1. Inflation rate in the U.S is higher compare to that of Mexico then the peso is going to appreciate relative to the dollar. Inflation rate is going to decrease the value of dollar in the long run compare to that of peso.
The long-run nominal exchange rate can be derived as difference between expected inflation of foreign country with domestic one (Bodenstein, Erceg & Guerrieri, 2017). This difference equals with expected rate of return. Hence, the nominal interest rate in the long run is related with expected inflation rate of these two countries.
(Ee(t+1) – Et)/ Et = fu.s – f m
Where, fu.s= expected inflation rate in the U.S and fm= expected inflation rate in Mexico.
2. The concept of reverse repurchase agreement means selling of securities by the Federal Reserve with a promise of buying those securities back on a specified date with a specified price (Ihrig, Meade & Weinbach, 2015).
Reverse repurchase agreement is a temporary market sale, which creates liabilities for of the balance sheet of the Fed (Hanson, Shleifer, Stein & Vishny, 2015). Open market operation influences the monetary base. In this context, open market selling reduces through this agreement has reduced the currency reserves of this bank and consequently has decreased the monetary base.
3. During financial crisis, monetary base has increased though the growth of M1 has remained comparatively low and unchanged.
Monetary base (MB) is the sum total of currency (C) and demand deposit (D). In this crisis, banks have increased excess reserves (er) while public have hold more currency compare to demand deposits (Thornton, 2018). This in turn has forced the money multiplier to decrease further and money supply has increased at a slower growth. Here, excess reserve (er) ratio is the ratio between excess reserve (ER) and demand deposits (D) and it has a negative relationship with money multiplier. Here, the equation of money multiplier is:
m= (1+c)/ (rr+er+c)
In the above equation, m is money multiplier, which has negative relation with er. Moreover, c is currency deposit ratio, that is, C/D, which is also increased during crisis and negatively has influenced the money supply.
4. To describe the expected change regarding the future nominal exchange rate, this expected rate can be considered as Ee t+1 and the current nominal exchange rate is Eet (Thornton, 2018). Let the current domestic nominal interest rate at present time t is if while this is for the foreign nominal interest rate is if,t. If, Ee t+1 < Eet then dollar is expected to depreciate. Here, dollar is considered as foreign capital. Hence, though foreign nominal interest rate remains high, investing in the dollar may create low return if it is expected to depreciate in future.
The relative rate of return (REL) is:
REL = it – [if,t-(Ee(t+1) – Et)/ Et]
When dollar is expected to depreciate, Ee(t+1) decreases and consequently REL shifts downward decreasing the equilibrium nominal exchange rate.
5. Time consistency policy refers that no incentive can deviate the government while behavior of the private sector is given. Those policies are credible (Bhattarai, Eggertsson & Gafarov, 2015). The Fed has decided to no longer bail out large financial firms. According to this bank, it is the best policy based on present and past situation and this is completely time consistent. Instead o this, the Fed can reorganize firms for future. Here, the Fed’s announcement can be believed regarding no longer bail out and private sectors decide to take low risks.
Due to this announcement, financial firms can take decision to take less risk according to the policy announcement to obtain their best outcome.
6. Spot exchange rate means an agreement between two countries to buy one currency at an agreed price for another currency, based on settlement on a spot date (Della Corte, Ramadorai & Sarno, 2016). Under a fixed exchange rate, domestic currency can decide to lower its nominal interest rate for some reason and this tends the domestic currency to depreciate further. In the absence of fixed exchange rate agreement, spot exchange rate is going to depreciate presently.
To maintain the fixed exchange rate, the foreign country can decrease its interest rate while relative rate of return is zero at fixed exchange rate.
7. a. As there is fluctuation in the demand curve and the discount rate is lower than the Federal Funds Rates, there will be gap in the supply and demand of the borrowed reserve (Wu & Xia, 2016). It will reduce the interest rate leading to depreciating of the domestic currency.
Non-borrowed reserve will put pressure on the equilibrium position and force it fall below the desired position.
b. The Federal Reserve performs monetary policy considering a target for the federal funds rate, which is determined through market interest rate at which the banks lend funds to each other (Ihriget al. 2015). Figure below shows the demand curve, where the required balance zone is inelastic because they are mandatory and the part next to this is elastic region.
8. a. If the government increases deficit spending, then it would lead to enhanced borrowing, which ultimately will enhance the interest rates in the short run (Diamond, Kashyap & Rajan, 2017). As the figure depicts, if the government borrows in higher amount for deficit financing, then it would shift the IS curve from IS0 to IS1. One the other hand, with enhanced production, government will try to reduce the supply leading to shift of the LM curve from LM0 to LM1. The new equilibrium will occur at such a place that will enhance the interest rate and when it comes to the balance of payment, then it will deteriorate with the higher amount of borrowing.
b. In 2004, the Federal Reserve changed the operational activity through discount window for making it standing lending facility. The Channel-Corridor approach helps to discount window lending generates a limit for equilibrium funds rate to deviate from target (Rathburn et al., 2017).. Moreover, adjustments in non borrowed reserve is not required.
If the purchasing power parity exist, then it will reduce the capability of the state to purchase with higher borrowing and devaluated domestic currency. It will reduce the interest rate in long rung and exchange rate in long run will fell for the state.
c. According to the J curve phenomenon, if the state devaluates its currency, then it will face bigger initial deficit and in the long run, it will face enhanced balance of payment due to enhanced export (Bahmani and Fariditavana 2016). Considering this, under the given scenario, the state will face lower balance of payment and as the days past, the export will rise and importable will be cheaper which will enhance the balance of payment further.
9. a. As the ideal mechanism to stop the depreciation, government can reduce the money supply and sell that foreign currency, in terms of which domestic currency is falling. As shown in the figure below, as the money supply reduces it will shift the MS curve from MS0 to MS1. With fall in the money supply, interest rate rise subsequently leading to higher amount of foreign investment, which will enhance the demand of the domestic currency in foreign market (Korinek 2017). It will ultimately stop the depreciation of the domestic currency.
b. Through reducing supply of money, liability of the central bank to the public of the state reduced and with the selling of the assets in order to reduce the liability further deteriorates the assets of the state too (Moreira & Savov, 2017). Through sourcing foreign exchange to the market, the central bank reduces its assets, which is done by purchasing local currency. It reduces the labiality of the bank and public liability also gets reduced.
Sterilization includes limiting of the capital outflow and inflow on the money supply that in case of depreciation will reduce the supply of dollars into the market and incase of appreciation will do reverse leading to enhancement of the satisfaction (Goyal 2017).
References:
Bahmani-Oskooee, M. and Fariditavana, H., 2016. Nonlinear ARDL approach and the J-curve phenomenon. Open Economies Review, 27(1), pp.51-70.
Bhattarai, S., Eggertsson, G. B., & Gafarov, B. (2015). Time consistency and the duration of government debt: A signalling theory of quantitative easing (No. w21336). National Bureau of Economic Research.
Bodenstein, M., Erceg, C. J., & Guerrieri, L. (2017). The effects of foreign shocks when interest rates are at zero. Canadian Journal of Economics/Revue canadienne d’économique, 50(3), 660-684.
Della Corte, P., Ramadorai, T., & Sarno, L. (2016). Volatility risk premia and exchange rate predictability. Journal of Financial Economics, 120(1), 21-40.
Diamond, D. W., Kashyap, A. K., & Rajan, R. G. (2017). Banking and the Evolving Objectives of Bank Regulation. Journal of Political Economy, 125(6), 1812-1825.
Goyal, A., 2017. Intervention And Signaling: Interaction Between Central Banks And Fx Markets In An Emerging Market. The Singapore Economic Review, 62(01), pp.193-225.
Hanson, S. G., Shleifer, A., Stein, J. C., & Vishny, R. W. (2015). Banks as patient fixed-income investors. Journal of Financial Economics, 117(3), 449-469.
Ihrig, J. E., Meade, E. E., & Weinbach, G. C. (2015). Rewriting Monetary Policy 101: What’s the Fed’s Preferred Post-Crisis Approach to Raising Interest Rates?. Journal of Economic Perspectives, 29(4), 177-98.
Ihrig, J.E., Meade, E.E. and Weinbach, G.C., 2015. Rewriting Monetary Policy 101: What’s the Fed’s Preferred Post-Crisis Approach to Raising Interest Rates?. Journal of Economic Perspectives, 29(4), pp.177-98.
Korinek, A., 2017. Regulating capital flows to emerging markets: An externality view. Journal of International Economics.
Moreira, A., & Savov, A. (2017). The macroeconomics of shadow banking. The Journal of Finance, 72(6), 2381-2432.
Rathburn, S. L., Bennett, G. L., Wohl, E. E., Briles, C., McElroy, B., & Sutfin, N. (2017). The fate of sediment, wood, and organic carbon eroded during an extreme flood, Colorado Front Range, USA. Geology, 45(6), 499-502.
Thornton, D. L. (2018). Greenspan’s Conundrum and the Fed’s Ability to Affect Long?Term Yields. Journal of Money, Credit and Banking, 50(2-3), 513-543.
Wu, J. C., & Xia, F. D. (2016). Measuring the macroeconomic impact of monetary policy at the zero lower bound. Journal of Money, Credit and Banking, 48(2-3), 253-291.
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