Question

1.Distinguish between three tools of Central bank’s monetary policy and how each is used to change the money supply.

2. The federal reserve funds rate will always rise when the interest rate paid on excess reserves rises

3. Distinguish between dynamic and defensive open market operations. What is the purpose of each type? How are defensive open market operations typically conducted?

4. Explain the theory of purchasing power parity. Explain the limitation of purchasing power parity in fully explaining exchange rate movements.

5. In a floating exchange rate regime between Japan and the U.S, what happens to the dollar in the following cases

a. An increase in the purchase of electronic equipment’s from Japan

b. Higher real interest rates in the U.S

c. Inflation in Japan and stable prices in the U.S

d. Higher Nominal Interest rates due to high expected inflation in the U.S

Answer 1

ANS 1: In order to run a healthy economic environment, the Central Bank uses three important tools of monetary policy. These are as follows- Open Market Operations, The Reserve Requirements and the Discount Rate.

These three major monetary tools can be distinguished as follows-

In open market operations, the securities are bought and sold by the Central Banks.Here the private banks of the country play major role because from the private banks these securities are bought or sold to these banks. There is increase in the reserves of the banks if the central bank buys securities.Whereas, if the central bank sells those securities, then then this decline the holdings of cash amount in the bank's reserves. With the existence of this monetary policy tool, an economy is very strong in the monetary base.

The Reserve Requirement is an important monetary policy tool. The commercial bank must hold a minimum amount of reserves which must not be less than a particular percentage of saving transactions which is determined by the central bank which the commercial bank give obligation to its customers.

The third important monetary policy tool of the central bank is the discount rate. This tool is mainly used only when the funds from other banks cannot be borrowed.

ANS 4: Famous Economist, Gustav Cassel developed the Purchasing Power Parity Theory in the year 1920.This Theory was propounded in order to determine the exchange rate between two countries on their inconvertible paper currencies.According to this theory, the equilibrium exchange rate between two inconvertible paper currencies is determined by the equality of the relative change in the relative price of the two countries. Let us take an example,

Suppose there are two countries say Country A and Country B and both the countries are on incovertible paper currencies.Here by spending Rs.200, the same quantity and quality of a particular good can be purchased in Country A as can be bought by spending 2 in Country B. According to the PPP Theory, here the exchange rate will be Rs.200=2. Now, if the exchange rate moves to Rs.190=2 but the price level is constant in the two countries, then in this case, less rupees are required to buy the same product in Country A which results in overvaluation and will ultimately encourage imports and discourage exports by Country A which will lead to increase in the demand for pounds in Country B. This process will again restore to its normal exchange rate of Rs.200=2. On the other hand, if the exchange rate moves to Rs.210=2, then currency for Country A becomes undervalued and exports are encouraged and imports are discouraged.where demand for rupees will increase and that for pound will decline so that the exchange rate is restored back to Rs.200=2.

One of the major limitation of the Purchasing Power Parity theory is in the calculation of the price levels of the two countries.Here the process of calculation involve the index number where difficulty arises in calculating the base year, method of calculation and coverage which very often differs in both the countries.

Another limitation of the PPP Theory is that there is no any structural changes in the factors. But in reality, there seems to be changes in the structural factors like technology, tastes, habits, resources.