Question

International Finance

Imagine that oil prices have recently dropped to $48 per barrel. Suppose you are a member of the monetary policy committee of a small open economy, dependent on oil exports, which also wants to maintain a currency peg to the dollar.

(a) Describe the pressures (in the form of appreciation or depreciation) that the domestic currency would face due to the decrease in oil prices. (Hint: Think about the effects of the lower oil prices−export prices−on the current account). How would the central bank have to respond in order to maintain the currency peg? Will this response by the central bank increase or decrease foreign reserves?

(b) Describe the impact of the Central Bank actions on the money supply, output, and domestic interest rates. If the economy is in a mild recession or below potential output, describe the dilemma that policymakers face.

(c) Suppose the central bank decides to sterilize its foreign-exchange intervention. Answer questions (a) and (b) once more. This time, will the central bank's domestic assets increase or decrease

Answer 1

The exports will fall leading to depreciation. The central bank will have to sell foriegn exchange to maintain peg. This will lower reserves of FR

B Central bank purchases domestic money with FR. As a result money supply will fall, employment will decrease and interest rates will rise. In recession govt has to increase money supply and reduce interest rates. But foriegn exchange intervention results in opposite results. Thus there is dilemma between foreign and domestic balance

C central bank will supply FE to counter depreciation and at the same time conduct open market operations to increase money supply. Foriegn exchange will still decline. But due to greater money supply intervention will not be as effective as otherwise

b The money supply and unemployment will not decrease. Interest rates will not rise. There will be no dilemma