answers7 - University of California, Berkeley Department of...

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University of California, Berkeley ` Fall 2007 Department of Economics ECON 182 Suggested Solutions to Problem Set 7 Problem 1 – Problem Set 1—Revisited, reinterpreted a. An increase in the price of imports worsens the trade balance and the current account, thus putting pressure on the currency to depreciate. [We will consider this as the main force on the exchange rate. However, note that an increase in the price level caused by the higher import prices lowers the real money supply, increasing interest rates and thus causing appreciating pressure on the currency.] The central bank has to sell foreign reserves (this increases demand for the domestic currency and lowers demand for foreign currency) in order to prevent the currency from depreciation. This action lowers the money supply. b. The money supply falls, thus interest rates increase. Either in AA/DD or in IS/LM framework, we can see that output falls. Also, the exchange rate indeed appreciates as a result of this intervention. If the economy is in recession or below potential output the foreign exchange intervention would further deteriorate the situation in the economy. So, the central bank is faced with a choice between defending the peg and stabilizing the
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answers7 - University of California, Berkeley Department of...

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