsJ fixed exchange rates give insight to effects of foreign exchange intervention under floating rates. IRegional Currency Arrangements C #xchange rate unions exist $here member nations fix mutual exchange rates. I eveloping Countries and Countries in !ransition C 8early half the $orld engages in currency !egging. I"essons o# $ast C 3ixed exchange rates $ere the norm in many historical !eriodsJ many economists !ro!ose resurrection of some fixed rate system. &. 4o$ A entral Ban( 3ixes the #xchange ?ate?

Ans$er% The entral ban( must al$ays be $illing to trade currencies at the fixed exchange rate $ith the !rivate actors in the foreign exchange mar(et to hold exchange rate constant. Assume central ban( fixes exchange rate at E>. 3oreign exchange mar(et is in e0uilibrium $hen interest !arity condition holds C $hen R, the domestic interest rate, e0uals RA, the foreign interest rate, !lus +Ee C E,DE, the ex!ected rate of de!reciation of the domestic currency against foreign currency. E> is today6s e0uilibrium exchange rate only if% R @ RA To hold the domestic interest at RA, the central ban(6s foreign exchange intervention must adjust the money su!!ly so that RA e0uates aggregate real domestic money demand and the real money su!!ly% MSDP @ L+RA,Y, When central ban( intervenes to hold exchange rate fixed, it must automatically adjust the domestic money su!!ly so that money mar(et e0uilibrium is maintained $ith R @ RA. 1*

*.

:u!!ose # is fixed at E> and that the asset mar(ets are in e0uilibrium. :uddenly out!ut rises. What monetary measures (ee! the current exchange rate constant given unchanged ex!ectations about the future rate?

Ans$er% I:ince out!ut rises, demand for domestic money risesJ this increase in money demand normally !ushes the domestic interest rate u!$ards. To !revent a!!reciation of home currency +given E> is ex!ected, the central ban( buys foreign assets in foreign exchange mar(et. IThis eliminates excess demand for domestic money because the central ban( issues money to !ay for the foreign assets it buys. IThe ban( increases the money su!!ly in this $ay until asset mar(ets clear $ith E @ E> and R @ RA. -. What is the !olicy of sterili)ation? ;ive an exam!le.

Ans$er% I%terili&ed #oreign exchange intervention C !olicy by $hich central ban(s carry out e0ual foreign and domestic asset transactions in o!!osite directions to nullify the im!act of foreign exchange o!erations on domestic money su!!ly. I#xam!le% Ban( of /ecunia sells K1>> in foreign assets, receives K1>> chec( from /ecunia or!. entral foreign assets and liabilities decline simultaneously by K1>>J fall in money su!!ly. ITo negate effect on money su!!ly, central ban( buys K1>> of domestic assets. This increases its domestic assets and its liabilities by K1>>, offsetting the money su!!ly effect of sale of foreign assets.

1. Ans$er%

#x!lain the !henomenon of ca!ital flight.

The reserve loss accom!anying a devaluation scare is often labeled ca!ital flight because the associated debt in the balance of !ayments accounts is a !rivate ca!ital outflo$. a!ital 1-

flight may force the central ban( to devalue sooner and by a larger amount than !lanned because the central ban(6s reserves are lo$ to begin $ith. 2. #x!lain ho$ the timing of a balance of !ayment crisis is determined. Be careful to state all assum!tions.

Ans$er% The assum!tions of the model are% I/rices are flexible. IOut!ut is at full em!loyment levels. IThe central ban( $ill allo$ domestic credits to ex!and forever. IThe exchange rate is currently at #> but $ill be allo$ed to float if foreign reserves ever fall to )ero. IBan( $ill defend #> by continuing to sell its reserves until they run out. I:!eculators, in an effort to float the exchange rate, $ill attem!t to buy all the ban(6s reserves. 8o$, according to #0uation 15 A''H* +"3A @+1Dm,"L/E+?,F,M C "A,. As A, 3AN, this is true because F is fixed and $ith a fixed exchange rate, #, ?@?A. :o eventually the central ban( $ill run out of reserves and # $ill float. The lo$er !anel of the gra!h sho$s ho$ reserves behave over time $hen domestic credits, A, are gro$ing. At !oint T, as a result of the s!eculative attac(, the rest of the reserves fall. ?eserves have to fall to )ero at !oint T to (ee! asset mar(ets in e0uilibrium An attac( can6t occur at T66 because if reserves fell to )ero the exchange rate $ould fall to #:T66 and everyone $ould then try to sell their reserves just before T66 because of the imminent a!!reciation of the home currency that $ill occur. 8o s!eculator $ould $ant to buy the reserves at a !rice of #> because they (no$ they are soon going to fall. The exact date on $hich a Balance of /ayments crisis $ill occur and force a country to float its exchange rates has thus been !in!ointed as only being able to occur at T. Ei(e$ise, an attac( can6t occur at T6 because the o!!osite $ould ha!!en.

11

12

5.

#x!lain $hy in !ractice the extent to $hich a measured balance of !ayments dis!arity, either a sur!lus or a deficit, $ill affect home and foreign money su!!lies is 0uite uncertain?

Ans$er% A fe$ reasons for that to be true% 3irst, it is not clear ho$ much financing of the !ayment ga! is done through home official intervention and ho$ much through foreign. This division de!ends on various factors, such as the economic goals of the central ban(s and institutional arrangements governing intervention. :econd, central ban(s may be sterili)ing to counter the monetary effects of reserve changes. Third, some central ban( transactions indirectly hel! to finance a foreign country6s balance of !ayments deficit, but they do not sho$ u! in the latter6s !ublished balance of !ayments figures +see also ha!ter 1&, for the third argument,. 7. 'f the central ban( does not !urchase foreign assets $hen out!ut increases but instead holds the money stoc( constant, can it still (ee! the exchange rate fixed at #>?

Ans$er% 8o. This is because the domestic interest rate $ould begin to rise above ?A. Traders in the foreign exchange mar(et $ould begin to bid u! the !rice of domestic currency in terms of foreign currency. 'n the absence of central ban( intervention, the exchange rate thus $ould fall belo$ #> 'n order to !revent this a!!reciation, the central ban( must sell domestic currency and buy foreign assets, thereby increasing the money su!!ly and !reventing any excess money demand from !ushing the home interest rate above ?A. =. #x!lain $hy under fixed exchange rate, monetary !olicy is ineffective $hereas under floating exchange rate it is effective in rising out!ut.

Ans$er% 9nder floating, by !urchasing domestic assets the central ban( causes an initial excess su!!ly of domestic money that simultaneously !ushed the domestic interest rate do$n$ard and $ea(ens the currency. 4o$ever, under fixed exchange rate the central ban( $ill resist any tendency of the currency to de!reciate by selling foreign assets for domestic money and so removing the initial excess su!!ly of money its !olicy move has caused. 1>. Analy)e the effects of devaluation on an economy.

Ans$er% "evaluation causes a rise in out!ut, a rise in official reserves, and an ex!ansion of the money su!!ly. A !rivate ca!ital inflo$ matches the central ban(6s reserve gain +an official outflo$, in the balance of !ayments accounts. 11. What are the three main reasons $hy governments sometimes chose to devalue their currencies? 1. Allo$ the government to fight domestic unem!loyment des!ite the lac( of effective monetary !olicy. &. 'm!rove the current account. *. 'ncrease foreign reserves held by the central ban(. 15

Ans$er%

Quantitative'(raphing $ro)lems 1. 9sing a figure sho$ the simultaneous e0uilibrium of the foreign exchange and domestic money mar(ets $hen the exchange rate is fixed at #> and is ex!ected to remain fixed at #> in the future. Assume both / and F are constants. 8o$, study the effect of an increase in income, F.

Ans$er% :ee figure, the E+?A, F, $ill shift do$n and to the right, $hich $ill necessitate an increase in . to .&. This $ill re0uire the domestic central ban( to !urchase foreign assets and thereby increase the money su!!ly, leaving # at #>. 8ote that ? @ ?A at the ne$ e0uilibrium as before.

17

&.

9se the fixed exchange rate "" C AA model to describe the economy6s shortHrun e0uilibrium. Then, use the same figure to study an ex!ansionary monetary !olicy. :ho$ that the !olicy is ineffective.

Ans$er% The fixed exchange rate "" C AA model re0uires the assum!tion that # @ #> . This sho$s that the economy6s shortHrun e0uilibrium is at !oint 1 $hen the central ban( fixes the exchange rate at the level . Out!ut e0uals F1 at !oint 1 and the money su!!ly is at the level $here a domestic interest rate e0ual to the foreign rate +?A, clears the domestic mar(et. To 'ncrease Out!ut% 4o!ing to increase out!ut to F&, the central ban( increases the money su!!ly through the !urchase of domestic assets and shifting AA1 to AA&. Because the exchange rate is fixed, the central ban( must maintain #>, it has to sell foreign assets for domestic currency, thereby decreasing the money su!!ly immediately and returning AA& bac( to AA1. Out!ut is unchanged as the initial e0uilibrium is maintained.

1=

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9nder fixed exchange rate, sho$ using a figure, the effects of an ex!ansionary fiscal !olicy. :ho$ the e0uilibrium under a flexible exchange rate. "iscuss the difference in the t$o regimes.

Ans$er% An ex!ansionary fiscal !olicy shifts the "" curve to the right. 9nder flexible exchange rate, !oint & in the figure is the e0uilibrium, e decreases +a!!reciates, and F goes u!. The !icture is more com!licated under fixed exchange rate, ho$ever, since # cannot change. Out!ut is going u! as a result of the fiscal ex!ansion, and thus the demand for domestic money increases. To !revent the increased money demand from increase domestic interest rate above ?A, and $ith the a!!reciation of the currency, the central ban( must buy foreign assets $ith domestic money and thereby increase the money su!!ly. The AA shifts to the right until # is restored to the initial fixed exchange rate, #>, at !oint * in the figure. :o under fixed exchanger rate, F $ill increase by more than under a flexible exchange rate regime. 9nli(e monetary !olicy, fiscal !olicy can be used to affect out!ut under a fixed exchange rate. A central ban( is forced to ex!and the money su!!ly through foreign exchange !urchases.

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9sing a figure, sho$ ho$ devaluation affects an economy.

Ans$er% When a currency is devalued from #> to #1, the e0uilibrium shifts from !oint 1 to &. Both out!ut and money su!!ly increase.

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Assume an economy is in a li0uidity tra!. A. Write an e0uation ex!ressing interest rate !arity under a fixed exchange rate regime.

Ans$er% Ei0uidity tra! im!lies ? @ >. ? @ > @ ?A B +#e C #,D#. B. Assume #e is fixed. :u!!ose that the central ban( raises the domestic money su!!ly so as to de!reciate the currency tem!orarily +that is, to raise # currently but return the rate to #e later,. :ho$ that # cannot be raised. Ans$er% :ince ? @ >, the e0uation in !art A, the interest !arity condition, im!lies% # @ #e D +1 C ?A,. :ince #e and ?A are fixed, # cannot change. 2. Write an ex!ression for interest rate !arity under the condition of im!erfect asset substitutability.

Ans$er% ? @ ?A B +#e C #,D# B a, $here, a denotes the ris( !remium that reflects the difference bet$een the ris( of domestic and foreign bonds.

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9se a figure to study the effects of a change in mar(et belief $ith regard to the fixed exchange rate, in !articular assume mar(et !artici!ants ex!ect the government to devaluate.

Ans$er% This figure belo$ sho$s the asset mar(ets e0uilibrium at !oints 1 +the money mar(et, and 16 +the foreign exchange mar(et, $ith the exchange rate fixed at #> and ex!ected to remain there indefinitely. .1 is the money su!!ly consistent $ith this initial e0uilibrium. "eterioration in the current account to devalue in the future and ado!t a ne$ fixed exchange rate, #1, that is higher than the current rate, #>. T4# 9//#? /A?T% a change in ex!ectations as a right$ard shift in the curve that measures the ex!ected domestic currency return on foreign currency de!osits. To hold the exchange rate fixed at #> after the mar(et decides , it $ill be devalued to #1, the central ban( must use its reserves to finance a !rivate ca!ital outflo$ that shrin(s the money su!!ly and raises the home interest rate. The ex!ectation of a future devaluation causes a balance of !ayments crisis mar(ed by a shar! fall in reserves and a rise in the home interest rate above the $orld interest rate. :imilarly, an ex!ected revaluation causes an abru!t rise in foreign reserves together $ith a fall in the home interest rate belo$ the $orld rate. The reserve loss accom!anying a devaluation scare is often labeled ca!ital flight because the associated debt in the balance of !ayments accounts is a !rivate ca!ital outflo$. a!ital flight may force the central ban( to devalue sooner and by a larger amount than !lanned because the central ban(6s reserves are lo$ to begin $ith.

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