Question

Discuss the following statements.

 

a.“When a change in a country’s nominal interest rate is caused by a rise in the expected real interest rate, the domestic currency appreciates. When the change in caused by a rise in expected inflation, the currency depreciates.”

 

b.“When domestic and foreign bonds are perfect substitutes, a central bank should be indifferent about using domestic or foreign assets to implement monetary policy.”

 

 

 

Answer 1

a) For discussing this situation we consider a comparison of a sticky-price with a flexible-price model. Reduction in the supply of money causes a rise in the nominal interest rate and hence it appreciates by interest parity relation in the sticky-price model. The real interest rate increases because of the increase nominal interest rate and also due to expected deflation. Real interest rate equals nominal minus expected inflation.
Now for a perfectly flexible price model, inflation increase causes an increase in the nominal rate.

b) The central bank requires an adequate buffer stock of foreign assets on hand during the balancing of payment deficits. It will no longer be able to keep the exchange rate from depreciationg to tackle pressure from defecits if its foreign stocks deplete.
It might lose its control over the number of reserves. This is because the supply exceeding and it cannot control exchange rate anymore. . Thus, a central bank maintaining a fixed exchange rate is not completely indifferent about using domestic or foreign assets to implement monetary policy