Quiz 4

Question 1

The choice of exchange rate system will affect:

Answer 1

• The monetary policy transmission mechanism
• The effects of fiscal policies
• Financial stability
• Microeconomic level — how consumers, firms, and governments deal with exchange rate volatility

Question 2

Exchange rate regimes

Answer 2

• Fixed exchange rate systems
• Managed exchange rate systems
• Flexible (floating) exchange rate system

Question 3

Fixed exchange rate systems

Answer 3

• Common currency — domestic and foreign economy (economies) use a common currency; e.g. the Euro area.
• Currency board — domestic currency fully-backed one-for-one by a foreign currency. Domestic and foreign currency are fully convertible.1 Examples of ‘dollarization’: El Salvador (2001) and Ecuador (2000). Argentina is considering dollarization.
• Fixed exchange rate (or pegged exchange rate) — central bank maintains currency value at announced level or within a band; requires the use of foreign exchange reserves.

Question 4

Managed exchange rate systems

Answer 4

• Crawling peg — central bank allows exchange rate to move along a specified path.
• Target zones — central bank intervenes to keep exchange rates within a target zone.
• Managed float — central bank regularly intervenes in the foreign exchange market to reduce exchange rate volatility.

Question 5

Flexible (floating) exchange rate system

Answer 5

The central bank does not intervene in the foreign exchange market.

Almost all countries with flexible exchange rates, e.g., Canada, maintain the ability to intervene in instances of extreme volatility in the currency value or in coordinated interventions to reduce global instability.

Question 6

Rationale for Fixed exchange rate systems

Answer 6

– Stable value for currency to facilitate trade in goods and services; trade in financial assets.
– Ensure credibility of monetary policy and financial system when domestic institutions are weak.

Question 7

Rationale for Managed exchange rate systems

Answer 7

– To promote export growth by devaluing the currency or maintaining a competitive value (A zero-sum game.)
– To reduce volatility in the currency value.

Question 8

Rationale for Floating exchange rate systems

Answer 8

– Sovereignty over monetary policy — monetary policy is available to manage the domestic business cycle.
– Exchange rate serves as a buffer to external shocks
– Facilitates external adjustment through the changes to the real exchange rate.

Question 9

Possible reasons to intervene in forex markets

Answer 9

1. To prevent (limit) extreme currency movements that would be destabilizing to the economy. This is the current policy for the Bank of Canada. Only rarely and only in extreme circumstances.
2. To systematically manage the volatility of the exchange rate.
3. To systematically manage the path of the exchange rate. A crawling peg.
4. To fix the exchange rate.

For (1) and (2), the central bank typically would use sterilized intervention. This is meant to ensure that monetary policy is not directly affected by the foreign exchange intervention.
For (3) and especially (4), the central bank must use monetary policy to fix the exchange rate; intervention is not sterilized.

Question 10

Under the fixed exchange rate system

Answer 10

• the central bank plays a central role in the foreign exchange market for the domestic currency
  -The central bank sets an exchange rate for the domestic currency against another currency or possibly a basket of currencies.
  -To fix the exchange rate, the central bank must buy or sell foreign exchange to maintain the exchange rate. To do so, it must have foreign exchange reserves
  -To fix the exchange rate , the central bank must have foreign exchange reserves

Question 11

How do central banks fix exchange rates?

Answer 11

-When there is excess demand for the domestic currency, the central bank must buy foreign exchange reserves and sell domestic currency.

-When there is an excess supply of the domestic currency, the central bank must sell foreign exchange reserves and buy domestic currency.

A sale or purchase of any asset, including foreign exchange reserves, affects the domestic money supply (unless sterilized).

Question 12

When the central bank sells foreign currency assets to private sector financial institutions

Answer 12

This reduces the reserves of the private banks at the central bank ( R < 0) and consequently reduces the money supply via the usual money multiplier process ( M < 0)

Net affect — the sale of a central bank asset reduces the domestic money supply.

Question 13

The balance of payments records

Answer 13

Records transactions between domestic and foreign residents. Transactions include

• Current account (CA): net exports plus net primary and secondary income.
• Capital account: (KA): minor account, measures capital transfers (ignore for our discussion)
• Financial account (FA): purchase and sale of financial assets, including official reserves
  Balance of payments

CA -FA = 0

Balance of payments, separating out private financial account transactions and changes in official reserves:

CA- (FA(private) + chnage in OR)=0

Question 14

A balance of payments deficit for the private sector (fixed exchange rates)

Answer 14

This means a loss of foreign exchange reserves and a contraction in the money supply:

Question 15

The balance of payments and the fixed exchange rate

Answer 15

determine monetary policy

Question 16

Impossible trinity

Answer 16

(1) exchange rate stability
(2) monetary policy autonomy
(3) open capital markets

Question 17

The main weaknesses to the Mundell-Fleming model

Answer 17

• Ad hoc specifications of consumer, firm, and policymaker behaviour, rather than being developed from microeconomic foundations.
• Emphasis on monetary aggregates for monetary policy, which is at odds with current central bank behaviour. However, as we shall see, fixed exchange rates and monetary aggregates are directly linked.

Question 18

The IS Curve

Answer 18

Aggregate production equals aggregate expenditure

Question 19

The LM Curve

Answer 19

Money-market equilibrium

Question 20

The Balance of Payments Curve

Answer 20

The balance of payments for an economy is
where
CA + FA - change in OR = 0
* CA: current account; for our purposes, CA = NX .
* FA: private financial account (capital inflows and outflows).
* OR: official international reserves (more on this later)

Question 21

An increase in the money supply under a fixed exchange rate (expansionary monetary policy):

Answer 21

no effect because monetary policy must be reversed to maintain fixed exchange rate.

Question 22

An increase in government spending under a fixed exchange rate (expansionary fiscal policy):

Answer 22

expansion due to both the increase in G and the need to expand the money supply to keep the exchange rate fixed