Chapter 18
ANSWERS TO QUESTIONS
1. If the Federal Reserve buys dollars in the foreign exchange market but conducts an offsetting
open market operation to sterilize the intervention, what will be the impact on international
reserves, the money supply, and the exchange rate?
The purchase of dollars involves a sale of foreign assets, which means that international
2. If the Federal Reserve buys dollars in the foreign exchange market but does not sterilize the
intervention, what will be the impact on international reserves, the money supply, and the
exchange rate?
3. For each of the following, identify in which part of the balance-of-payments account the
transaction is recorded (current account, capital account, or net change in international
4. Why does a balance-of-payments deficit for the United States have a different effect on its
international reserves than a balance-of-payments deficit for the Netherlands?
5. How can a large balance-of–payments surplus contribute to a country’s inflation rate?
6. Why can balance-of-payments deficits force some countries to implement contractionary
monetary policies?
7. Under the gold standard, if Britain became more productive relative to the United States,
what would happen to the money supply in the two countries? Why would the changes in the
money supply help preserve a fixed exchange rate between the United States and Britain?
8. What is the exchange rate between dollars and Swiss francs if one dollar is convertible into
1/20 ounce of gold and one Swiss franc is convertible into 1/40 ounce of gold?
9. “Inflation is not possible under the gold standard.” Is this statement true, false, or
uncertain? Explain your answer.
False. Inflation occurred when the world was under the gold standard before World War I.
10. What are some of the disadvantages of China’s pegging the yuan to the dollar?
11. If a country’s par exchange rate was undervalued during the Bretton Woods fixed exchange
rate regime, what kind of intervention would that country’s central bank be forced to
undertake, and what effect would the intervention have on the country’s international reserves
and money supply?
The situation would be as depicted in Figure 2, Panel (b). The central bank would need to sell
12. “The abandonment of fixed exchange rates after 1973 has led countries to pursue more
independent monetary policies.” Is this statement true, false, or uncertain? Explain your
answer.
13. “If a country wants to keep its exchange rate from changing, it must give up some control
over its money supply.” Is this statement true, false, or uncertain? Explain your answer.
14. Why is it that in a pure, flexible exchange rate system, the foreign exchange market has no
direct effect on the money supply? Does this mean that the foreign exchange market has no
effect on monetary policy?
15. Why did the exchange-rate peg lead to difficulties for the countries in the ERM after the
German reunification?
16. How can exchange-rate targets lead to a speculative attack on a currency?
17. What are the advantages and disadvantages of having the IMF as an international lender of
last resort?
currency. Moreover, it can help prevent speculative attacks that can lead to contagion among
other emerging market countries. A disadvantage to the IMF as an international lender of last
a time-inconsistency problem.
18. How can the long-term bond market help reduce the time-inconsistency problem for
monetary policy? Can the foreign exchange market also perform this role?
19. “Balance-of-payments deficits always cause a country to lose international reserves.” Is this
statement true, false, or uncertain? Explain your answer.
reserves unchanged.
20. How can persistent U.S. balance-of-payments deficits stimulate world inflation?
21. What are the key advantages of exchange-rate targeting as a monetary policy strategy?
22. When is exchange-rate targeting likely to be a sensible strategy for industrialized countries?
When is exchange-rate targeting likely to be a sensible strategy for emerging market
countries?
23. What are the advantages and disadvantages of currency boards and dollarization over a
monetary policy that uses only an exchange-rate target?
ASWERS TO APPLIED PROBLEMS
24. Suppose the Federal Reserve purchases $1,000,000 worth of foreign assets.
a. If the Federal Reserve purchases the foreign assets with $1,000,000 in currency, show
the effect of this open market operation, using T-accounts. What happens to the monetary
base?
Federal Reserve System
Assets
Liabilities
Foreign assets
(international
reserves)
Currency in
circulation
base?
Federal Reserve System
Assets
Liabilities
Foreign assets
(international reserves)
Currency in
circulation
Government bonds
25. Suppose the Mexican central bank chooses to peg the peso to the U.S. dollar and commits to
a fixed peso/dollar exchange rate. Use a graph of the market for peso assets (foreign
exchange) to show and explain how the peg must be maintained if a shock in the U.S.
economy forces the Fed to pursue contractionary monetary policy. What does this say about
the ability of central banks to address domestic economic problems while maintaining a
pegged exchange rate?
An increase in U.S. interest rates as a result of the contractionary monetary policy will
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database, and find data on the capital account
(BOPCAT) and the current account (BOPBCA). Calculate the net change in government
international reserves for the most recent quarter of data available and for the same quarter
five years prior. What do the numbers imply about the net wealth of the United States relative
to the net wealth of the rest of the world? How does the fact that the dollar is used as an
international reserve currency affect your interpretation?
For 2013:Q3, the current account was –$96.4 billion, and the capital account was –$0.1
billion, meaning the net change in international reserves for the U.S. was a net payment to
2. Go to the St. Louis Federal Reserve FRED database, and find data on the monthly U.S.
dollar exchange rate to the Chinese yuan (EXCHUS), the Canadian dollar (EXCAUS), and
the South Korean won (EXKOUS). Download the data into a spreadsheet.
a. For the most recent five-year period of data available, use the average, max, min, and
b. Using the maximum and minimum values of each exchange rate over the last five years,
calculate the ratio of the difference between the maximum and minimum values to the
average level of the exchange rate (expressed as a percentage by multiplying by 100).
This value gives an indication of how tightly the exchange rate moves. Based on your
results, which of the three countries is most likely to peg its currency to the U.S. dollar?
How does this country’s currency compare with the other two?
c. Calculate the ratio of the standard deviation to the average exchange rate over the last
five years (expressed as a percentage by multiplying by100). This value gives an
indication of how volatile the exchange rate is. Based on your results, which of the three
currencies is most likely to be pegged to the U.S. dollar? How does this currency
compare with the other two?
(a) See table below for July 2008 to July 2013. (b) See table below. The Chinese yuan has a
Chinese yuan
Canadian
dollar
South Korean
won
Average
6.5697
1.0462
1163.9063
Maximum
6.8539
1.2645
1449.6159
Minimum
6.1342
0.9553
1015.0545
Standard Deviation
0.256
0.076
93.632
Max Min
Difference/Average
10.95%
29.55%
37.34%
SD/Average
3.89%
7.29%
8.04%