Homework Assignment – 7
Chapter 16 Questions
1. 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.
2. 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.
3. 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. A British subject’s purchase of a share of Johnson & Johnson stock
A receipt in the capital account;
b. An American’s purchase of an airline ticket from Air France
a payment in the current account;
c. The Swiss government’s purchase of US Treasury bills
a receipt in the method of financing;
d. A Japanese’s purchase of California Oranges
a receipt in the current account;
e. $50 million of foreign aid to Honduras
a payment in the current account;
f. A loan by an American bank to Mexico
a payment in the capital account
g. An American bank’s borrowing of Eurodollars
a receipt in the capital account.
4. 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.
5. 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.
6. 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?
2 CHF/USD
7. 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.
8. 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.
9. “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.
10. 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.
11. “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.
12. 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.
13. 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.
14. 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.
15. “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.
16. 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.
17. 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.
18. 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.
19. 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.
20. 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
1. The Federal Reserve purchase $1m of foreign assets for $1m. Show the effect
of this open market operation using T-Accounts.
Federal Reserve System
Assets
$1 million
Foreign assets

Liabilities
$1 million
Currency in
circulation
(international
reserves)
2. 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
Assets
Foreign assets

Liabilities
$1 million
Currency in
circulation

(international reserves)
Government bonds
$1 million
3. 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:
1.326/1.04 =$1.275/EUR.
4. 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.
5. 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
1. 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:
 A debt to GDP ratio of less than 60%
 Government budget deficits had to under control
 Inflation within a certain band
 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.
2. 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?
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
45,000,000,000
40,000,000,000
35,000,000,000
30,000,000,000
25,000,000,000
20,000,000,000
15,000,000,000
10,000,000,000
5,000,000,000
0
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.
3. 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.
a. Draw T-accounts for the German and Greek Bank.
German Bank
Assets
Liabilities
Loan to Greek
1,000
German
1,000
Bank
Company Bank
Account
Greek Bank
Assets
Liabilities
Loan to Greek
1,000
Loan from
1,000
Customer
German Bank
b. 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.
German Bank
Assets
Liabilities
Reserves from
1,000
German
1,000
Greek Central
Company Bank
Bank
Account
Greek Bank
Assets
Liabilities
Loan to Greek
1,000
Loan from
1,000
Customer
Greek Central
Bank
Greek Central Bank
Assets
Loan to Greek
1,000
Bank
Reserves
Liabilities
1,000