Question

For question 5 I chose c... question 6 stems off of question 5 directly, so I would like clarification on whether my question 5 is right, and then come to a question 6 answer.

QUESTION 5

1. The central bank of Saudi Arabia (Saudi Arabian Monetary Authority or SAMA) has pegged (fixed) the country’s currency, Saudi riyal (SAR), to the US dollar (USD) at the rate of 3.75 SAR/$. To implement this policy, the SAMA prints money (SAR) and buys USD from anyone who wants to exchange USD for SAR at that rate. By doing so, SAMA increases the Saudi money supply. Similarly, it sells USD to anyone who wants to exchange SAR for USD at that rate. Such transactions reduce the Saudi money supply. In recent months businesses in Saudi Arabia have been buying large amounts of USD with their riyals to move their financial assets to the US. Assuming no other changes that impact the money market, this process

   	a.	may have made the LM curve in Saudi Arabia flatter or steeper.
   	b.	could not have had any impact on the LM curve in Saudi Arabia.
   	c.	must have made the LM curve in Saudi Arabia steeper.
   	d.	must have made the LM curve in Saudi Arabia flatter.

10 points   

QUESTION 6

1. In the above question, suppose the interest parity condition holds and the USD risk-free interest rates have not changed since businesses in Saudi Arabia started purchasing US dollars in large quantities. Also, everyone is confident that SAMA can keep the SAR-USD exchange rate constant for many years to come. Further, assume that the GDP, price level, long-term prospects, and the parameters of the Saudi economy do not change as a result of the USD purchases. Finally, assume that the Saudi money market has been in equilibrium before and after the dollar purchase. In this situation, as a result of the dollar purchase by businesses, the risk-free interest rates in Saudi Arabia

   	a.	must have gone up.
   	b.	must have gone down.
   	c.	may have gone up or down.
   	d.	should have remained unchanged

Answer 1

Question 5: Answer D

As the Money supply in Saudi decreases, the interest elasticity of the demand for money increases or in simple a slight change in interests causes demand change in money. Hence that flattens the LM curve.

Question 6: Answer D

With money market at equilibrium, fixed exchange rate and ceteris paribus, the inflation rate remains constant too. And as we know the risk free rates are indexed with government securities adjusted to inflation, we can expect that the risk free return to be constant. Maybe slight changes might occur, but on most of the times it's constant thus remains unchanged.

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