Chapter 19
Exchange-Rate Policy and the Central Bank
Conceptual and Analytical Problems
1. Explain the mechanics of a speculative attack on the currency of a country with a
fixed exchange-rate regime. (LO3, LO4)
Answer: Assume that Country A has a fixed exchange rate, and that its central bank
holds a specific volume of foreign currency reserves. Investors come to believe that
scale, the central bank will deplete its foreign currency reserves, and be forced to
devalue its currency or abandon its fixed exchange rate entirely. Knowing that the
currency.
2. Country A frequently experiences large business cycle swings. Under what conditions
might it be appropriate for Country A to dollarize? (LO4)
Answer: If Country A’s business cycle is synchronized with the U.S. cycle, then U.S.
monetary policy also would suit Country A because it would be stimulative when the
cycles are closely aligned.
3. In the first half of 1997, the Bank of Thailand maintained a fixed exchange rate of 26
and lending it in Thailand. (LO3)
a. Why was this transaction profitable?
b. What risks were associated with this method of financing?
c. Describe the impact of a depreciation of the baht on the balance sheets of Thai
banks involved in these transactions.
Answer:
a. Bankers could borrow money in Japan at a low rate, and lend in Thailand at a
b. There was the risk that the baht could depreciate, making it more costly to repay
c. When the baht depreciated, the costs to the Thai banks of repaying their loans
4. During the time of the currency board, Argentinean banks offered accounts in both
Answer: The Argentinean banks had to pay interest payments in dollars on the
5. Consider a scenario where investors become nervous just before a key government
a. How could concern over an election drive up the risk premium?
b. How is the risk premium connected to the value of the currency?
Answer:
a. Investors could be concerned that the policies supported by one of the candidates
b. When the country’s government bonds become more risky relative to alternatives,
6. Explain why a well-capitalized domestic banking system might be important for the
Answer: In order for a fixed exchange rate regime to be successful, investors must
believe that the central bank will manage interest rates in a manner consistent with the
banking sector.
7. *Explain why, in the absence of the time consistency problem, you might expect a
Answer: To boost the value of its domestic currency, the central bank would have to
sell foreign currency in exchange for domestic currency. The central bank can only
continue to do this until it runs out of foreign exchange reserves. In contrast, in order
a longer period than the former. In the long run, however, the latter policy will lead
to inflationary pressures in the economy.
8. Describe how the time consistency challenge for monetary policy can make it
difficult for a central bank to cap the value of its domestic currency. (LO3)
Answer: As the Swiss National Bank learned during the euro-area crisis, a
commitment to supply an unlimited quantity of its own currency may not prove
efforts to cap the Swiss franc and allowed it to rise in response to strong demand.
9. Why might sterilized foreign exchange market intervention have a greater impact on
conditions? (LO2)
Answer: When markets are functioning normally, the shift in central bank assets
associated with a sterilized intervention are extremely small in relation to the volume
reduced and so the size of the central bank intervention may be significant.
10. When asked about the value of the dollar, the Chair of the Federal Reserve Board
Answer: Since the U.S. Treasury is technically responsible for exchange rate policy
U.S. economy, and in formulating such policy the FOMC does take the exchange
value of the dollar into consideration.
11. *Explain why a consensus has developed that countries should either allow their
exchange rates to float freely or adopt a hard peg as an exchange-rate regime? (LO4)
Answer: The widespread removal of capital controls and advances in technology have
facilitated the integration of international markets while the development of
foreign exchange reserves, to withstand a speculative attack. Therefore, soft pegs are
no longer a sustainable option.
12. Explain the costs and benefits of dollarization. Could a dollarized regime collapse?
(LO4)
Answer:
Costs of dollarization:
Benefits
Eliminates exchange-rate risk, making international trade easier.
Dollarization is reversible and so it can collapse. It does not preclude the fiscal
on fiscal policy restraint.
13. You observe that two countries with a fixed exchange rate have current inflation rates
purchasing power parity? (LO1)
Answer: Purchasing power parity (PPP) tells us about the relationship between
inflation rate differentials and exchange rate movements over long periods such as
pressures.
14. Assuming the country is open to international capital flows, which of the following
combinations of monetary and exchange-rate policies are viable? Explain your
reasoning. (LO1)
Answer: Combinations a and c are both viable as they both represent independent
domestic monetary policy combined with a floating exchange rate. Option b is not
independent interest rate policy would be impossible.
15. Show the impact on the Federal Reserve’s balance sheet of a foreign exchange market
intervention where the Fed sells $1,000 worth of foreign exchange reserves. Explain
Answer:
Selling foreign exchange reserves in exchange for dollars will reduce foreign
currency reserves on the asset side of the balance sheet. On the liability side, bank
reserves fall, as the bank that receives the FX from the Fed pays by running down its
demand for the dollar.