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1) Assume that Victor Rodriguez Ceja (current governor of the Banco de México) d...
Apr 19, 2024
1) Assume that Victor Rodriguez Ceja (current governor of the Banco de México) decides to decrease the supply of Mexican Peso circulating in the economy. a) In order to accomplish this, explain what official reserves are (one sentence) and whether Victor will order the central bank to buy or sell reserves? b) Using the concept of money market equilibrium, explain what will happen to Mexican interest rates in the short-run? In doing so, use your picture of the money market equilibrium. c) Based on your answer to (b), explain what will happen to the value of the Mexican peso versus the U.S. dollar using the concept of interest rate parity. In doing so, use your IRP equation.
Answer
Victor will order the central bank to sell reserves, which will lead to an increase in Mexican interest rates in the short-run and an appreciation of the Mexican peso versus the U.S. dollar.
Solution
a
Official reserves are assets held by a central bank that are used to balance the payments of a country and to influence the exchange rate. To decrease the supply of Mexican Peso, Victor will order the central bank to sell reserves
b
In the money market equilibrium, a decrease in the supply of money (due to the sale of reserves) will lead to an increase in interest rates in the short-run, as depicted by the upward movement along the money demand curve. The money supply curve shifts to the left, from S1S_1 to S2S_2, causing the equilibrium interest rate to rise from i1i_1 to i2i_2
c
According to the interest rate parity (IRP) equation, an increase in Mexican interest rates relative to U.S. interest rates will lead to an appreciation of the Mexican peso versus the U.S. dollar. The IRP equation is F=S×(1+idomestic)(1+iforeign)F = S \times \frac{(1 + i_{domestic})}{(1 + i_{foreign})}, where FF is the forward exchange rate, SS is the spot exchange rate, idomestici_{domestic} is the domestic interest rate, and iforeigni_{foreign} is the foreign interest rate
Key Concept
Money market equilibrium and interest rate parity
Explanation
The sale of official reserves by a central bank decreases the money supply, leading to higher interest rates, which in turn appreciates the domestic currency due to the interest rate parity condition.
1. In the asset model if foreign interest rates increase the domestic currency will appreciate. TF\mathrm{T} \quad \mathrm{F} 2. If a Central Bank wants to fight inflation it will tend to decrease the money supply TF \mathrm{T} \quad \mathrm{F} 3. Foreign reserves are a stock of assets (e.g., foreign bonds) that a Central Bank holds which it can buy and sell to change the money supply. TF \mathrm{T} \quad \mathrm{F} 4. According to the monetary model, as long as the money supplies in the two countries are the same, the exchange rate will be equal to one. TF \mathrm{T} \quad \mathrm{F} 5. During a currency crisis, the central bank will often lower interest rates to prevent capital flight. T F 6. An advantage of a fixed exchange rate is that it increases the effectiviness of monetary policy. T F T \quad \mathrm{~F} 8. Today, most countries are members of a multilateral fixed exchange rate system organized by the International Monetary Fund  T F \text { T } F 8. Prior to the adoption of the euro, many European countries were part of a European fixed exchange rate system called the European Monetary System. TF \mathrm{T} \quad \mathrm{F} 9. A central bank will sell reserves in order to raise the money supply.  T F \text { T } F 10. The Bretton Woods conference led to the creation of the International Monetary Fund (IMF). TF\mathrm{T} \quad \mathrm{F} 11. The current world exchange rate system is usually described as an adjustable peg system. TF \mathrm{T} \quad \mathrm{F} 12. A cost of joining a currency union is the increased prices in international transactions TF \mathrm{T} \quad \mathrm{F} 13. With a floating exchange rate the government allows the market to determine the exchange rate of the currency. T F
Answer
F
Solution
Key Concept
Asset Model of Exchange Rates
Explanation
An increase in foreign interest rates leads to a depreciation of the domestic currency as capital flows to higher interest rate countries.
Answer
T
Solution
Key Concept
Anti-Inflationary Monetary Policy
Explanation
Decreasing the money supply is a common strategy used by central banks to fight inflation.
Answer
T
Solution
Key Concept
Foreign Reserves
Explanation
Central banks use foreign reserves to manage the money supply and stabilize the domestic currency.
Answer
F
Solution
Key Concept
Monetary Model of Exchange Rates
Explanation
Exchange rates are influenced by a variety of factors, not solely by the equality of money supplies.
Answer
F
Solution
Key Concept
Currency Crisis Management
Explanation
Higher interest rates can help prevent capital flight during a currency crisis.
Answer
F
Solution
Key Concept
Fixed Exchange Rate Impact on Monetary Policy
Explanation
A fixed exchange rate constrains monetary policy effectiveness in addressing domestic issues.
Answer
F
Solution
Key Concept
Current Exchange Rate Systems
Explanation
The majority of countries today use floating or managed floating exchange rates, not a multilateral fixed system.
Answer
T
Solution
Key Concept
European Monetary System
Explanation
The European Monetary System was a precursor to the euro, aiming to stabilize exchange rates among European countries.
Answer
F
Solution
Key Concept
Central Bank Operations
Explanation
Selling reserves is a tool for decreasing the money supply, while buying reserves increases it.
Answer
T
Solution
Key Concept
Bretton Woods Conference
Explanation
The Bretton Woods conference established the IMF and the World Bank to oversee the international monetary system.
Answer
F
Solution
Key Concept
World Exchange Rate System
Explanation
Today's global exchange rate system is diverse and not solely defined by an adjustable peg system.
Answer
F
Solution
Key Concept
Currency Union Costs
Explanation
The main cost of joining a currency union is the loss of monetary policy autonomy, not increased international transaction prices.
Answer
T
Solution
Key Concept
Floating Exchange Rate System
Explanation
In a floating exchange rate system, the currency's value is set by supply and demand in the foreign exchange market.
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