Assignment: International Finance
Instructions: Provide complete answers to the following questions. A group-work is strongly encouraged to do this problem set, but you will have to submit your own solutions. Write your answers as CLEARLY as possible. Illegible answers may lose points. Lastly, make sure to accompany appropriate reasoning or calculation as part of your solutions if it is required to understand your answer.
I. Central Bank Intervention and the Money Supply
The central bank balance sheet of the imaginary country Pecunia is shown below:
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Assets
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Liabilities
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Foreign assets
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$1,000
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Deposits held by private banks
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$500
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Domestic assets
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$1,500
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Currency in circulation
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$2,000
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We want to analyze how the sale of $100 worth of its foreign assets affects the central bank's balance sheet. The assumption in the textbook example (pg.467) was that the buyer of the foreign assets paid in the form of domestic currency cash. Suppose instead that the buyer pays with a check drawn on her account at Pecuniacorp, a private domestic bank. Using a balance sheet like the one presented above, show how the transaction affects the central bank's balance sheet and the money supply.
II. Fiscal Expansion under a Fixed Exchange Rate
How does fiscal expansion affect the current account under a fixed exchange rate? Do you expect the changes in current account to be smaller or larger than under floating (a flexible exchange rate)? Explain.
III. Fixed Exchange Rates and Central Bank Intervention
Imagine that oil prices have recently dropped to $48 per barrel. Suppose you are a member of the monetary policy committee of a small open economy, dependent on oil exports, which also wants to maintain a currency peg to the dollar.
(a) Describe the pressures (in the form of appreciation or depreciation) that the domestic currency would face due to the decrease in oil prices. (Hint: Think about the effects of the lower oil prices-export prices-on the current account). How would the central bank have to respond in order to maintain the currency peg? Will this response by the central bank increase or decrease foreign reserves?
(b) Describe the impact of the Central Bank actions on the money supply, output, and domestic interest rates. If the economy is in a mild recession or below potential output, describe the dilemma that policymakers face.
(c) Suppose the central bank decides to sterilize its foreign-exchange intervention. Answer questions (a) and (b) once more. This time, will the central bank's domestic assets increase or decrease?
IV. Import Tariff under a Fixed Exchange Rate
Using the DD-AA model, analyze the output and balance of payments effects of an import tariff under fixed exchange rates (Note that imposing tariffs by the domestic government will raise the price of imports.). What would happen if all countries in the world simultaneously tried to improve employment and the balance of payments by imposing tariffs?