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 effect on international reserves, the money supply and the exchange rate?
The purchase of dollars involves a sale of foreign assets that 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.
If the Federal Reserve buys dollars in the foreign exchange market but does not sterilize the intervention, what will be the effect on the 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.
For each of the following identify in which part of the balance-of-payments account it appears (current account, capital account or net change in international reserves) and whether it is a receipt or a payment:
A British subject’s purchase of a share of Johnson & Johnson stock
Why does a balance-of-payments deficit for the United States have a different effect on its international reserves than a balance of payments deficit or the Netherlands?
Because other countries often intervene in the foreign exchange market when the United States has a deficit so that U.S. holdings of international reserves do not change. By contrast, when the Netherlands has a deficit, it must intervene in the foreign exchange market and buy guilders, which results in a reduction of international reserves for the Netherlands.
Under fixed exchange rates, if Britain becomes more productive relative to the United States, what foreign exchange intervention is necessary to maintain the fixed exchange rate between dollars and pounds? Which country undertakes this intervention?
If exchange rates were not fixed then the increase in British productivity would create a tendency for the pound to appreciate relative to the dollar. The exchange rates are fixed so one would expect that the exchange rate would be undervalued relative to the dollar. As the exchange rate is fixed the British would need to intervene to bring demand back in line with the exchange rate. To reduce demand for the pound the Bank of England would need to increase the monetary base by buying dollars and selling pounds.
What is the exchange rate between dollars and Swiss francs if one dollar is convertible into 1/20 ounce of gold and one Swiss franc is convertible into 1/40 ounce of gold?
If a country’s par exchange rate was undervalued during the Bretton Woods fixed exchange rates regime, what kind of intervention would that country’s central bank be forced to undertake, and what effect would it have on its international reserves and the money supply?
The situation would be as depicted in Figure 2, Panel (b). The central bank would need to sell domestic currency and buy foreign assets, thus increasing its international reserves and the monetary base.
The resulting rise in the money supply would then lead to a decline in the domestic interest rate which would decrease the expected return on dollars and shift the demand curve to the left so that the equilibrium exchange rate would be at par.
How can a large balance-of-payments surplus contribute to the country’s inflation rate?
A large balance-of-payments surplus may require a country to finance the surplus by selling its currency in the foreign exchange market, thereby gaining international reserves. The result is that the central bank will have supplied more of its currency to the public, and the monetary base will rise. The resulting rise in the money supply can cause the price level to rise, leading to a higher inflation rate.
“If a country wants to keep its exchange rate from changing, it must give up some control over its money supply.” Is this statement true, false or uncertain? Explain your answer.
True, because when the exchange rate is falling, the central bank must buy its currency, which lowers its holdings of international reserves and its monetary base. Similarly, when the exchange rate is rising, it must sell its currency, which raises its holdings of international reserves and its monetary base. The necessary central bank intervention to keep its exchange rate fixed thus affects the monetary base and hence the money supply.
Why can balance-of-payments deficits force some countries to implement a contractionary monetary policy?
Countries may implement a contractionary monetary policy when they decide to intervene in the foreign exchange market and buy domestic currency to finance the deficit. The result is that they sell off international reserves and their monetary base falls, leading to a decline in the money supply.
“Balance-of-payments deficits always cause a country to lose international reserves.” Is this statement true, false or uncertain? Explain your answer.
False. As seen in the chapter, a reserve currency country, such as the United States, can have its balance of payment deficits financed by foreign central banks, leaving its international reserves unchanged.
How can persistent U.S. balance-of-payments deficits stimulate world inflation?
When other countries buy U.S. dollars to keep their exchange rates from changing vis-à-vis the dollar because of the U.S. deficits, they gain international reserves and their monetary base increases. The outcome is that the money supply in these countries grows faster and leads to higher inflation throughout the world.
Why did the exchange rate peg lead to difficulties for the countries in the ERM when German reunification occurred?
In the aftermath of German Reunification the Bundesbank faced rising inflationary pressures. In order to get inflation under control they raised interest rates significantly to near double-digit levels. If exchange rates had been allowed to float at this time then one would have expected the increase in interest rates to strengthen the deutschemark against the pound. As the exchange rates were pegged the pound became overvalued against the deutschemark. In order to maintain the peg the Bank of England would have had to raise interest rates significantly. The British were having a very bad recession and thus did not want to raise interest rates.
Why is it that in a pure flexible exchange rate system, the foreign exchange market has no direct effects on the monetary base and money supply? Does this mean that the foreign exchange market has no effect on monetary policy?
There are no direct effects on the money supply because there is no central bank intervention in a pure flexible exchange rate regime; therefore, changes in international reserves that affect the monetary base do not occur. However, monetary policy can be affected by the foreign exchange market because monetary authorities may want to manipulate exchange rates by changing the money supply and interest rates.
“The abandonment of fixed exchange rates after 1973 has meant that countries have pursued more independent monetary policies.” Is this statement true, false or uncertain? Explain your answer.
Uncertain. Although after 1973, countries no longer must intervene in the foreign exchange market to keep their currencies at a par level and so could pursue more independent monetary policy, they have not chosen to do so; rather, they have continued to engage in substantial intervention in the foreign exchange market. Thus they continue to have substantial fluctuations in international reserves, which affect their money supply.
Are controls on capital outflows a good idea? Why or Why not?
Although capital outflows can harm a country when they lead to a devaluation of the domestic currency, controls in capital outflows are generally not thought to be a good idea. They are seldom effective in a crisis because the private sector figures out ways to get around them; they may even stimulate further capital outflows because they weaken confidence in the government. They also can lead to corruption and may also encourage governments to procrastinate and not take the steps necessary to reform their financial systems.
Discuss the pros and cons of controls on capital inflows.
By keeping out capital inflows, there may be less speculative capital to flow out during a crisis and a lower likelihood that capital inflows will fuel a lending boom and excessive risk-taking on the part of banks. On the other hand, capital controls on inflows keep funds that would be used for productive investment from entering a country. Capital controls on inflows might also produce substantial distortions and misallocations of resources and also lead to corruption.
Why might central banks in emerging-market countries find that engaging in a lender-of-last-resort operation might be counterproductive? Does this provide a rationale for having an international lender of last resort like the IMF?
Engaging in a lender-of-last resort operation is likely to weaken the credibility of the central bank and lead to inflation and an even larger depreciation of the domestic currency. Because debt is short-term and denominated in foreign currency in emerging-market countries, the depreciation would lead to a deterioration of balance sheets; thus, the lender-of-last resort operation is likely to make the financial crisis even worse.
Has the IMF done a good job in performing the role of the international lender of last resort?
Some critics think not. They believe that IMF lending which was used to bail out foreign lenders makes financial crises more likely. These lenders then expect to be bailed out and thus provided funds that were used to fuel excessive risk taking. Critics also believe that lending to the Russian government encouraged it to resist adoption of appropriate reforms to stabilize its financial system. The IMF has also been criticized for imposing austerity programs which make it easier for politicians to mobilize public opinion against doing what is necessary to reform the financial system. On the other hand, if the IMF had not provided funds to countries in trouble, their financial crises might have been much worse.
What steps should an international lender of last resort take to limit moral hazard?
The international lender of last resort needs to make it clear that it will extend liquidity only to governments that take measures to prevent excessive risk taking. It can also reduce moral hazard
by restricting the ability of governments to bail out stockholders and large uninsured creditors of domestic financial institutions.
Chapter 16 – Quantitative Problems
The Federal Reserve purchase $1m of foreign assets for $1m. Show the effect of this open market operation using T-Accounts.
Again, the Federal Reserve purchases $1m of foreign assets. However, to raise the funds, the trading desk sells $1m of T-bills. Show the effect of this open market operation using T-accounts.
Federal Reserve System
Currency in circulation
If the interest rate is 4% on euro deposits and 2% on dollar deposits, while the euro is trading at $1.3 per euro, what does the market expect the exchange rate to be 1-year from now?
Consider the situation where you have 1 EUR today. You can deposit it into a bank account for 1 year and have 1.04 EUR in a years time. You can then convert it into dollars at the unknown exchange rate. Or you can take your EUR, convert it into 1.3 dollars today and deposit it for a year. It will be worth 1.3*1.02 = 1.326 USD. Thus the exchange rate in a years time must be:
If the dollars begins trading at $1.3 per euro, with the same interest rates given in problem 3, and the ECB raises interest rates so that the rate on euro deposits rises by 1%, what will happen to the exchange rate (assuming that the expected future exchange rate is unchanged)?
This is the same problem as above but but you need to solve for the spot exchange rate. The 1 EUR grows at 5% and then can be converted into USD at $1.275/EUR (from the previous problem). This is worth 1.05*1.275 = 1.33875. Alternatively you can convert your EUR to dollars at the unknown exchange rate, invest for a year at 2% and it must equal $1.33875. Thus the exchange rate must be 1.33875/1.02 = $1.3125/EUR.
If the balance in the current account increases by $2bn while the capital account falls by $3.5bn, what is the effect on governmental international reserves?
The governmental international reserves is equal to the current account plus the capital account. Thus the change in international reserves must be $2bn-$3.5bn = -1.5bn.
Chapter 16 – Additional Questions
Identify three criteria necessary for a currency to join the euro. Why were these criteria seen as important to the success of the euro?
The criteria for a currency to join the euro include:
Interest rates had to be close to European average
Exchange rate stability
These were set up to try to ensure that an economy that joined the euro was stable and was entering at the correct exchange rate.
The following is a graph of the Greek trade deficit before and after Greece joined the euro. Why might one have seen a significant increase in imports after joining the Euro?
In general a trade deficit would be associated a weakening currency. By pegging the currency against the euro this stopped the Greek currency from devaluing against the euro. As the trade imbalance was not corrected this lead to an implied strengthening of the Greek Drachma versus the euro. This allowed Greeks to import more goods.
In addition interest rates were significantly lowered in Greece which meant consumers were able to borrow more cheaply and import more goods.
A German Bank lends 1,000 EUR to a Greek Bank that then lends 1,000 EUR to a Greek customer. The Greek customer then buys goods from a German company for 1,000 EUR The German company then deposits the 1,000 EUR into its bank account at the German Bank.
The German Bank then withdraws the loan from the Greek Bank. The Greek Bank then borrows the money from the Greek central bank. Draw new T-accounts for the German Bank, The Greek Bank and the Greek Central Bank.