Assume that country A exists in a fixed exchange rate regime with country B and
ID: 1103577 • Letter: A
Question
Assume that country A exists in a fixed exchange rate regime with country B and a few other neighoring countries. Suppose country A experiences a significant reduction to aggregate demand in its' economy, and causes the unemployment rate to rise. Under this situation, the centeral bank of country A plans to use a monetary policy to move the country A economy back toward full employment. a) Using the market for federal funds, show and explain the policy which country A would take. b) Does the effectiveness of the policy depend on bank behavior? Explain. c) Does country A maintain its' fixed exchange rate? Explain. d) Is there a loss or a gain of international reserves? Explain. e) Is there a need for sterilization to maintain equilibrium in both the domestic and international markets? Explain
Explanation / Answer
a)Fed uses open market operations to change the money supply. If economic growth is considered to be undesirably slow or the economy is in a recession, the Fed will undertake an expansionary monetary policy with the goal of accelerating economic growth and lowering the unemployment rate.
b) The Fed uses monetary policy to influence economic activity. But the Fed does not have direct control over the pace of economic growth. Rather, it uses policy tools to accomplish the task.
c) Once it decides to implement a specific policy, the Fed undertakes open market operations which will change interest rates and economic growth.
The Fed increased the money supply by using open market operations. The increase in the supply of money falls market interest rates. Investment demand has an inverse relationship with interest rates. when interest rates fall investment raises and investment is a component of GDP and aggregate demand. An increase in investment due to lower interest rates also leads to an incline in aggregate demand. The increase in aggregate demand increases output but also increases inflation and inflationary pressures. Which will eventually end up undervaluing the currency which will lead to change in exchange rate.
d) Undervalued currency leads to undervaluing exchange rate, An undervalued A thus boosts its exports, while at the same time making B’s made goods more expensive in A’s.
Which means a loss in international reserves.