International Finance

9.

a. Define and give an example of sterilized foreign exchange intervention

Sterilized foreign exchange intervention is when the central bank carries out equal foreign and domestic asset transactions to nullify the impact on the domestic money supply. An example would be the central bank selling a $100,000 of domestic assets and buying $100,00 of foreign assets.

b. If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, can it still keep the exchange rate fixed at E^0?

c. Discuss the difference between the terms “devaluation” and “depreciation:

Devaluation refers to a drop in a fixed exchange rate and is intentional by the central bank. Depreciation refers to a drop in the value of a currency because of market changes and is not intentional.

10. Please describe a self-fulfilling currency crisis

Self-fulfilling crisis refers to a situation that a financial crisis is not directly caused by the unhealthy economic fundamental conditions or improper government policies, but a consequence of pessimistic expectations of investors. In so investors’ fear of the crisis makes the crisis inevitable, which justified their initial expectations. Instead of blindly adhering to fixed exchange rate until running out of its foreign reserve, in the self-fulfilling model the government will abandon pegged exchange rate when it is optimal.

11.

a. Describe the actions the central bank must take to maintain a fixed exchange rate following an increase in output.

An increase in output from Y1 to Y2 will increase the real money demand, so the central bank must purchase foreign assets and raise the money supply from M1 to M2 in order to maintain a fixed exchange rate.

b. Illustrate the ineffectiveness of monetary policy to spur on an economy under a fixed exchange rate. (To “spur on” in this case means to increase economic activity or production).

See attachment.

12.

a. How does the phrase “Don’t put all your eggs in one