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Question about Floating exchange rate

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A country has a lower inflation rate than all other countries, It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say about each of the following (and why)?:

a. The exchange rate?
b. The current account balance?
c. The expected exchange rate?
d. The interest rate differential?
e. Interst rate parity?
f. Purchasing power equity?

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A country has a lower inflation rate than all other countries. It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say about each of the following (and why)?:

a. The exchange rate?

Changes in relative inflation between two countries must cause a change in exchange rates. If domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than the foreign currency

The country's currency will be strong and appreciate against other countries.

Spot exchange rates between currencies will change to the differential in inflation rates between countries.

b. The current account balance?

Initially, this country would have a current account surplus. However, finally the current account would balance (no surplus or deficit).

Because this country has lower inflation, its prices would be lower and foreigners would like to purchase goods from this country. The citizens of this country would demand less of ...

Solution Summary

The solution describes the exchange rate, the current account balance, the expected exchange rate, the interest rate differential, the interst rate parity and the purchasing power equity in a country which has a lower inflation rate than all other countries, more rapid economic growth and where the central bank does not intervene in the foreign exchange market.

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See Also This Related BrainMass Solution

6 questions on International Macroeconomics that deal with 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.

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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