Economics Chp. 10 & 12

Indicate whether the following would cause the Mexican peso to appreciate or depreciate: b. Mexico encounters severe inflation.

depreciate

Indicate whether the following would cause the Mexican peso to appreciate or depreciate: c. Deteriorating political relations reduce American tourism in Mexico.

depreciate

Indicate whether the following would cause the Mexican peso to appreciate or depreciate: d. The United States' economy moves into a severe recession.

depreciate

Indicate whether the following would cause the Mexican peso to appreciate or depreciate: e. The U.S. engages in a high interest rate monetary policy.

depreciate

What is the basic objective of monetary policy?

to assist the economy in achieving a full-employment, noninflationary level of total output

Explain: A country's currency will appreciate if its inflation rate is less than that of the rest of the world.

If a country's inflation rate is lower than rates in other countries, the foreign prices of its products will decline relative to foreign made products, increasing exports and the supply of foreign currency. At the same time, the domestic prices of foreign imports will increase relative to domestically made goods, decreasing the demand for foreign currency. Both factors will cause the country's currency to appreciate.

Explain: A nation whose interest rate is rising more rapidly than interest rates in other nations can expect the international value of its currency to appreciate.

If domestic real interest rates are increasing more quickly than those in other countries, foreign financial investment will be attracted to the country, causing a rise in the supply of foreign currency and therefore an appreciation of the country's currency.

Explain: A country that grows faster than its major trading partners can expect the international value of its currency to depreciate.

If high rates of economic growth mean that the real incomes of a country's citizens are rising more rapidly than in other countries, its imports will rise. The demand for foreign currency by its citizens will increase more than the supply of foreign currency, causing the value of the domestic currency to decline.

State the cause-effect chain through which monetary policy is made effective.

Monetary policy affects the economy through a complex cause-effect chain: (a) Policy decisions affect commercial bank reserves; (b) changes in reserves affect the money supply; (c) changes in the money supply alter the interest rate; (d) changes in the interest rate affect investment; (e) changes in investment affect aggregate demand; and (f) changes in aggregate demand affect the equilibrium real GDP and the price level.

Why is monetary policy easier to undertake than fiscal policy?

Monetary policy is formed by the seven members of the Board of Governors. Fiscal policy requires the consent of both houses in Congress, plus the president. One of the implications is that monetary policy has a much shorter administrative lag than fiscal policy.

What is the impact of the following transaction on commercial bank reserves? c. The Fed reduces the reserve ratio.

Reducing the reserve ratio will not directly change the reserves of commercial banks. It will, however, change some of the bank reserves from required to excess reserves. To the extent that it also encourages greater lending, the increase in the money supply will generate more reserves.

What is the impact of the following transaction on commercial bank reserves? b. Commercial banks borrow from Federal Reserve Banks at the discount rate.

Reserves will rise if commercial banks borrow from the Fed.

Distinguish between the Federal funds rate and the prime interest rate. Which of these two rates does the Fed explicitly target in undertaking its monetary policy?

The Federal funds interest rate is the interest rate banks charge one another on overnight loans needed to meet the reserve requirement. The prime interest rate is the interest rate banks charge on loans to their most creditworthy customers. The Fed currently focuses monetary policy on altering the Federal funds rate as needed to stabilize the economy. The Fed can target the Federal funds rate because it knows that interest rates in general typically rise and fall with that rate.

Explain why the U.S. demand for Mexican pesos is downward-sloping and the supply of pesos to Americans is upward-sloping.

The U.S. demand for pesos is downward-sloping because when the peso depreciates in value (relative to the dollar), the United States finds that Mexican goods and services are less expensive in dollar terms and purchases more of them, demanding a greater quantity of pesos in the process. The supply of pesos to the United States is upward-sloping because as the peso appreciates in value (relative to the dollar), US. goods and services become cheaper to Mexicans in peso terms. Mexicans buy more dollars to obtain more U.S. goods, supplying a larger quantity of pesos.

What are the major strengths of monetary policy?

The major strengths of monetary policy are its speed and flexibility compared to fiscal policy, that the Board of Governors is somewhat removed from political pressure, and its successful record in preventing inflation and keeping prices stable.

Suppose that you are a member of the Board of Governors of the Federal Reserve System. The economy is experiencing a sharp and prolonged inflationary trend. What changes in (a) the reserve ratio, (b) the discount rate, and (c) open-market operations would you recommend?

To reduce inflation, the reserve ratio and the discount rate should be increased. A higher reserve ratio will decrease reserves, thereby decreasing the money supply, raising the interest rate, and decreasing investment, consumption, and aggregate demand. The restrictive monetary policy would reduce the lending ability of the banking system, increase the real interest rate, reduce investment spending, reduce aggregate demand, and reduce inflation.

Why do changes in bank reserves resulting from open-market operations by the Fed produce multiple changes in checkable deposits (and therefore money) in the economy?

When the Fed buys government securities from a commercial bank, for example, it increases the reserves of that bank. Assuming these new reserves are excess reserves, the bank can then loan them out, creating new money. As this new money is deposited, it creates additional excess reserves, which can then also be loaned out to create new money. The process can continue as long as there are excess reserves to be lent and deposits to be made, and it all started with the purchase of government securities from a single commercial bank.

Indicate whether the following would cause the Mexican peso to appreciate or depreciate: a. The United States unilaterally reduces tariffs on Mexican products

appreciate

Indicate whether the following would cause the Mexican peso to appreciate or depreciate: f. Mexican products become more fashionable to U.S. consumers.

appreciate

What is the impact of the following transaction on commercial bank reserves? a. The New York Federal Reserve Bank purchases government securities from private businesses and consumers.

If private businesses and consumers deposit the proceeds from their sale of government securities to the Fed, commercial bank reserves will rise. If they hold the proceeds as cash, no change in reserves will occur.

What measures do governments use to promote exports and restrict imports?

Governments promote exports by providing subsidies to export producers, which effectively lowers their costs and enables them to sell their products at lower prices on world markets. Subsidies enable export firms or industries to compete against other nations, but the fact the subsidy was necessary for this competition means that the most efficient use of resources is not taking place. Restriction of imports can be accomplished by tariffs, import quotas, and non-tariff barriers such as licensing requirements, unreasonable quality standards, and unnecessary import procedures.

If the European euro were to depreciate relative to the U.S. dollar in the foreign exchange market, would it be easier or harder for the French to sell their wine in the United States? Suppose you were planning a trip to Paris. How would the depreciation of the euro change the dollar price of this trip?

If the European euro declines in value, it means that Americans can receive more euros for each dollar. Therefore, they do not need as many dollars to pay the euro price of a bottle of French wine, so the quantity demanded would rise and it should be easier to sell French wine in the U.S. Likewise, the euro depreciation would make it less costly for Americans to travel in France, since the dollar would now buy more euros (assuming that prices inside France have not risen to entirely offset the depreciation of the euro).

How is the equilibrium interest rate in the market for money determined?

On a graph measuring the interest rate vertically and the amount of money demanded horizontally, the two demands for the money curves can be summed horizontally to get the total demand for money. This total demand shows the total amount of money demanded at each interest rate. The equilibrium interest rate is determined at the intersection of the total demand for money curve and the supply of money curve.

What is the basic determinant of the amount of money demanded for assets, given a particular asset demand for money curve?

The interest rate. The higher the interest rate, the smaller the amount of money demanded as an asset.

What is the basic determinant of the strength of the transactions demand for money?

The level of nominal GDP. The higher this level, the greater the amount of money demanded for transactions.

Indicate whether the following would cause the Mexican peso to appreciate or depreciate: g. The Mexican government encourages U.S. firms to invest in Mexican oil fields.

appreciate