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chapter
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Money Policy and
Exchange Rates
1. Suppose that firms in Boversia gain confidence in the economy, so domestic in-
vestment rises for any given interest rate. For now, assume that net capital outflows
don’t change. Using graphs, show what happens to output and the real exchange
rate under three assumptions about Boversia’s monetary policy:
ANSWER: The change in output (Y) in response to the increase in domestic invest-
ment (I) needs to be discussed within the AE/PC framework. The equilibrium real ex-
The assumption that net capital outflows do not change should be interpreted to mean
a. The central bank holds the real interest rate constant.
ANSWER: As domestic firms increase spending on new equipment and buildings (I),
aggregate spending increases for each level of the real interest rate. Graphically, this
By assumption, NCO is unchanged in response to the gain in confidence in Bover-
sia and the real interest rate is constant. Therefore NCO does not shift. In order to dis-
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b. The central bank adjusts the real interest rate to keep output constant.
ANSWER: In the case of a rightward shift in the AE curve, caused by the increase in
domestic investment (I), the central bank needs to increase the real interest rate to
keep output constant. Since output does not change, NX does not change. The higher
real interest rate causes NCO to decrease and the real exchange rate will increase.
Graphically this can be shown as a constant NX curve and a leftward shift in the NCO
curve in the foreign exchange market.
c. The central bank adjusts the real interest rate to keep the real exchange rate
constant.
ANSWER: Going back to the answer in (a), ignoring the output effect on NX implies
that the real exchange rate stays constant. In that case no changes in the real inter-
2. Suppose again that investment rises in Boversia. In this case, assume that higher
confidence in the economy also causes a decrease in net capital outflows. Use
graphs to answer the following questions:
ANSWER: The answers below assume that output changes will impact NX. In par-
a. If the central bank holds the real interest rate constant, what happens to out-
put and the real exchange rate?
ANSWER: As in Problem 1, the increase in domestic investment (I) shifts the AE
curve to the right and causes output to increase when the real interest rate is held
constant. In response to the increase in output, net exports (NX) drop (more imports
as domestic income increases) and by assumption net capital outflows (NCO) de-
CHAPTER 17 Monetary Policy and Exchange Rates A-113
b. If the central bank wants to keep output constant, should it raise or lower the
interest rate?
ANSWER: The central bank needs to raise the real interest rate in response to the
increase in investment spending in order to keep output constant. As discussed in
Chapter 12, a rise in the real interest rate reduces AE by affecting consumption, in-
c. If the central bank wants to keep the exchange rate constant, should it raise or
lower the interest rate?
ANSWER: Since the real exchange rate can increase, decrease, or stay constant
after the rise in investment and the decrease in NCO, the central bank may be called
on to raise, lower, or keep the real interest rate constant. Take the example from
3. Consider the scenario in Figure 17.4: a rise in confidence causes a fall in net cap-
ital outflows, and the central bank adjusts the interest rate to keep the exchange rate
constant. For this case, explain what happens to each of the components of aggre-
gate spending: consumption, investment, government purchases, and net exports.
ANSWER: For this scenario, the four components of aggregate spending (C, I, G, and
NX) are simultaneously impacted by two changes: (1) the increase in output and (2)
the decrease in the real interest rate that counters the fall in net capital outflows
(NCO) and keeps the real exchange rate constant.
Consumption: The increase in confidence as well as the lower real interest rate will
net exports are not affected by the change in the real interest rate, but the increase
in output causes the NX curve to shift to the left.
4. Suppose government spending rises in Boversia, shifting the AE curve outward.
The central bank would like to keep both output and the real exchange rate constant.
Using graphs, show how policymakers can accomplish these goals through a com-
bination of an interest-rate adjustment and capital controls.
ANSWER: The increase in government spending shifts the AE curve to the right.
Without action from the central bank, output will increase. In order to keep output
5. Compare two statements about exchange rates that Henry Paulson, Treasury sec-
retary under President Bush, made in 2007: (1) “A strong dollar is in our nation’s in-
terest.” (2) “The currency [China’s yuan] needs to appreciate, and it needs to
appreciate faster.” Are the two statements consistent with one another? Why might
the same official make both statements?
ANSWER: Appreciation of the Chinese yuan means that the yuan is worth more
measured in dollars. For example, if the value of the yuan changes from 0.13 dollars
per yuan to 0.15 dollars per yuan, the yuan is appreciating. The flip side of the yuan
6. What is the difference between a depreciation of a currency and a devaluation of
a currency? What is the difference between an appreciation and a revaluation?
ANSWER: Both a depreciation and a devaluation of a currency imply that the cur-
rency becomes less valuable as measured in units of a foreign currency. What is dif-
ferent is the process by which the currency loses value. In the case of devaluation,
Appreciation and revaluation of a currency imply that a currency becomes more valu-
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7. In 2020, Boversia fixes its exchange rate at 0.5 dollars per bover. From 2020 to
2025, Boversia experiences inflation of 5 percent per year, while U.S. inflation is 2 per-
cent per year.
a. By how much does Boversia’s real exchange rate change from 2020 to 2025?
ANSWER: Recall the definition of the real exchange rate,
ε
= eP/P* = cost of Bover-
sian goods/cost of U.S. goods. Assume that initially the price level in Boversia and the
b. If Boversia wants to return the real exchange rate to its 2020 level, by how
much should it devalue or revalue its currency in 2025?
ANSWER: Boversia needs to devalue its currency by approximately 15% percent in
8. Some countries have a “crawling peg” for their nominal exchange rate: they adjust
it by a fixed percentage every year. For example, Boversia might reduce its exchange
rate against the dollar by 3 percent per year. Why might a country adopt a crawling
peg?
ANSWER: A country might adopt a crawling peg if it has an inflation rate that is con-
sistently different from that of the United States. For example, if the United States
consistently achieves inflation rates of about 2 percent, but Boversia has an inflation
9. Boversia has a fixed exchange rate against the dollar. Taxes rise in the United
States, reducing U.S. aggregate expenditure. The Federal Reserve adjusts the U.S.
interest rate to keep output constant, and Boversia’s central bank adjusts its interest
rate to keep the exchange rate constant. Using graphs, show what happens to Bover-
sia’s output, interest rate, and exchange rate.
ANSWER: In the United States, the Federal Reserve needs to lower interest rates in
order to prevent output from falling after the tax increase. If Boversia leaves its inter-
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10. Under the Maastricht Treaty, a country may adopt the euro only if its government
budget deficit is less than 3 percent of GDP. What is the rationale for this require-
ment? (Hint: See Section 14.2.)
ANSWER: As described in Chapter 14, high budget deficits have historically caused
high inflation. Countries with high budget deficits have often had trouble in financing
the deficits by raising funds from private savers. In those cases, the central bank started
Secondly, when a country joins the euro area, it gives up its national currency as well
as its own ability to conduct monetary policy. The European Central Bank has to con-
11. Suppose the U.S. dollar is abolished. To replace it, each of the 12 Federal Re-
serve Banks issues a currency for its region. The Boston Fed issues the New Eng-
land dollar, the Richmond Fed issues the Mid-Atlantic dollar, and so on. What are the
costs and benefits of this change?
ANSWER: Regional currencies will impede the free movement of goods, services,
capital, and possibly labor across the United States. Interregional trade becomes
more costly since foreign currency transactions are necessary and trade is subject to
12. A currency board issues money backed by a foreign currency (review Section
2.2). Like a currency union, a currency board is an extreme version of a fixed ex-
change rate. Are speculative attacks a danger with a currency board? Explain.
ANSWER: A speculative attack refers to the strategy of selling a currency that may
be devalued. Once the devaluation occurs, the currency can be bought back at a
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A currency board is different from other forms of fixed exchange rates in that every
unit of the local currency issued—for example the bover—is backed by enough units
ONLINE AND DATA QUESTIONS
www.worthpublishers.com/ball2
13. On the text Web site, examine (1) the behavior of the U.S.-Canada exchange
rate over 2005–2007 and (2) the interest-rate targets chosen by the Bank of Canada
over the same period.
a. Over 2005–2007, did the Bank of Canada respond to movements in the ex-
change rate in the manner described in the Case Study in Section 17.1?
ANSWER: In the time period before 2005, the Bank of Canada responded to an in-
crease in the value of the Canadian currency (fewer Canadian dollars per U.S. dol-
b. Economists attribute changes in Canada’s exchange rate over 2005–2007 to
increases in the prices of commodities that Canada exports, including oil and
metals. Does this help explain the answer to part (a)? (Hint: See the discussion
of commodity prices in Section 6.5.)
ANSWER: World prices of oil and metals such as copper and nickel, measured in
U.S. dollars, increased substantially over the period of 2005–2007. All of these com-
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14. Through Internet research, update the information in Figure 17.12. Find out which
countries have joined the euro area recently or are likely to join soon. Why are these
countries joining while others in the European Union are still left out?
ANSWER: On January 1st, 2008, Cyprus and Malta joined the euro area and be-
came the 14th and 15th Member States. Slovakia joined the euro area in January
2009. There are currently 16 European Union member countries that use the euro as
their currency. Before countries are allowed to join the euro area, a number of macro-
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