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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-ofpayments 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 subjects purchase of a share of Johnson &
Johnson stock
A receipt in the capital account;
b. An Americans purchase of an airline ticket from Air France
a payment in the current account;
c. The Swiss governments purchase of US Treasury bills
a receipt in the method of financing;
d. A Japaneses 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 banks 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 countrys par exchange rate was undervalued during the
Bretton Woods fixed exchange rates regime, what kind of
intervention would that countrys 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
countrys 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--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 doubledigit 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 emergingmarket 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.
FederalReserveSystem
Assets
Foreignassets
(internationalreserves)

Liabilities
$1million

Currencyincirculation

$1million

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.
FederalReserveSystem
Assets
Foreignassets
(internationalreserves)
Governmentbonds

Liabilities
$1million

Currencyincirculation

$1million

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?
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
1,000
German
1,000

Greek Bank
Greek Bank
Assets
Loan to
1,000
Greek
Customer

Company
Bank
Account
Liabilities
Loan from
1,000
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
1,000
German
1,000
from Greek
Company
Central Bank
Bank
Account
Greek Bank
Assets
Liabilities
Loan to
1,000
Loan from
1,000
Greek
Greek
Customer
Central Bank
Greek Central Bank
Assets
Loan to
1,000
Greek Bank

Reserves

Liabilities
1,000