when the home currency depreciates by 1 If pass through is 1 any exchange rate

When the home currency depreciates by 1 if pass

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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 = E e /(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.
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- 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
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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.
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