EIFM Seminar 7 – week commencing Nov 22nd 2021
Question 1: If the Federal Reserve buys dollars in the foreign exchange market but conducts an offsetting open market operation to sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?
The purchase of dollars involves a sale of foreign assets, which means that international reserves fall. However, the offsetting open market purchase means that the monetary base and the money supply will remain unchanged. There is thus no change in the expected return on dollar assets, so the demand curve does not shift, and the exchange rate also remains unchanged.
Question 2: If the Federal Reserve buys dollars in the foreign exchange market but does not sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?
The purchase of dollars involves a sale of foreign assets, which means that international reserves fall and the monetary base decreases. The resulting fall in the money supply causes interest rates to rise and lowers the future price level, thereby raising the future expected exchange rate. Both of these effects raise the expected return on dollar assets at any given exchange rate, shifting the demand curve to the right and raising the equilibrium exchange rate.
Question 3: For each of the following, identify in which part of the balance-of-payments account the transaction is recorded (current account or capital account) and whether it is a receipt or a payment.
a. A British subject’s purchase of a share of Johnson & Johnson stock
b. An American citizen’s purchase of an airline ticket from Air France
c. A Japanese citizen’s purchase of California oranges
d. $50 million of foreign aid to Honduras
e. A loan by an American bank to Mexico
f. An American bank’s borrowing of Eurodollars
(a) A receipt in the capital account; (b) a payment in the current account; (c) a receipt in the current account; (d) a payment in the current account; (e) a payment in the capital account; and (g) a receipt in the capital account.
Question 4: Under the gold standard, if Britain became more productive relative to the United States, what would happen to the money supply in the two countries? Why would the changes in the money supply help preserve a fixed exchange rate between the United States and Britain?
The increase in British productivity would create a tendency for the pound to appreciate relative to the dollar. The higher value of the pound would now cause Americans to exchange dollars for gold, ship the gold to Britain, and then buy British pounds with the gold. The result is that British holdings of gold (international reserves) would increase, which would raise the money supply because the monetary base would increase. The higher British money supply would then tend to lower the exchange rate back down to its par level because it would cause the price level to rise, which would lead to a depreciation of the pound.
Question 5: How can exchange-rate targets lead to a speculative attack on a currency?
With a pegged exchange rate, speculators are sometimes presented with a one-way bet in which the only direction for a currency to go is down in value when a country’s central bank is unable or unwilling to defend the currency’s value. In this case, selling the currency before the likely depreciation gives speculators an attractive profit opportunity with potentially high expected returns. As a result, they jump on board and attack the currency.
Question 6: Suppose the Mexican central bank chooses to peg the peso to the U.S. dollar and commits to a fixed peso/dollar exchange rate. Use a graph of the market for peso assets (foreign exchange) to show and explain how the peg must be maintained if a shock in the U.S. economy forces the Fed to pursue contractionary monetary policy. What does this say about the ability of central banks to address domestic economic problems while maintaining a pegged exchange rate?
An increase in U.S. interest rates as a result of the contractionary monetary policy will increase the demand for dollar assets and reduce the demand for peso assets from D1 to D2, which will appreciate the dollar and depreciate the peso. This results in the peso being valued below the peg; in order to maintain the peg, the Mexican central bank must increase domestic interest rates by selling foreign assets, and buying domestic peso currency. This results in the demand for peso assets to increase back up to D1 as shown in the graph below. This demonstrates one of the main disadvantages to pegging the domestic currency in that domestic monetary policy in the pegging country is dependent on foreign business cycles, meaning that there is no scope for domestic monetary policy stabilization. In this case, Mexico was forced to import a contractionary policy, which could create unexpected and undesirable contraction in the domestic economy.