Question

If the FED wanted to offset a large depreciation of the dollar against the Mexican peso, what policy could the FED take to achieve this objective (do not forget to discuss the role of FED’s balance sheet in the your answer).

Answer 1

To offset depreciation of dollar, Fed has to increase the value of dollar using following methods.

(I) Fed can decrease domestic money supply (by open market sale of federal securities or by increasing reserve ratio or discount rate). Lower money supply will decrease the supply of dollar, shifting dollar supply curve to left, appreciating dollar.

(II) Alternatively, Fed can buy dollars in forex market and sell existing foreign currency. This will increase the demand for dollars, shifting dollar demand curve rightward, appreciating dollar.