Fixed Exchange Rates And Foreign Exchange Intervention

Question 1

Describe the effect a purchase of any asset has on the Ms

Answer 1

• purchase of any asset by CB increases money supply

Question 2

Describe effect of the sale of any asset on the Ms

Answer 2

• sale of any asset by the CB decreases the domestic money supply

Question 3

What is sterilisation?

Answer 3

• offsetting changes in the money supply

Question 4

If the CB fixes the exchange rate but Y rises explain what happens in the economy and how CB offsets this

Answer 4

• increase in output raises the demand for real monetary assets
• RMD schedule (money market) shifts down
• excess demand for money
• excess supply of bonds
• bond price falls
• interest rate rises
• would cause appreciation of domestic currency and E to fall

To prevent this CB should:
- buy foreign assets in the FX market
- this increases domestic money supply
- reduces interest rates in the SR
- value of domestic currency is decreases

Question 5

Describe the impact of monetary policy under a fixed exchange rate regime

Answer 5

• monetary policy is ineffective in influencing output and employment under a fixed exchange rate regime

Question 6

What is revaluation?

Answer 6

CB deliberately makes domestic currency more valuable

Question 7

What is devaluation?

Answer 7

• CB deliberately makes domestic currency less valuable

Question 8

Describe a devaluation using the AA-DD model

Answer 8

• CB buys foreign assets
• increasing Ms
• excess supply of real money
• excess demand for bonds
• bond price increases
• interest rate falls
• return on domestic deposits is less than expected return abroad
• demand for foreign deposits increases
• domestic currency depreciates
• E rises
• AA curve shifts up
• domestic products become less expensive relative to foreign products
• AD and output increase
• official international reserve assets increases

Question 9

When would a balance of payment crisis occur?

Answer 9

• may be caused when a CB does not have enough official international reserve assets to maintain fixed exchange rate

Question 10

How can balance of payment crisis be worsened?

Answer 10

• if investors expect that the domestic currency will be revalued they switch demand to foreign assets

Question 11

What is capital flight?

Answer 11

• financial capital is quickly moved from domestic assets to foreign assets

Question 12

Describe the effect of capital flight in the economy and how CB tries to reduce this impact

Answer 12

• capital flight leads to low AD
• to prevent this CB has to push interest rates up to make domestic assets more attractive
• it does this through the sale of domestic of foreign assets which reduces the money supply
• this increases interest rates in the SR
• however this can cause low AD, high interest rates, low output and low employment in the economy

Question 13

Why do expectations change?

Answer 13

1. Expectation about CB ability and willingness to maintain fixed exchange rate
2. Expectations about economy (reduction of domestic demand relative to foreign demand )
3. Expectations of devaluation can cause devaluation (self-fulfilling crisis)

Question 14

Describe Britain and ERM

Answer 14

• joined around 1990
• joining did not bring prosperity
• opted out in 1992
• following departure interest rates fell, and real GDP growth increased faster relative to those who remained
• opting out was effective

Question 15

What is the main benefit of fixed exchange rate regimes?

Answer 15

• fixed exchange rate regimes make trade more attractive as they reduce uncertainties regarding prices