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Fixed and Floating Exchange Rate Systems

1. Suppose Mexico fixes its exchange rate against the U.S. dollar. Explain the effect on the foreign reserve holdings of the Mexican central bank if the level at which the exchange rate is pegged turns out to be lower than the one which would be obtained if the exchange rate had been allowed to float freely (in other words, Mexico enters the peg at an overvalued exchange rate). What are the implications for the Mexican money supply? Show the balance sheet of the Mexican central bank.

2. Suppose Argentina unilaterally decides to peg its currency to the U.S. dollar. Now assume that there are only these two countries in the world, and that the United States shows a surplus in its net official settlements balance the following year. Can you make a statement about how the money supply in the U.S. changed in that year?

3. Exchange rate devaluation is often used by countries to improve their current accounts. Since the current account equals national saving less investment, this improvement can occur if investment falls, saving rises, or both. How might a devaluation affect national saving and domestic investment?

4. When a central bank devalues after a BOP crisis, it usually gains foreign reserves. Can you explain this capital flow? What would happen if the market believes another devaluation was to occur in the near future?

5. Suppose that the foreign interest rate falls in a fixed exchange rate regime.
a. Use the international asset/money-market diagram to show the effects of this change on domestic interest rates and the domestic nominal money supply in the short run.
b. Describe any required changes in the balance sheet of the domestic central bank, assuming this bank is committed to the fixed exchange rate.
c. Use the AA-DD diagram to discuss any change in the short-run level of output.

6. Consider the case of Germany after WWII. It is beginning a period of temporary increases in government spending to rebuild its economy. At the same time, it is considering whether to join the Bretton-Woods reserve currency standard.
a. Suppose that Germany undertakes its expansionary fiscal policy while maintaining a flexible exchange rate. Derive the short-run effects on output, the exchange rate, and the current account by using the AA-DD-XX-diagram.
b. Now suppose that Germany joins Bretton-Woods and fixes its exchange rate to the U.S. dollar. Discuss the effects of an expansionary fiscal policy on output, the exchange rate, and the current account. Compare results to your answer in part (a).

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1. Suppose Mexico fixes its exchange rate against the U.S. dollar. Explain the effect on the foreign reserve holdings of the Mexican central bank if the level at which the exchange rate is pegged turns out to be lower than the one which would be obtained if the exchange rate had been allowed to float freely (in other words, Mexico enters the peg at an overvalued exchange rate). What are the implications for the Mexican money supply? Show the balance sheet of the Mexican central bank.
If the Mexican currency is overvalued then its current account will be advesely affected and it will have a balance of payment deficit. To cover this deficit the central bank will have to sell its foreign reserves through foreign exchange intervention. As the assets are sold by the Mexican Central Bank the money supply in Mexico will decrease. ( Decrease in assets= Decrease in money supply)

Assets Liabilities
Foreign Assets Deposits held by Pvt Banks
Domestic Assets Currency in circulation

2. Suppose Argentina unilaterally decides to peg its currency to the U.S. dollar. Now assume that there are only these two countries in the world, and that the United States shows a surplus in its net official settlements balance the following year. Can you make a statement about how the money supply in the U.S. changed in that year?

US has shown a surplus in its current account. Thus Argentina has to pay the US the CA surplus amount. This can be done in two ways.
1. Argentina's Central Bank sells its holding of foreign reserve assets (US financial assets) and gets the dollars in return.
2. US buys financial assets from Argentina and pays Argentina for these assets.
These two operations must give Argentina the dollars required to cover the CA surplus.
The first operation reduces the money in circulation in Argentina (decrease in assets with the Argentina's Central Bank would reduce its money in circulation)
The ...

Solution Summary

The answers to 6 questions on international macroeconomics discuss issues like fixed exchange rate system, foreign exchange reserves, floating currency, exchange rate devaluations, current accounts, BOP crisis, domestic and foreign interest rates, short-run level of output, expansionary fiscal policy, international asset/money-market diagram, pegged exchange rate, Bretton-Woods, reserve currency standard, AA-DD-XX-diagram, expansionary, money-market, settlements, devaluation, central bank.

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