# International Business Chapter 20 The Backing Ratio Declines But The Central Bank Has Sufficient Reserves Defend

Document Type
Homework Help
Book Title
International Economics 4th Edition
Authors
Alan M. Taylor, Robert C. Feenstra
Answer: Emerging markets and developing countries are more likely to adopt
e. Which groups are more likely to suffer from twin or triple crises? Why?
Answer: Emerging markets and developing countries are more likely to suffer
twin or triple crises. First, there is feedback between the three crises discussed
2. Consider the central bank balance sheet for the country of Patria. Patria currently has
2,500 million lira in its money supply, 1,800 million of which is backed by domestic
government bonds. Assume that Patria maintains a fixed exchange rate and the
foreign interest rate remains unchanged.
a. Show Patria’s central bank balance sheet, assuming there are no private banks.
Calculate the backing ratio.
Answer: Patria holds 700 million lira in reserves. The backing ratio is 28% (=
700/2,500).
Assets
Liabilities
Reserves, R
700
Money supply, M
2,500
Domestic credit, B
1,800
b. Suppose that Patria’s central bank sells 300 million lira in government bonds.
Show how this affects the central bank balance sheet.
Answer: This leads to a 300 million reduction in domestic credit. Reserves
increase by the same amount, leaving the money supply unchanged.
Assets
Liabilities
Reserves, R
1,000
Money supply, M
2,500
Domestic credit, B
1,500
c. Calculate the new backing ratio. Does this change affect Patria’s money supply?
Explain why or why not.
Answer: The new backing ratio is 40% (= 1,000/2,500). The money supply
d. Now suppose that there is an economic recession in Patria so that output falls by
5%. How will this affect money demand in Patria? How will forex traders respond
to this change? Explain.
Answer: A decrease in output leads to a reduction in money demand. From the
e. Using a new balance sheet, show how the change described in (d) affects Patria’s
central bank (starting from the new balance sheet in [b]), assuming that real
money balances change by 200 million lira. What happens to domestic credit?
What happens to Patria’s foreign exchange reserves? Calculate the new backing
ratio.
Answer: Domestic credit is unchanged because the central bank does not buy or
sell bonds. The new backing ratio is 35% (= 800/2,300).
3. Suppose a country has \$2,000 million in money supply and \$1,200 million in
reserves.
a. Illustrate the central bank balance sheet diagram. Calculate the backing ratio.
Answer: See the following figure. Point A represents the country’s initial
equilibrium. Initially, B = \$800 million. See the figure for (b). Point A shows the
b. Because of a recent banking crisis, the central bank extends \$800 billion in credit
to deal with liquidity problems in the banking system. Illustrate this situation in a
new central bank balance sheet diagram. Is the country still able to maintain a
fixed exchange rate? Explain how you know this.
Answer: Yes, the country is able to defend the exchange rate. See the following
c. Suppose that rather than the previous scenario described, the central bank extends
\$800 billion in credit to prevent bank insolvency. Illustrate this situation on your
graph. Is Patria able to maintain a fixed exchange rate? Explain how you know
this.
Answer: See the following diagram. In this case, the central bank is serving as a
lender of last resort. It is extending domestic credit to help failing banks, rather
Assets
Liabilities
Reserves, R
400
Money supply, M
2,000
Domestic credit, B
1,600
d. In practice, widespread bank insolvency indicates longer-term problems in the
banking sector. Suppose the central bank repeats the operation conducted in (b)
for another year. Will the central bank be able to defend the exchange rate peg in
this case? Explain why or why not.
Answer: If the central bank repeats the expansion of domestic credit by \$800
c. The central bank sells government bonds.
Answer: This affects the composition of the money supply. When the central
d. Currency traders expect a depreciation in the currency in the future.
Answer: This implies an increase in the currency premium, so interest rates must
5. Compare and contrast the following scenarios in terms of their costs and benefits.
a. The central bank uses sterilization bonds to obtain reserves.
Answer: The benefit of using sterilization bonds is that it allows the central bank
to expand or contract its reserves without affecting the money supply. The
b. The central bank follows a strict currency board system.
Answer: A currency board system means that changes in money demand are
c. A country maintains a backing ratio that exceeds 100%.
Answer: Countries can maintain a backing ratio above 100% through sterilization
bonds. All else equal, a higher backing ratio means the central bank is in a better
d. The central bank bails out the banking system to avert a financial system crisis.
Answer: If the central bank expands domestic credit to bail out the backing
system, this limits its ability to defend the peg. When domestic credit increases,
6. Using a first-generation model, we’ve seen that fiscal policy plays a role in the central
bank’s ability to maintain the exchange rate peg. Using a central bank balance sheet
diagram, illustrate how this situation affects reserves, domestic credit, and the money
supply. The money supply is initially 900 million sols and the central bank holds 600
million sols in domestic credit. Assume P = P* = E = 1 and i* = 7%.
a. Calculate the backing ratio for this country and illustrate the central bank balance
sheet diagram. Label this point 1 on your diagram. R = 300 million sols. Backing
ratio = R/M = 37.5%.
Answer: See the following figure.
b. Beginning at time t = 1, the government runs a deficit of 75 million sols each
year. You may assume the deficit growth is not anticipated. On your central bank
diagram, label the economy’s outcomes (points 2, 3, etc.).
Answer: See the previous figure. Reserves decline as domestic credit expands.
c. When will the central bank be forced to float the currency? Before this point,
what is the inflation rate? The expected depreciation in the currency?
d. Suppose that after one year of observing the 75 million deficit, investors adjust
their expectations. How does your previous answer change? Note that investors
do not adjust their expectations until after one year of observing deficits.
Answer: At time t = 3, investors will anticipate the depreciation, selling off
7. In the text, we examined how government deficits affect the country’s ability to
defend a peg using a first-generation model. Suppose an economy has \$5,760 billion
in money supply and \$4,000 billion in domestic credit. Assume P = P* + E + 1 and i*
= 4%. The economy begins in year 1. For the following questions, assume investors
are myopic. L(i) = 1 and M= 5,760 billions.
a. Calculate the central bank’s reserves and backing ratio.
b. The government begins running an unanticipated deficit that grows by 20% each
year. The initial budget deficit in year 2 is equal to \$800 billion. Calculate the
central bank’s reserves, money supply, and backing ratio for years 1 through 5.
Answer: See the following table.
Time, t
R
R/M
P
1
1,760
30.6%
1.00
2
960
16.7%
1.00
3
0
0.0%
1.33
4
0
0.0%
1.60
5
0
0.0%
1.91
c. Based on the previous information, at what time is the central bank forced to
float? Calculate the inflation rate and rate of depreciation under the fixed regime
and after the country floats.
Answer: The central bank is forced to float at time t = 3. Because the expansion
d. Using the Fisher effect, calculate the new interest rate in this economy. Suppose
this change in the interest rate causes L(i) to decrease from 1 to 0.75. Calculate
real money demand under the fixed exchange rate regime and under the floating
exchange rate regime.
Answer: The interest rate rises from 4% = i* to 24%.
Time 1–2 (fixed):

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