1979. (The M1 growth rate was annualized, then smoothed, using a 3-month moving
average.) Between June and August of 1978, the M1 growth rate fell from almost 12% to
about 6%. The Fed funds rate rose from 7.60% to 8.04%, and continued rising until
Teaching Tip 2: The graph in “Application: Can Central Banks Always Control the
Interest Rate?” shows that between April 2008 and December 2009 interest rates stayed
fairly constant despite the Fed’s extraordinary interventions. Ask your students to explain
this. (Given the size of the Fed’s quantitative easing, a liquidity trap argument is not
IN–CLASS PROBLEMS
1. Suppose you are the policy advisor to the chairperson of the central bank in your
country and you have been asked to analyze the effects of a change in monetary
policy. Discuss how the monetary approach to exchange rate determination (from
Chapter 14) differs from the asset approach. Describe briefly how you would use each
approach in your analysis of how monetary policy affects the economy.
Answer: The asset approach is used to analyze exchange rate movements, assuming
that prices are sticky in the short run. In the asset approach, nominal interest rates
2. Consider the fundamental equation of the asset approach to exchange rates for two
countries, China and Thailand. The current spot exchange rate is 4 Thai baht per
Chinese yuan, Ebaht/yuan = 4. Analyze the following situations. For each, explain each
of the following changes from the perspective of a Thai investor: expected rate of
return on Thai deposits, expected rate of return on Chinese deposits, and the spot
exchange rate.
a. The expected exchange rate increases, Eebaht/yuan > 4, and interest rates in both
countries remain unchanged.
b. The interest rate on Chinese and Thai deposits increases by the same amount and
the expected exchange rate remains unchanged.
c. The interest rate on Chinese deposits decreases, Thai interest rates remain
unchanged, and the expected exchange rate is unchanged.
3. Use the FX market diagram to answer the following question. Consider the
relationship between the Mexican peso and the Canadian dollar (C$). Let the
exchange rate be defined as Mexican pesos per Canadian dollar, Epesos/C$. For each of
the following cases, illustrate the effects on the FX market and state how the
following variables change: interest rates in Mexico (ipeso) and Canada (iC$), the spot
exchange rate (Epesos/C$), and the expected rate of return on Canadian and Mexican
deposits (from the perspective of a Mexican investor). Unless otherwise noted, you
may assume that the expected exchange rate is unchanged.
a. Canada’s interest rate increases.
b. Investors in the market anticipate an appreciation in the peso.
c. Mexico’s interest rate decreases.
Answer: ipeso decreases, iC$ is unchanged, the spot exchange rate
d. Canada and Mexico decrease interest rates by the same amount.
Answer: ipeso and iC$ decrease by same amount, the spot exchange rate Epesos/C$ is
4. This question compares the effects of temporary and permanent shocks to the money
supply. In answering it, define the exchange rate as U.S. dollars per Chinese yuan,
E$/Y.
a. Illustrate the short-run and the long-run effects of a temporary increase in the U.S.
money supply.
b. Illustrate the short-run and the long-run effects of a permanent increase in the
U.S. money supply.
c. Illustrate how each of the following variables changes over time: U.S. money
supply, U.S. price level, U.S. real money supply, U.S. interest rate, E$/Y, and Ee$/Y.
Assume the change in the money supply occurs at time T and the long-run
equilibrium is at time T + k.
Answer: See Figure 15-13 in the textbook. (The yuan is analogous to the euro in
d. Compare the two cases above in terms of exchange-rate overshooting. Define
exchange rate overshooting and state whether each type of shock (temporary and
permanent) leads to exchange-rate overshooting, referring to your previous
diagrams.
Answer: The short-run exchange rate overshoots its long-run value, E, in the case
5. Use the FX and money market diagrams to answer the following questions. This
exercise considers the relationship between the Japanese yen (¥) and U.S. dollar ($).
Let the exchange rate be defined as $ per ¥, E$/¥. On all graphs, label the initial
equilibrium point A.
a. Illustrate how a temporary decrease in Japan’s money supply affects the money
and FX markets. Label your short-run equilibrium point B and your long-run
equilibrium point C.
Answer: See the following diagram. The decrease in Japan’s money supply
b. Using your diagram from (a), state how each of the following variables changes in
the short run (increase/decrease/no change): U.S. interest rate, Japanese interest
rate, E$/¥, Ee$/¥, and U.S. price level.
c. Using your diagram from (a), state how each of the following variables changes in
the long run (increase/decrease/no change relative to their initial values at point
A): U.S. interest rate, Japanese interest rate, E$/¥, Ee$/¥, and U.S. price level.
Answer: No change in any of the variables in the long run. Because we assumed
6. What is exchange rate overshooting in the context of the asset/monetary approach
used in this chapter? How does the prevalence of short-run exchange rate volatility
depend on monetary policy and the existence of a nominal anchor?
Answer: Exchange rate overshooting refers to the observation that when there is a
shock affecting the foreign exchange market, the spot exchange rate tends to change
7. Use the FX and money market diagrams to answer the following questions. All
consider the relationship between Swedish kronor (SK) and Danish krone (DK). Let
the exchange rate be defined as Swedish kronor per Danish krone, ESK/DK. On all
graphs, label the initial equilibrium point A. Suppose that there is an economic boom
in Sweden, leading to an increase in real money demand in that country.
a. Assume this change in real money demand is temporary. Using the FX and money
market diagrams, illustrate how this change affects the money and FX markets.
Label your short-run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagrams.
b. Assume this change in real money demand is permanent. Using a new diagram,
illustrate how this change affects the money and FX markets. Label your short-
run equilibrium point B and your long-run equilibrium point C.
Answer: See the following diagrams.
c. Illustrate how each of the following variables changes over time in response to a
permanent increase in real money demand: nominal money supply MS, price level
PS, real money supply MS/PS, Swedish interest rate iSK, and the exchange rate
ESK/DK.
8. This exercise considers how the FX market will respond to changes in monetary
policy. For these questions, define the exchange rate as British pounds (£) per euro,
E£/€. Use the FX and money market diagrams to answer them.
a. Suppose the European Central Bank (ECB) permanently increases its money
supply. Illustrate the short-run (label the equilibrium point B) and long-run effects
(label the equilibrium point C) of this policy.
b. Suppose the ECB permanently increases its money supply, but investors believe
the change is temporary. That is, investors
don’t adjust their expected exchange
rate
because they believe the policy will be reversed before prices adjust. Describe
how
this situation would affect the spot exchange
rate compared with (a).
Answer: In this case, the FR line will not
shift as far downward. The Eurozone
c. Finally, suppose the ECB announces its plans
to permanently increase the money
supply,
but doesn’t actually implement such a policy.
How will this affect the FX
market in the
short run if investors believe the ECB’s announcement?
Answer: In this case, (2) changes but (1)
does not. Therefore, the market will go to
9. In 1992, several European countries had their individual currencies pegged to the
ECU (a precursor to the euro) in anticipation of forming a common currency area. In
practice, this meant that countries were pegged to the German Deutsch Mark (DM).
This question considers how different countries responded to the European Exchange
Rate Mechanism (ERM) crisis. For the following questions, you need only consider
short-run effects. Also, treat Germany as the foreign country.
a. Following the economic consequences of German reunification in 1990, the
Bundesbank (Germany’s central bank) raised its interest rate. On September 14,
1992, Great Britain decided to float the British pound (£) against the DM. Using
the FX and money market and treating Britain as the home country, illustrate the
effects of Germany increasing its interest rate.
Answer: See the following diagram.
b. After Britain abandoned the ERM (e.g., allowed its currency to float against the
DM), investors grew concerned that France would no longer be able to maintain
its currency peg. The Banque de France (France’s central bank) wanted to keep its
currency (French franc, FF) pegged to the DM. Using the FX and money market
and treating France as the home country, illustrate the effects of Germany
increasing its interest rate, assuming that the currency peg is maintained.
c. Denmark had a similar experience to that of Britain and France. Suppose
Denmark’s prime minister approaches you about how to respond. He doesn’t want
to give up monetary policy autonomy, but wants to maintain the exchange rate
peg. Is this possible? Explain why or why not.
Answer: Yes, it is possible. If Denmark imposes capital controls, restricting the
d. Compare and contrast the three approaches above. Which would you favor as a
policy maker? Explain.
10. In the late 1990s, several East Asian economies had their currencies pegged to the
U.S. dollar. Suppose there is an economic boom in the United States that leads to an
increase in U.S. interest rates. At the same time, investors begin to worry that the East
Asian economies will be unable to maintain their exchange rate pegs. How could
policy makers in these countries respond? What are the pros and cons of these
options? Discuss how the trilemma applies to this situation.
■ In the first case, the government could abandon the exchange rate peg, allowing
its currency to float against the U.S. dollar. The benefit of this approach is that it
does not require government intervention in the money market or in restricting
capital movements.
■ In the second case, the government would need to restrict the flow of capital
between the home country and the United States. This would allow for differences