ECON 442 Assignment 3 (due Nov 4) Please write your answers in the space provided below. Use Figures where necessary to explain your answers. (50 Points) (8) A balance sheet for a central bank of is shown below Central Bank Balance Sheet
Deposits held by private banks
Currency in circulation
The central bank of a country with a fixed exchange rate buys 500 worth of foreign bonds. What kind of external balance would be most likely to prompt such an action by the bank Write the new balance sheet of the central bank. What happens to the money supply as a result of this action What should the bank do to sterilize this effect on the money supply Write the new balance sheet after the central bank undertakes this sterilization action. ( 12) a. Draw a figure (showing the money market and foreign exchange market) illustrating the actions the central bank must take to maintain a fixed exchange rate following an increase in output.
b. Explain why sterilization of the Central Banks intervention (in part a) would make it impossible for the Central Bank to maintain a fixed exchange rate. http//intl.econ.cuhk.edu.hk/topic/index.phpdid9 c. Show how an expected devaluation (under a fixed exchange rate) could lead to a balance of payments crisis. Please explain with the aid of a figure. (16) a. Use the DD-AA model to examine and compare the response of an economy under fixed and floating exchange rate to a temporary fall in foreign demand for its exports HYPERLINK https//www.google.com/searchqUsetheDD-AAmodeltoexamineandcomparetheresponseofaneconomyunderfixedan- dfloatingexchangeratetoatemporaryfallinforeigndemandforitsex- portsoqUsetheDD-AAmodeltoexamineandcomparetheresponseof https//www.google.com/searchqUsetheDD-AAmodeltoexamineandcomparetheresponseofaneconomyunderfixedan- dfloatingexchangeratetoatemporaryfallinforeigndemandforitsex- portsoqUsetheDD-AAmodeltoexamineandcomparetheresponseofaneconomyunderfixedan- dfloatingexchangeratetoatemporaryfallinforeigndemandforitsex- portsaqschrome..69i57.369j0j9sourceidchromees_sm119ieUTF-8 Use the DD AA model to examine and compare the response of an economy under fixed and floating exchange-rate regimes to a temporary fall in foreign demand for its exports. Answer The DD curve shifts to the left. When the exchange rate floats, because the demand shift is assumed to be temporary, it does not change the long-run expected exchange rate and so does not move the asset market equilibrium schedule AA. Thus, E rises, i.e. the currency depreciates and output falls. Under a fixed exchange rate policy, the central bank must prevent the currency depreciation that occurs under a floating rate thus, it buys domestic money with foreign currency, reducing the domestic money supply and shifting the AA to the left and down. E will remain constant and output will fall. What is the impact of a temporary increase in the foreign interest rate under flexible exchange rates How does this differ from the impact under fixed exchange rates.
c. Show the impact of a permanent rise in foreign inflation rate under flexible exchange rates in the short run and the long run What would the impact under fixed exchange rates be ( Use the AA DD framework)
d) Discuss briefly what kind of exchange rate system you would recommend for a small country in a integrated global economy (with capital mobility) fixed or flexible. Explain the reasons for your policy recommendations clearly. (14) Use the AA DD framework to answer the following questions (with diagrams) Assume you are starting from a full employment equilibrium. There is an outbreak of war in the main trading partner of the country (the leading export destination of the countries products). This results in a temporary disruption of trade between the two countries (assuming the country is not importing much from this country) What is the impact on the DD and AA curves Why is the...
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