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Homework 4_solution

Homework 4_solution - Homework 4 E305 Money and Banking...

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Homework 4 E305: Money and Banking Spring 2010 1. Problem 19.12 The US and the UK have a floating exchange rate and you note that the one-year interest rate on a UK bond is higher than the one-year interest rate on a comparable US bond of equal risk. Assuming capital market arbitrage, what would you expect to happen to the value of the dollar versus the British pound over the next year? Answer: You would expect the dollar to appreciate against the British pound. If the two bonds are comparable and so investors are indifferent between the two of them, then the return must be the same on the two bonds. In order to compensate for the higher interest rate on the U.K. bond, the U.S. dollar must be expected to strengthen. 2. Problem 19.15 If the Federal Reserve decides to sterilize the foreign-exchange market intervention described in question 14, show the impact on the Fed’s balance sheet. What would the overall impact be on the monetary base? What would be the impact, if any, on the exchange rate? Answer: If the Fed decides to sterilize the FX market intervention, it will carry out an open market operation to offset the impact of the FX intervention on the monetary base. In this case, it will carry out an open market operation where it purchases $1000 of U.S. securities. This will increase U.S. securities by $1000 on the asset side of the balance sheet and increase bank reserves by $1000 on the liability side of the balance sheet. The Fed pays the bank it gets the securities from by crediting their account at the Fed – thus increasing bank reserves. The overall impact on the balance sheet is shown below. On the asset side, there is a compositional change between FX and domestic securities while on the liabilities side there is no change. The fall in
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