HW4_solution - Chapter 17 1 An expansion of the central...

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Chapter 17: 1. An expansion of the central bank’s domestic assets leads to an equal fall in its foreign assets, with no change in the bank’s liabilities (or the money supply). The effect on the balance-of-payments accounts is most easily understood by recalling how the fall in foreign reserves comes about. After the central bank buys domestic assets with money, there is initially an excess supply of money. The central bank must intervene in the foreign exchange market to hold the exchange rate fixed in the face of this excess supply: the bank sells foreign assets and buys money until the excess supply of money has been eliminated. Since private residents acquire the reserves the central bank loses, there is a non-central bank capital outflow (a financial-account debit) equal to the increase in foreign assets held by the private sector. The offsetting credit is the reduction in central bank holdings of foreign assets, an official financial inflow. 3. A one-time unexpected devaluation initially increases output; the output increase, in turn, raises money demand. The central bank must accommodate the higher money demand by buying foreign assets with domestic currency, a step that raises the central bank’s liabilities (and the home money supply) at the same time as it increases the bank’s foreign assets. The increase in official foreign reserves is an official capital outflow; it is matched in the balance of payments accounts by the equal capital outflow associated with the public’s own reduction in net foreign asset holdings. (The public must exchange foreign assets for the money it buys from the central bank, either by selling foreign assets or by borrowing foreign currency abroad. Either course of action is a capital inflow.) A more subtle issue is the following: when the price of foreign currency is raised, the value of the initial stock of foreign reserves rises when measured in terms of domestic currency. This capital gain in itself raises central-bank foreign assets (which were measured in domestic currency units in our analysis)—so where is the corresponding increase in liabilities? Does the central bank inject more currency or bank-system reserves into the economy to balance its balance sheet? The answer is that central banks generally create fictional accounting liabilities to offset the effect of exchange-rate fluctuations on the home-currency value of international reserves. These capital gains and losses do not automatically lead to changes in the monetary base. 4. As shown in Figure below, a devaluation causes the AA curve to shift to A A which reflects an expansion in both output and the money supply in the economy. Figure below also contains an XX curve along which the current account is in balance. The initial equilibrium, at point 0, was on the XX curve, reflecting the fact that the current account was in balance there. After the devaluation, the new equilibrium point is above and to the left of the XX curve, in the region where the current account is in surplus. With fixed prices, a devaluation improves an economy’s competitiveness, increasing its exports, decreasing its imports, and raising the level of output.
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