Chapter 18 - Fixed Exchange Rates and Foreign Exchange Intervention

Question 1

What are the assets (4) and liabilities (2) on the central bank balance sheet?

Answer 1

Assets: 1) Foreign government bonds 2) Gold 3) Domestic government bonds 4) Loans to domestic banks Liabilities: 1) Deposits of domestic banks 2) Currency in circulation

Question 2

What is the relationship between assets, liabilities and net worth? What is the effect of an increase or decrease in assets?

Answer 2

Assets = Liabilities + Net Worth A increase or decrease in assets leads to an equal increase or decrease in liabilities, as net worth is assumed to be constant.

Question 3

What happens when the central bank purchases an asset? (3) What happens to domestic money supply when the central bank buys domestic or foreign bonds?

Answer 3

1) A purchase of any asset by the central bank will be paid for with currency or a check written from the central bank. 2) Both of which are denominated in domestic currency, and both of which increase the supply of money in circulation. 3) The transaction leads to equal increases of assets and liabilities. When the central bank buys domestic bonds or foreign bonds, the domestic money supply increases.

Question 4

What happens when the central bank sells an asset? (4) What happens to domestic money supply when the central bank sells domestic or foreign bonds?

Answer 4

1) A sale of any asset by the central bank will be paid for with currency or a check written to the central bank. 2) Both of which are denominated in domestic currency. 3) The central bank puts the currency into its vault of reduces the amount of deposits of banks, 4) Causing the supply of money in circulation to shrink. The transaction leads to equal decreases of assets and liabilities. When the central bank sells domestic bonds or foreign bonds, the domestic money supply decreases.

Question 5

How do central banks trade foreign government bonds? What is the distinction between foreign currency deposits and foreign government bonds? What is the significance of the the quantities of foreign government bonds/foreign currency deposits?

Answer 5

Central banks trade foreign government bonds in the foreign exchange markets. Foreign currency deposits and foreign government bonds are often substitutes. We will treat them as if they are the same thing. Quantities of foreign currency deposits/foreign government bonds that are bought and sold influence the exchange rate.

Question 6

What is sterilisation? (3)

Answer 6

1) Because buying and selling of foreign bonds in the foreign exchange markets affects the domestic money supply, a central bank may want to offset this effect. 2) This offsetting effect is called sterilisation. 3) If the central bank sells the foreign bonds in the foreign exchange markets, it can buy domestic government bonds in bond markets - hoping to leave the amount of money in circulation unchanged.

Question 7

How does the central bank fix the exchange rate?

Answer 7

To fix the exchange rate, a central bank influences the quantities supplied and demanded of currency by trading domestic and foreign assets, so that the exchange rate (the price of foreign currency in terms of domestic currency) stays constant.

Question 8

When are foreign exchange markets in equilibrium?

Answer 8

Foreign exchange markets are in equilibrium when R = R* + (Ee – E)/E When the exchange rate is fixed at some level E0 and the market expects it to stay fixed at that level, then R = R* To fix the exchange rate, the central bank must trade foreign and domestic assets in the foreign exchange market until: R = R*

Question 9

Suppose that the central bank has fixed the exchange rate at E0 but the level of output rises, raising the demand of real monetary assets. This is predicted to put upward pressure on interest rates and the value of the domestic currency. How should the central bank respond if it wants to fix exchange rates? (4)

Answer 9

1) The central bank should buy foreign assets in the foreign exchange markets, 2) Thereby increasing the domestic money supply. 3) Thereby reducing interest rates in the short run. 4) By demanding (buying) assets denominated in foreign currency and by supplying (selling) domestic currency, the price/value of foreign currency is increased and the price/value of domestic currency is decreased.

Question 10

What is the downside of using the buying and selling of foreign assets to keep the exchange rate fixed?

Answer 10

When the central bank buys and sells foreign assets to keep the exchange rate fixed and to maintain domestic interest rates equal to foreign interest rates, it is not able to adjust domestic interest rates to attain other goals. In particular, monetary policy is ineffective in influencing output and employment.

Question 11

What is the conflict between fiscal policy and fixed exchange rates in the short run? (3)

Answer 11

1) Temporary changes in fiscal policy are effective in influencing output and employment in the short run: 2) The rise in aggregate demand and output due to expansionary fiscal policy raises demand for real monetary assets, putting upward pressure on interest rates and on the value of the domestic currency. 3) To prevent an appreciation of the domestic currency, the central bank must buy foreign assets, thereby increasing the money supply and decreasing interest rates.

Question 12

What happens in terms of fiscal policy and fixed exchange rate in the long run, when output is above its potential level? (7)

Answer 12

1) When output is above its potential level, wages and prices tend to rise in the long run. 2) A rising price level makes domestic products more expensive: a real appreciation (EP*/P falls). 3) Aggregate demand and output decrease as prices rise: DD curve shifts left. 4) Prices tend to rise until employment, aggregate demand, and output fall to their normal (potential or natural) levels. 5) Prices are predicted to change proportionally to the change in the money supply when the central bank intervenes in the foreign exchange markets. 6) AA curve shifts down (left) as prices rise. 7) Nominal exchange rates will be constant (as long as the fixed exchange rate is maintained), but the real exchange rate will be lower (a real appreciation).

Question 13

What is the difference between appreciation/depreciation and revaluation/devaluation?

Answer 13

Depreciation and appreciation refer to changes in the value of a currency due to market changes. Devaluation and revaluation refer to changes in a fixed exchange rate caused by the central bank.

Question 14

What is the difference between devaluation and revaluation?

Answer 14

With devaluation, a unit of domestic currency is made less valuable, so that more units must be exchanged for 1 unit of foreign currency. With revaluation, a unit of domestic currency is made more valuable, so that fewer units need to exchanged for 1 unit of foreign currency.

Question 15

How does a central bank bring about a devaluation of domestic currency? (3)

Answer 15

1) For devaluation to occur, the central bank buys foreign assets, so that domestic monetary assets increase and domestic interest rates fall, causing a fall in the rate of return on domestic currency deposits. 2) Domestic products become less expensive relative to foreign products, so aggregate demand and output increase. 3) Official international reserve assets (foreign bonds) increase.

Question 16

What are the consequence of a central bank not having enough international reserve assets to maintain a fixed exchange rate? (4)

Answer 16

1) When a central bank does not have enough official international reserve assets to maintain a fixed exchange rate, a balance of payments crisis results. 2) To sustain a fixed exchange rate, the central bank must have enough foreign assets to sell in order to satisfy the demand of them at the fixed exchange rate. 3) Investors may expect that the domestic currency will be devalued, causing them to want foreign assets instead of domestic assets, whose value is expected to fall soon. 4) This expectation or fear only makes the balance of payments crisis worse: Investors rush to change their domestic assets into foreign assets, depleting the stock of official international reserve assets more quickly.

Question 17

What can bring about expectation of a balance of payments crisis? (2)

Answer 17

1) Expectations about the central bank’s ability and willingness to maintain the fixed exchange rate. 2) Expectations about the economy: shrinking demand of domestic products relative to foreign products means that the domestic currency should become less valuable. In fact, expectations of devaluation can cause a devaluation: a self-fulfilling crisis.

Question 18

For many countries, the expected rates of return are not the same: R > R*+(Ee –E)/E. Why? (2)

Answer 18

1) Default risk: The risk that the country’s borrowers will default on their loan repayments. Lenders therefore require a higher interest rate to compensate for this risk. 2) Exchange rate risk: If there is a risk that a country’s currency will depreciate or be devalued, then domestic borrowers must pay a higher interest rate to compensate foreign lenders.

Question 19

Show graphically, asset market equilibrium with a fixed exchange rate.

Answer 19

To hold the exchnage rate fixed at E0 when output rises from Y(1) to Y(2), the central bank must purchase foreign assets and thereby raise the money supply from M(1) to M(2).

Question 20

Show graphically, that monetary expansion is ineffective under a fixed exchange rate.

Answer 20

Hoping to increase output to Y(2), the central bank decides to increase the money supply by buying domestic assets and shifting the AA curve. Because the central bank must maintain E(0), heowever, it has to sell foreign assets for domestic currency, an action that decreaes the money supply immediately and returns the AA curve back to its original position. The economy’s equilibrium is therefore unchanged.

Question 21

Show graphically, fiscal expansion under a fixed echange rate.

Answer 21

Question 22

Show graphically, the effect of a currency devaluation.

Answer 22

Question 23

Show graphically and explain how the central bank can maintain the exchnage rate, when faced with the issue of capital flight.

Answer 23

To hold the exchnage rate fixed, the central bank must use its resources to finance a private financial outflow that shrinks the money supply and raises the home interest rate.