Economics 3200, fall 2003, alston study guide for midterm # 3 (also see the questions/problems at the end of each chapter) Essay Questions and Answers for Chap 19

Essay Questions and Answers for Chapter 21

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Essay Questions and Answers for Chapter 21

1. Explain and demonstrate graphically how a purchase of foreign currency reserves leads to overshooting of the exchange rate, and describe the long-run behavior of the exchange rate.

A purchase of foreign assets increases the monetary base and money supply, increasing the price level and decreases the expected appreciation of the domestic currency. The reduction of the expected appreciation of the domestic currency increases the expected return on foreign assets, shifting RF to the right. The domestic monetary expansion lowers interest rates in the short run, shifting RD left, and lowering the exchange rate to E2. As the interest rate returns to its original value, the exchange rate appreciates to E3. This behavior of the exchange rate is overshooting.

2. Explain and demonstrate graphically the situation of an overvalued exchange rate in a fixed exchange rate system. What alternative policies are available to eliminate the overvaluation of

the exchange rate?
As indicated in the graph below, the par value is above the equilibrium value, resulting in overvaluation of the exchange rate. One approach is to pursue contractionary monetary policies, raising interest rates and shifting RD to the right. This process continues until equilibrium at par value is restored. The other alternative is to depreciate the exchange rate.

3. Describe and show graphically the situation of a speculative crisis against a fixed exchange rate. What can the central bank do to defend the currency? Indicate this policy graphically. Why might the alternative of devaluation be preferable?

As seen in the graph below, the par value is above the equilibrium value, resulting in an overvalued currency. When the speculative attack begins, the expected depreciation of the domestic currency increases substantially, shifting RF far to the right. Very stringent monetary policy is needed to increase domestic interest rates enough to defend the currency, as RD must shift to The cost to the central bank in terms of the costs of intervention and the contractionary effect on the economy may make devaluation preferable.

4. Explain the operation of the gold standard system. What was the required behavior for deficit and surplus nations? What were the implications of this behavior for each nation’s money supply?

Under the gold standard, each country sets the price of gold in terms of the domestic currency, and the exchange rate is determined by the ratio of these prices. Gold would flow from deficit to surplus nations, reducing the money supply in the deficit nation and increasing it in the surplus nation. The money supply changes would change the price levels in each country in the same direction. Exports from the deficit nation become more competitive due to deflation, while exports from the surplus nation become less competitive due to inflation. These adjustments continued until balance of payments equilibrium was restored. Under the gold standard, nations did not control their money supplies, as gold discoveries and international gold flows determined domestic money supplies.

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