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1.1 The difference is what the central bank is buying or selling. A foreign exchange market intervention involves the central bank buying or selling foreign assets (assets denominated in a foreign currency) whereas a domestic open market intervention involves the central bank buying or selling domestic assets, typically domestic government securities.

1.2 The Fed’s holdings of international reserves decrease by $2 billion, and the monetary base decreases by $2 billion.

1.3 The purchases have the same effect on the monetary base. In either case, the Fed acquires an asset and increases bank reserves by an equivalent amount.

1.4 With a sterilized foreign-exchange intervention, the central bank offsets the effect of the intervention on the monetary base. With an unsterilized foreign-exchange intervention, the central bank does not offset the effect on the monetary base.

1.5 a. A sterilized intervention refers to a foreign exchange intervention where the central bank offsets the effect of the intervention on the monetary base.

b. If the Fed purchased foreign assets, it would also sell U.S. Treasury securities, or if the Fed sold foreign assets it would also buy U.S. Treasury securities.

c. A sterilized intervention will not have any effect on the value of the dollar because a sterilized intervention will not change domestic interest rates.

1.6 The Fed’s international reserves decrease by $5 billion, and the monetary base decreases by $5 billion. This is an unsterilized intervention because the Fed takes no action to offset the effect of the foreign exchange intervention on the monetary base.

Federal Reserve

|Assets |Liabilities |

|Foreign assets −$5 billion |Bank reserves at the Fed −$5 billion |

|(international reserves) | |

1.7 The monetary base does not change. This is a sterilized intervention because the Fed took action to offset the effect of the foreign exchange intervention on the monetary base.

Federal Reserve

|Assets |Liabilities |

|Foreign Assets +$2 billion |Bank reserves +$2 billion |

|(international reserves) | |

|Treasury securities ($2 billion |Bank reserves ($2 billion |

1.8 a. The monetary base increases by $10 billion because bank reserves will increase by that amount.

b. The monetary base does not change because the effects of the two actions on the base offset.

c. The monetary base does not change because sterilized foreign exchange interventions do not affect the base.

d. The monetary base decreases by $20 billion because bank reserves will fall by that amount.

2.1 To raise the foreign exchange rate, the central bank would sell foreign assets, which would reduce the monetary base and raise domestic interest rates.

2.2 A sterilized central bank intervention does not affect the demand curve or the supply curve for a country’s currency because domestic interest rates do not change.

2.3 Capital controls are government-imposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets. Countries may impose capital controls because currency crises are fueled in part by sharp inflows and outflows of financial investments. The disadvantages of imposing capital controls are:

1. They can increase government corruption with government officials demanding bribes to exchange domestic currency for foreign currency.

2. Multinational firms may be reluctant to build factories and other facilities in countries with capital controls.

3. Individuals and firms can evade the capital controls through the black market for the currency.

2.4 Foreign investors demand U.S. dollars. An increase in U.S. interest rates relative to Japanese interest rates increases the demand for dollars because foreign investors typically wish to purchase U.S. financial assets rather than just holding U.S. currency.

2.5 The sale of $5 billion of U.S. Treasury securities by the Bank of Japan will raise interest rates in Japan by reducing the monetary base. The higher Japanese interest rates will increase the demand for yen and decrease the supply of yen, pushing up the exchange value of the yen. In the graph below, the demand curve for yen shifts to the right from D1 to D2, and the supply curve for yen shifts to the left from S1 to S2. As a result, the equilibrium exchange rate increases from EX1 to EX2.

[pic]

2.6 a. Raising the floor from 1.2 francs = €1 to 1.3 francs = €1 would result in a depreciation of the Swiss franc against the euro because it would take more francs to buy a euro. b. To raise its floor exchange rate between the franc and the euro, the Swiss National Bank would need to buy euro-denominated assets and sell Swiss francs, which would increase the Swiss monetary base and decrease Swiss interest rates. In the graph below, the decrease in interest rates would decrease the demand for Swiss francs, causing the demand curve to shift to the left from D1 to D2, and increase the supply of Swiss francs, causing the supply curve to shift to the right from S1 to S2. The result would be a decrease the exchange value of the Swiss franc relative to the euro, with the exchange rate declining from EX1 to EX2. Note in the graph below a depreciation in the Swiss franc is a decrease in euros per Swiss franc.

[pic]

c. The SNB could add to its foreign-currency reserves indefinitely in the sense that it will not run out of Swiss francs to pay for the foreign-currency denominated assets. However, purchases of foreign assets increase the Swiss monetary base, which could cause inflation in Switzerland.

3.1 The current account records transactions of currently produced goods and services, and the financial account records transactions of existing financial or real assets. If a country runs a current account deficit, its exports of goods and services are smaller than its imports of goods and services.

3.2 Each international transaction represents an exchange of goods, services, or assets among households, businesses, or governments. Therefore, the two sides of the exchange must always balance. Suppose the United States runs a current account deficit of $500 billion, meaning that it spent $500 billion more on currently produced goods and services than it received. Every dollar of the $500 billion was used by foreign individuals, firms, or governments to invest in the United States or was added to foreign holding of dollars. There is nowhere else for the dollars to go—they must have been spent on investments in the United States or not spent at all. Dollars that aren’t spent are added to foreign holdings of dollars and included in official reserve transactions. Therefore, a current account deficit must be exactly offset by a financial account surplus. Similarly, a country that runs a current account surplus must run a financial account deficit of exactly the same amount.

3.3 When the official settlements balance is excluded from the financial account, a country can run a balance-of-payments surplus (it gains international reserves) or a balance-of-payments deficit (it loses international reserves).

3.4 Official reserve assets are assets that central banks hold and that they use in making international payments to settle the balance of payments and to conduct international monetary policy.

3.5 The financial account balance would be a surplus of $400 billion, and would represent a net capital inflow.

3.6 The purchase of the 10 Volkswagen autos would be recorded in the current account as a $200,000 payment to foreigners, which is recorded as a negative number. The purchase of the U.S. Treasury bond would be recorded in the financial account as a $200,000 receipt from foreigners, which is recorded as a positive number.

3.7 The transaction is recorded as in the financial account as a $300 million increase in U.S. international reserves.

3.8 When the official settlements balance is excluded from the financial account, a country can run a balance-of-payments surplus (it gains international reserves) or a balance-of-payments deficit (it loses international reserves). A country would finance a balance of payments deficit in this sense by a reduction in international reserves. The important difference between the ways in which a U.S. balance-of-payments deficit can be financed and the ways in which other countries must finance their balance-of-payments deficits is that U.S. dollars and dollar-denominated assets serve as the largest component of international reserves. Other countries’ willingness to hold U.S. Treasury securities as international reserves leads to lower interest rates on these Treasury securities.

4.1 The gold standard was a fixed exchange rate system under which currencies of participating countries were convertible into an agreed-upon amount of gold. The quantity of gold held by a country determined its money supply, and gold served as official reserves. Trade deficits lead to gold outflows and a decrease in the money supply, and trade surpluses lead to gold inflows and an increase in the money supply. The Bretton Woods system of fixed exchange rates was not as tied to gold and had more flexibility (though not much). Unlike under the gold standard, under the Bretton Woods system, countries were not willing to redeem their domestic currencies for gold. Even though the United States agreed to convert dollars into gold at a price of $35 per ounce, the money supply of the world or a country was not determined by the quantity of gold they held. Exchange rates could fluctuate within a small range. The IMF was created to help with fluctuations and exchange rate problems. As with any fixed exchange rate system, however, countries were not free to pursue independent monetary policy. The U.S. dollar served as the primary reserve currency.

4.2 a. The gold standard was a fixed exchange rate system with exchange rates determined by the relative amounts of gold in different currencies.

b. Countries were not able to pursue active monetary policies because the monetary base of a country was determined by gold flows.

c. Countries that ran trade deficits experienced gold outflows because they were importing more than they were exporting. To pay for the difference between their imports and their exports, gold had to flow to other countries.

d. A gold inflow would increase a country’s monetary base and its inflation rate.

e. During the Great Depression, some countries had to pursue contractionary monetary policies to maintain the gold standard, and countries had difficulty pursuing expansionary monetary policies.

4.3 Devaluations and revaluations refer to the lowering (devaluation) and raising (revaluation) of a country’s official fixed exchange rate. A depreciation refers to a drop in the value of a currency in a flexible exchange rate system, whereas a devaluation refers to a drop in the official fixed exchange rate in a fixed exchange rate system. Countries were hesitant to pursue a devaluation because the governments had to face political charges that their monetary policies were flawed. Devaluations also increased the domestic currency price of imports, potentially increasing the domestic inflation rate. Countries were even more hesitant to pursue a revaluation because it made domestic goods and services less competitive in world markets, reducing exports.

4.4 The euro zone refers to the 17 European countries that use the euro as a common currency. Using a single currency eliminates the transactions costs of currency conversion and eliminates exchange rate risk for firms and investors in dealing with other countries in the euro zone. Also, the removal of high transactions costs in cross-border trades increases efficiency in production by offering the advantage of economies of scale. When a country’s economic conditions are worse than the euro zone as a whole, using a single currency prevents that country from pursuing an independent monetary policy. In particular, a country cannot benefit from an increase in exports that would result if its currency depreciated.

4.5 Pegging is the decision by a country to keep the exchange rate fixed between its currency and another country’s currency. Countries peg their currencies to gain the following advantages of a fixed exchange rate: reduced exchange rate risk, a check against inflation, and protection for firms that have taken out loans in foreign currencies. A peg can run into the problem of the pegged currency becoming overvalued or undervalued and then being subject to speculative attacks. The controversy with China’s pegging of the value of the yuan is that it is undervalued, making Chinese exports cheaper in foreign currencies and imports into China more expensive in Chinese currency.

4.9 The support for a fixed exchange system has tended to be higher in Europe than in the United States because of the large volume of commercial and financial transactions among the European countries. Fixed exchange rates reduce the costs of uncertainty about exchange rates in international commercial and financial trading. The United States has traditionally imported and exported less as a percentage of GDP than have most European countries.

4.10 a. The euro eliminates the transactions costs of currency conversion.

b. A competitive devaluation occurs when a country on a fixed-exchange rate reduces the foreign exchange value of its domestic currency to reduce the cost of its exports and stimulate its economy. Not being able to devalue its currency can be a disadvantage when a country has a recession while the rest of the euro zone does not.

c. If countries abandon the euro and return to using their own currencies, then the single European market is destroyed in the sense that the countries do not benefit from the reduction in transactions costs, and the businesses and investors in the countries will face more exchange rate risks. The harmonization of economic regulations and policies among the euro countries would likely to be at least slowed, if not stopped.

4.12 a. To the degree that the Chinese yuan is undervalued, the prices of U.S. exports to China are “artificially inflated in price”—that is the yuan-price of U.S. exports is increased, and the prices of Chinese imports to America are “artificially deflated in price”—that is, the dollar price of Chinese imports is decreased.

b. The undervaluation of the yuan makes exports of U.S. goods and services to China more expensive and imports of Chinese goods and services to the U.S. less expensive thereby giving Chinese firms a competitive advantage over U.S. firms.

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