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).
