International Economics Study Set 8
Quiz 17 :
Fixed Exchange Rates and Foreign Exchange Intervention
Central bank is also called as reserve bank manages and controls the money supply, interest rates and all other financial factors relating to its respective country. Foreign exchange market is a place where country's exchange (buying and selling)currencies. Domestic assets are the holdings of central bank that are used for future payments from its domestic financial institutional sources and individual sources. The foreign assets of a central bank fall when it expands its domestic assets without changing its liabilities. This can be identified by the effect on balance of payments (BOP). The perfect level balance of payments depends on the adjustment of the burden (financing through)allocated to foreign and domestic banks. That is how much money is to be financed from foreign bank and how much from a domestic bank. There will be excess supply of money in case if the central bank buys assets by holding the exchange rates fixed. The excess money supply can be eliminated by selling foreign assets and buying money till the required level.
The common wisdom has been that output and income in the economy will increase for an increase in the government spending. Because an increase in government expenditure will create an opportunity for earning profits, more firms will enter into the production activity; thereby increasing the variety of goods and services produced. As a result aggregate output will increase and income will increase. In response to the rise in output and income, consumption either remains unchanged or increases. If consumption tends to increase, the demand for money will increase. ________________________________________________________________________now the central bank reacts to the government expenditure in such way that its effect on the consumption is opposite and dominates the initial effect of the government expenditure shock that is the excess money demand. An excess demand for money in the economy will appreciate the domestic currency. As a result the central bank will make transactions in the foreign exchange market. It will buy foreign assets by spending domestic currency in the market. This will increase liabilities of the central bank that is the money supply will increase. As a result the exchange rate comes back to its initial level. So the central bank will respond to increased government expenditure by increasing money supply. The purchase of foreign assets by the central bank will be recorded as debit item on the balance of payment statement.
Financial intermediaries can lower the transaction costs in the economy by the following ways: Taking advantage of economies of scale: A retail investor incurs higher transaction costs in the form of buying and selling stocks, gathering information and other transportation costs. These all will pile up to large amount if we add all the implicit and explicit costs of an individual (retail investor). On the other hand, an institutional investor or a financial intermediary pools up the capital and invests into different stocks. The intermediary's costs of gathering information, costs incurred in buying and selling, and other costs will be spread over his total stock it holds. Thus, an intermediary can gain through economies of scale, as the costs incurred per dollar investments are much lower than that is incurred by an individual or a retail investor. A one-time unexpected devaluation initially increases output; the output increase, in turn, raises money demand. The central bank must accommodate the higher money demand by buying foreign assets with domestic currency, a step that raises the central bank's liabilities (and the home money supply)at the same time as it increases the bank's foreign assets. The increase in official foreign reserves is an official capital outflow; it is matched in the balance of payments accounts by the equal capital outflow associated with the public's own reduction in net foreign asset holdings. (The public must exchange foreign assets for the money it buys from the central bank, either by selling foreign assets or by borrowing foreign currency abroad. Either course of action is a capital inflow.)