Question

a) Using appropriate diagrams, explain foreign exchange operation, open market operation and sterilization under Portfolio Balance Model.

b) In view of the Walras's law, if n-1 markets are already specified. the specification of bond market would have been superfluous. Explain bond market equilibrium using IS-LM.bb model.

c) What is Walras Law? Explain using appropriate equations.

d) Explain what is meant by exchange rate overshooting/undershooting.

Answer 1

a) Foreign Exchange Market- The foreign exchange market is the market where currencies are traded. A currency is the money of a country. It serves as the country's legal tender, the medium with which debts can be discharged and taxes can be paid.

As a general rule, every country has its own currency, though there are some prominent exceptions. By extension, practically every country has a central bank.

Open Market Operations-  Open-market operation, any of the purchases and sales of government securities and sometimes commercial paper by the central banking authority for the purpose of regulating the money supply and credit conditions on a continuous basis. Open-market operations can also be used to stabilize the prices of government securities, an aim that conflicts at times with the credit policies of the central bank. When the central bank purchases securities on the open market, the effects will be (1) to increase the reserves of commercial banks, a basis on which they can expand their loans and investments; (2) to increase the price of government securities, equivalent to reducing their interest rates; and (3) to decrease interest rates generally, thus encouraging business investment. If the central bank should sell securities, the effects would be reversed.

sterilization-

The word “sterilization” is one of those economic terms — like “inflation,” “deflation,” the “balance of payments,” and several others — with no clear meaning. It is applied to a wide variety of situations which are actually very different, in their causes and outcomes. This is confusing; and, like those other terms as well, it tends to be used by people who are confused.

The basic idea behind “sterilization” is a situation in which a central bank increases its holdings of one asset and decreases its holdings of another, which results in little change to overall assets and also little change to overall base money.

This condition can be the result of a variety of different processes, all of which have very different implications and consequences.

Unsterilized Foreign Exchange Purchase and Open Market Sale

B)

The IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates and assets market (also known as real output in goods and services market plus money market)

C)

Walras' law is an economic theory that the existence of excess supply in one market must be matched by excess demand in another market so that it balances out. Walras' law asserts that an examined market must be in equilibrium if all other markets are in equilibrium. Keynesian economics, by contrast, assumes that it is possible for just one market to be out of balance without a "matching" imbalance elsewhere.

Walras' law is named after French economist Léon Walras (1834 - 1910), who created general equilibrium theory and founded the Lausanne School of economics. Walras' famous insights can be found in the book Elements of Pure Economics, published in 1874. Walras, along with William Jevons and Carl Menger, were considered founding fathers of neoclassical economics.

Consider an exchange economy with {\displaystyle n} agents and {\displaystyle k} divisible goods.

For every agent {\displaystyle i}, let {\displaystyle E_{i}} be their initial endowment vector and {\displaystyle x_{i}} their Marshallian demand function (demand vector as a function of prices and income).

Given a price vector {\displaystyle p}, the income of consumer {\displaystyle i} is {\displaystyle p\cdot E_{i}}. Hence, their demand vector is {\displaystyle x_{i}(p,p\cdot E_{i})}.

The excess demand function is the vector function:

{\displaystyle z(p)=\sum _{i=1}^{n}(x_{i}(p,p\cdot E_{i})-E_{i})}

Walras's law can be stated succinctly as:

{\displaystyle p\cdot z(p)=0}

PROOF: By definition of the excess demand:

{\displaystyle p\cdot z(p)=\sum _{i=1}^{n}(p\cdot x_{i}(p,p\cdot E_{i})-p\cdot E_{i})}

The Marshallian demand is a bundle {\displaystyle x} that maximizes the agent's utility, given the budget constraint. The budget constraint here is:

{\displaystyle p\cdot x=p\cdot E_{i}}

Hence, all terms in the sum are 0 so the sum itself is 0.^{[6]:317–318}

^d)

The term overshooting indicates the excessive fluctuation of the nominal exchange rate in response to a change in the monetary supply. This phenomenon, first defined by Dornbusch (1976) and due to price stickiness, contributes to explaining the high volatility displayed by nominal exchange rates. The Dornbusch’s model assumes price stickiness (a reasonable assumption in the short run) and helps to explain why exchange rates move so sharply from day to day. Since prices do not adjust immediately, a monetary shock affects the real balances and the nominal interest rate. Let's consider, for example, a rise (decrease) in money supply. The Uncovered interest parity (UIP) implies a nominal depreciation (appreciation) to compensate for the negative (positive) spread between the domestic and the foreign nominal interest rate. Thus, the exchange rate adjusts instantaneously to equate supply with demand for foreign exchange, overshooting (undershooting) its long run equilibrium level. In the medium run, prices adjust according to the money supply and the exchange rate moves downward (upward). Hence, in the long run, the principle of neutrality is satisfied.