Book cover for The Economics of Money, Banking, and Financial Markets

The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

ISBN #9780132770248

10th Edition

610 Questions

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Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

This chapter section explores the dynamics of central bank interventions in the foreign exchange market, detailing how unsterilized interventions alter the monetary base directly while sterilized interventions employ offsetting operations to maintain a stable money supply. Moreover, it highlights how these interventions interact with broader economic frameworks, such as the balance-of-payments, the policy trilemma, and various exchange rate regimes, thereby underscoring their significance in shaping effective monetary policy and ensuring economic stability.

Learning Objectives

1

Differentiate between sterilized and unsterilized interventions in the foreign exchange market.

2

Explain how central bank interventions influence the monetary base, international reserves, and exchange rates.

3

Analyze the impact of interventions on interest rates and asset returns.

4

Understand the roles of the balance-of-payments framework, policy trilemma, and various exchange rate regimes in shaping monetary policy.

Key Concepts

CONCEPT

DEFINITION

Central Bank Interventions

Actions taken by a country's central bank in the foreign exchange market to influence the value of its currency.

Sterilized Intervention

A type of intervention where the central bank offsets the impact on the money supply by conducting counteracting open market operations.

Unsterilized Intervention

An intervention that directly affects the money supply, leading to changes in interest rates and asset returns, and potentially influencing currency values.

Balance-of-Payments Framework

A record of all economic transactions between residents of a country and the rest of the world, which reflects the nation’s economic relationship externally.

Policy Trilemma

A principle stating that it is impossible for a country to achieve simultaneously a fixed exchange rate, free capital movement, and an independent monetary policy.

Exchange Rate Regimes

Different systems for managing a nation's currency in relation to other currencies, such as exchange-rate targeting, currency boards, and dollarization.

Example Problems

Example 1

If the Federal Reserve buys dollars in the foreign exchange market but conducts an offsetting open market operation to sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?

Example 2

If the Federal Reserve buys dollars in the foreign exchange market but does not sterilize the intervention, what will be the impact on international reserves, the money supply, and the exchange rate?

Example 3

For each of the following, identify in which part of the balance-of-payments account it appears (current account, capital account, or net change in international reserves and whether it is a receipt or a payment. a. A British subject's purchase of a share of Johnson \& Johnson stock b. An American's purchase of an airline ticket from Air France c. The Swiss government's purchase of U.S. Treasury bills d. A Japanese's purchase of California oranges e. $\$ 50$ million of foreign aid to Honduras f. A loan by an American bank to Mexico g. An American bank's borrowing of Eurodollars

Example 4

Why does a balance-of-payments deficit for the United States have a different effect on its international reserves than a balance-of-payments deficit for the Netherlands?

Example 5

How can a large balance-of-payments surplus contribute to a country's inflation rate?
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Step-by-Step Explanations

QUESTION

How does an unsterilized intervention affect a nation’s money supply and exchange rate?

STEP-BY-STEP ANSWER:

Step 1: The central bank intervenes by buying or selling foreign currency, directly impacting the domestic currency supply.
Step 2: This direct intervention increases (or decreases) the monetary base by altering the amount of money in circulation.
Step 3: The change in the money supply impacts interest rates and asset returns, influencing investor behavior.
Step 4: The altered investor behavior leads to either a currency appreciation or depreciation, depending on the direction of the intervention.
Final Answer: Unsterilized interventions directly change the money supply and, as a result, can affect interest rates, asset returns, and ultimately the exchange rate.

Unsterilized Intervention

QUESTION

How do sterilized interventions maintain the money supply while still aiming to influence exchange rates?

STEP-BY-STEP ANSWER:

Step 1: The central bank intervenes in the foreign exchange market to influence the currency value.
Step 2: At the same time, the central bank conducts offsetting open market operations (such as selling or buying government bonds) to neutralize the impact on the money supply.
Step 3: This dual-action ensures that while the exchange rate might be affected by the intervention, the overall monetary base remains unchanged.
Step 4: By maintaining a constant money supply, the central bank aims to influence the exchange rate without triggering secondary effects on interest rates or inflation.
Final Answer: Sterilized interventions use counteractive measures to keep the money supply constant even while attempting to adjust exchange rate dynamics.

Sterilized Intervention

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Common Mistakes

  • Confusing sterilized interventions with unsterilized ones, not recognizing that sterilized interventions are intended to leave the money supply unchanged.
  • Overlooking the impact that unsterilized interventions have on interest rates and asset returns.
  • Underestimating the broader implications of the policy trilemma and the balance-of-payments framework on a nation's monetary policy.
  • Assuming that all central bank interventions will directly influence exchange rates without considering the counteracting effects of sterilization.