Question

1. Using the central bank balance sheet, evaluate how each of the following shocks affects a country’s ability to defend a fixed exchange rate. In the following answers, we assume the central bank keeps domestic credit unchanged whenever possible.

a. The central bank sells government bonds.

b. Currency traders expect a depreciation in the home currency in the future. c.

C. An economic contraction leads to a change in home money demand.

D. The foreign interest rate falls

Answer 1

(a) When the central government sell the government bonds which leads to increase in its reserves and decrease the supply of money in market so this will help the country ability to defend fixed exchange rate.

(b) This will not help in country's ability to defend fiixed exchange rate because traders expections of depriciation of home currency will lead the decrese in demand for assets and also trader will buy foreign currency and sold home currency which leads to decrease in central bank reserves as well as money supply. This will discourage the country's ability to defend fixed exchange rate.

(c) This will not help in country's ability to defend fiixed exchange rate because due to economic contraction the home demand for money also decrease which leads to decrease in interest rates and due to decrease in demand in currency central bank will intervene in foreign exchange market central bank must sell foreign currency reserves and buy home currency. it will reduce the reserves and money supply so it reduce the ability to defend exchange rate.

(d) This will help in country's ability to defend fiixed exchange rate because fall in foreign interest rate will help to increase in domestic money demand and after the intervention of foreign exchnage market by buying foreign reserves and selling home currency this will increase the money supply which will increase the country's ability to defend the fixed exchange rate.