Question

Suppose the Central Bank of Country X has $700 million in foreign assets, $1,200 million in domestic assets, and holds $600 million in deposits by private banks.

1. How much currency in circulation is there in Country X (in millions)?

2. Suppose the Cental Bank engages in a non-sterilized purchase of foreign assets in the amount of $200 million. Determine the balance sheet ( domestic assets, foreign assets, currency in circulation, and bank deposits).

3. Suppose the purchase above is sterilized. Determine the new balance sheet ( domestic assets, foreign assets, currency in circulation, and bank deposits).

Answer 1

Balance sheet of the Central Bank

  Liabilities Assets

Deposits by private banks ($600mn) Foreign Assets ($700mn)

Domestic Assets ($1200mn)

1) In the Balance Sheet, Assets and Liabilities always balances. But in the above balance sheet, assets are more than the liabilities. The total of assets side is $1900 million and the total of liabilities side is $600 million. Currency in circulation comes on the liabilities side in case of a central bank's balance sheet. So the currency in circulation in country X is $1300 million.

2) When the Central Bank purchases the non-sterilized foreign assets the foreign assets in the assets side of balance sheet will increase by the amount $200 million. The purchase of foreign assets will increase the demand for foreign currency and thus strengthen it and will decrease the demand for domestic currency and thus weakens it. So when there is less demand for domestic currency the currency in circulation will get increased and the bank deposit will reduce.This could be offset by reducing the policy rates by the Central Bank.

3) When the purchase of foreign assets is sterilized, then the amount of foreign assets purchased is bought using the domestic assets, so there will be an increase in foreign assets and simultaneous decrease in domestic assets by the amount of $200 million in the balance sheet. Since the purchase was sterilized there will be no effect on the currency in circulation and bank deposits.