International Macroeconomics
Question Set 8
NOTE: Please submit Exercise 1(a) to 1(c), Exercise 2(a) to 2(b), and Exercise 3(b) before next tutorial/seminar. Except for graphs, your submission must be typed.
Exercise 1 Consider the central bank balance sheet for the country of Riqueza. Riqueza currently has $1,800 million escudos in its money supply, $1,100 million of which is backed by domestic government bonds; the rest is backed by foreign exchange reserves. Assume that Riqueza maintains a fixed exchange rate of 1 escudo per dollar, the foreign interest rate remains unchanged, and money demand takes the usual form, M/P = L(i)Y. Assume prices are sticky.
(a) Show Riqueza’s central bank balance sheet, assuming there are no private banks. What is the backing ratio? Also draw the central bank balance sheet diagram and indicate the current position as point A.
(b) Suppose that Riqueza’s central bank sells $200 million in government bonds. Show how this affects the central bank balance sheet. Does this change affect Riqueza’s money supply? Ex- plain why or why not. What is the backing ratio now?
(c) Now, starting from this new position, suppose that there is an economic downturn in Riqueza, so that real income contracts by 10%. How will this affect money demand in Riqueza? How will forex traders respond to this change? Explain the responses in the money market and the forex market.
(d) Using a new balance sheet, show how the change described in (c) affects Riqueza’s central bank. What happens to domestic credit? What happens to Riqueza’s foreign exchange re- serves? Explain the responses in the money market and the forex market.
(e) How will the previous change affect the central bank’s ability to defend the fixed exchange rate? What is the backing ratio now? Describe how this situation differs from one in which the central bank buys government bonds in part (b).
Exercise 2 The government of the Republic of Andea is currently pegging the Andean peso to the dollar at E = 1 peso per dollar. Assume the following:
In year 1 the money supply M is 2,250 pesos reserves R are 1,250 pesos, and domes- tic credit B is 1,000 pesos. To finance spending, B is growing at 50% per year. Infla- tion is currently 0, prices are flexible, PPP holds at all times, and initially, P = 1. Assume also that the foreign price level is P* = 1, so PPP holds. The government will float the peso if and only if it runs out of reserves. The U.S. nominal interest rate is 5%. Real output is fixed at Y = 2,250 at all times. Real money balances are M/P = 2, 250 = L(i)Y , and L is initially equal to 1.
(a) Assume that Andean investors are myopic and do not foresee the reserves running out. Cal- culate domestic credit in years 1, 2, 3, 4, and 5. At each date, also calculate reserves, money supply, and the growth rate of money supply since the previous period (in percent).
(b) Continue to assume myopia.When do reserves run out? Call this time T. Assume inflation is constant after time T. What will that new inflation rate be? What will the rate of depreci- ation be? What will the new domestic interest rate be? (Hint: use PPP and the Fisher effect.)
(c) Continue to assume myopia. Suppose that at time T, when the home interest rate i increases, thenL(i) drops from 1 to 2/3. Recall that Y remains fixed. What is M/P before time T? What will be the new level of M/P after time T once reserves have run out and inflation has started?
(d) Continue to assume myopia. At time T, what is the price level going to be right before reserves run out? Right after? What is the percentage increase in the price level? In the exchange rate? [Hint: Use the answer to part (c) and use PPP.]
(e) Suppose investors know the rate at which domestic credit is growing. Is the path described above consistent with rational behavior? What would rational investors want to do instead?
(f) Given the data presented in the question so far, when do you think a speculative attack would occur? At what level of reserves will such an attack occur? Explain your answer.
Exercise 3 Using the central bank balance sheet diagrams, evaluate how each of the following shocks affects a country’s ability to defend a fixed exchange rate.
(a) The central bank sells government bonds.
(b) Currency traders expect a depreciation in the home currency in the future.
(c) An economic contraction leads to a change in home money demand.
(d) The foreign interest rate falls.
Exercise 4 (For Discussion) You are the economic advisor to Sir Bufton Tufton, the Prime Minister of Perfidia. The Bank of Perfidia is pegging the exchange rate of the local currency, the Perfidian albion. The albion is pegged to the wotan, which is the currency of the neighboring country of Wagneria. Until this week both countries have been at full employment. This morning, new data showed that Perfidia was in a mild recession, 1% below desired output. Tufton believes a downturn of 1% or less is economically and politically acceptable but a larger downturn is not. He must face the press in 15 minutes and is considering making one of three statements:
(a) “We will abandon the peg to the wotan immediately.”
(b) “Our policies will not change unless economic conditions deteriorate further.”
(c) “We shall never surrender our peg to the wotan.”
What would you say to Tufton concerning the merits of each statement?
Exercise 5 In 1994, political uncertainty in Mexico worried international investors, who thought that Mexico might default on its government debt. At the same time, Mexico has a currency crisis and had to devalue its exchange rate. Explain how a sovereign debt crisis might contribute to a currency crisis.
Exercise 6 In the 1890s, the US was experiencing a period of deflation. Explain how the gold standard would play a role in creating deflation.