when the home currency depreciates by 1% - If pass-through is 1%, any exchange rate change is passed through completely to import prices (this is shown in DD-AA model) - Degree of pass through may be far less than 1 in the short-run
One reason for incomplete pass-through: International market segmentation- allows imperfectly competitive firms to price to market by charging different prices for the same product in different countries
The Liquidity Trap - Once an economy’s nominal interest rate falls to zero, the central bank cannot reduce it further by increasing the money supply (that is, by increasing the economy’s liquidity) - Note: cannot have negative interest rates b/c people would find money strictly preferable to bonds and bonds would become excess supply - Assumes expected future exchange rate is fixed
E = Ee/(1 - R *) - Currency cannot depreciate further - If people are indifferent b/w bonds and money, open market purchases/sales will not disturb the market, so there will be no change in the exchange rate. Increasing the money supply will have no effect on the economy.
- Eventually, as Y rises even further, increased money demand results in progressively higher interest rates and therefore in progressive currency appreciation along the downward-sloping segment of AA - However, equilibrium is still at point 1. Monetary expansion has no effect on output or the exchange rate, thus the economy is “trapped”
Chapter 18- Fixed Exchange Rates and Foreign Exchange Intervention
Managed floating exchange rates- a system in which governments may attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed
Foreign assets- foreign currency bonds Domestic assets- domestic gov’t bonds and loans to domestic private banks
Assets = Liabilities + net worth
Money multiplier effect- magnifies the impact of central bank transactions on the money supply (due to multiply deposit creation within the private banking system) - Any CB purchase of assets = increase in the domestic money supply - Any CB sale of assets = decrease in the domestic money supply
Sterilization (foreign exchange intervention)- CB carries out equal foreign and domestic asset transactions in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply
Sterilized foreign exchange sale therefore has no effect on the money supply.
Balance of payments = Current Account + Capital Account – Non-reserve component of the Financial Account balance
A home balance of payments deficit = country’s net foreign reserve liabilities are increasing.
If Central Banks are not sterilizing and the home country has a balance of payments surplus, any associated increase in the home central bank’s foreign assets implies an increased home money supply. - Similarly, any associated decrease in a foreign central bank’s claims on the home country implies a decreased foreign money supply.