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