Monetary Policy Week 4
Currency Board (3)
1) Domestic currency backed 100% by foreign currency 2) Fixed exchange rate established 3) CB stands ready to exchange domestic for foreign currency at public request
Three reasons PPP doesn't explain all of exchange rate
1) Non-tradable items (haircuts) 2) Non-identical items (toyotas vs. chevys) 3) Trade Barriers (Tariffs)
IMF two primary functions
1) Promote growth of world trade 2) Make loans to countries with BOP issues
Four factors that change long run exchange rates
1) Relative price levels 2) Trade barriers (increase causes appreciation) 3) Productivity (increase causes appreciation) 4) Preferences of foreign vs. domestic goods
Policy Trilemma involves what three policies
1) free capital mobility 2) fixed exchange rate 3) independent monetary policy
If the Indian government unexpectedly announces that the tariffs on foreign goods will be higher one year from now, what will happen to the value of the Indian rupee today?
Appreciate
The Fed sells 100 of its foreign assets in exchange for 100 of U.S. currency. What is this effect on the Fed's balance sheet
Assets: Foreign assets (international reserves) -100 Liabilities: Currency in circulation -100
If a country's par exchange rate is undervalued, what kind of intervention should that country's central bank be forced to undertake
CB should sell domestic currency for foreign assets, increasing international reserves and decreasing the money supply. This causes appreciation of the currency.
Unsterilized intervention in which domestic currency is bought and foreign assets are sold causes what changes to the balance sheet and to the exchange rate
Decrease to assets (foreign assets), decrease to liabilities (deposits with the Fed), appreciation
In September 2012, the Federal Reserve announced a large-scale asset-purchase program (known as QE3) designed to lower intermediate and longer-term interest rates. What effect should this have had on the dollar/ euro exchange rate?
Depreciation of U.S. dollar
Why can it be good to have a weak domestic currency
Domestic products are cheaper, causing higher demand for goods amongst other countries
Exchange Rate Graph
Except supply is inelastic, x axis is "quantity of dollar assets"
Seignorage
Gov. loses revenue from making currency once dollarization is established
How can exchange rate targets lead to a speculative attack on a currency?
If Cb doesn't defend currency's value and depreciation of the currency is likely, speculators will sell currency before depreciation hits
Bretton Woods System created what two things
International Monetary Fund (IMF) and World Bank
Speculative Attack
Massive sales of weak currency or purchase of strong currency causes sharp change in exchange rate
Dollarization
Poorer country adopts sound currency like USD as their own
Under the gold standard, if Britain became more productive relative to the US, 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 US and Britain?
Pound would appreciate, causing Americans to exchange USD for . gold, ship gold to Britain and exchange it for the pound. This increases British monetary base and money supply, bringing the exchange rate back down.
World Bank main function
Provide long-term loans to developing countries
In 2008 international financial institutions significantly increased their purchases of U.S. Treasury securities as a safe haven investment. How should this have affected U.S. dollar exchange rates?
Sharp appreciation due to high demand for U.S. dollar
Purchasing Power Parity (PPP)
The exchange rate should make it that the cost of a basket of goods and services in two separate countries' is equal
Current Account Balance =
Trade Balance (NEX) + Net Investment Income + Transfers
If a country wants to keep its exchange rate from changing, it must give up some control over its money supply. True, False, Uncertain. Explain.
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.
Two ways policymakers can affect foreign exchange market with flexible exchange rate system
change the money supply or interest rates
If a central bank does not want to see its currency fall in value, it may pursue ________(contractionary, expansionary) monetary policy to ________ (raise, lower) the domestic interest rate, thereby strengthening its currency.
contractionary, raise
When domestic interest rates rise due to expected inflation, domestic currency will
depreciate
Under exchange- rate targeting, the central bank in the targeting country ________ (does, does not) lose the ability to pursue its own independent monetary policy and any shocks to the anchor country is ________ (directly, not directly) transmitted to the targeting country.
does, directly
The theory of portfolio choice suggests that the most important factor affecting the demand for domestic and foreign assets is the ________ on these assets relative to one another.
expected return
Suppose that the European Central Bank enacts expansionary policy. Everything else held constant, this will cause the demand for U.S. assets to ________ (increase, decrease) and the U.S. dollar to ________ (appreciate, depreciate).
increase; appreciate
An increase in the foreign interest rate causes the demand for domestic assets to shift to the ________ (left, right) and the domestic currency to ________ (depreciate, appreciate), everything else held constant.
left, depreciate
A central bank ________ (purchase, sale) of domestic currency and corresponding ________ (purchase, sale) of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base, everything else held constant.
purchase, sale
When domestic currency is overvalued the CB ___ (purchases, sells) domestic currency to fix the exchange rate which causes loss of ___
purchases, international reserves
Everything else held constant, if a central bank makes an unsterilized ________ (purchase, sale) of foreign assets, then the domestic money supply will decrease and the domestic currency will ________ (appreciate, depreciate).
sale, appreciate
increase in foreign exchange rate causes what shift in exchange rate graph
shifts demand left, causing lower domestic exchange rate (depreciation), same quantity of dollar assets
A rise in expected future exchange rate causes what shift in exchange rate graph
shifts demand right, causing greater exchange rate (appreciation) same quantity of dollar assets
Increase in domestic interest rate causes what shift in exchange rate graph and appreciation or depreciation of domestic currency
shifts demand right, causing higher exchange rate (appreciation), same quantity of dollar assets
When gold production was low in the 1870s and 1880s, the money supply grew ________ causing ________.
slowly, deflation
sterilized vs. unsterilized foreign exchange intervention
sterilized = no change to monetary base unsterilized = change to monetary base
Real Exchange Rate
the rate at which domestic goods and services trade for foreign goods and services
Under a fixed exchange rate regime, if a country has an ________ (undervalued, overvalued) exchange rate, then its central bank's attempt to keep its currency from appreciating will result in a ________ (gain, loss) of international reserves.
undervalued, gain