Question

2.           To your surprise, Nicholas Madura has appointed you as head of the central bank of Venezuela. Currently Venezuela has the highest interest rates and inflation in the world. Your mission is to reduce inflation and interest rates. You consider three options – reduce money growth but keep a floating exchange rate. Second, fix the exchange rate to the dollar but keep the Venezuelan currency. Third, form a currency board where all Venezuelan currency is backed by foreign reserves at a fixed exchange rate to the dollar. The foreign reserves will be held in the US.

a) what are the likely effects of these policies on inflation and interest rates in Venezuela? Support your answers by what you learned from the class.

b) Which policy do you recommend?

Answer 1

Solution A

• Reducing money growth will curb inflation however keeping floating exchange rate will drastically swing it and also may rupture economy and current account deficits.
• Keeping Venezuelan curreency but at fixed rate to dollar will just help in exports which neither will solve inflation or rising interest rate problem.
• Dollarization is much better as this will dump and abolish the currency however add Venezuelan debt and may loose control to American Government. However this is most immediate and stable option to solve situations. This will peg inflation and interest rates to Us economy which is most robust as of now.

Solution B

The best option is third one because this straightway dumps Boliviar currency if Venezuela and backs it by dollarization which is much nore stable and will push inflation down and interest rates at much stable level then before.