Eric Zhang ECON 310 HW #5 Question 1: How will a floating exchange rate adjust to the following shocks?

a) An increase in current domestic interest rates -an increase in current domestic interest rates will cause the demand of the currency to go up and thus drive up the floating exchange rate which will ultimately cause appreciation in the currency and drive net demand for domestic goods down because they are relatively now more expensive b) An increase in current domestic price level -an increase in current domestic price level means demand for domestic goods falls which means the floating exchange rate will cause a depreciation of the currency c) An expected increase in future domestic price level -an increase in the future domestic price level (future inflation) causes depreciation of the expected future exchange rate which causes the exchange rate today to depreciate as well d) Expectations of future exchange rate appreciation -if the exchange rate is expected to appreciate in the future, the floating exchange rate will move so that it appreciates the current exchange rate because it is expected that the currency will become stronger in the future, thus raising the demand and driving up the rate Question 2: What is the role of the central banks official reserves in a fixed exchange rate regime? If domestic interest rates fall, and capital beings to flow out of the country, how will official reserves vary? What effect does this have on the money supply? In a fixed exchange rate regime, the role of the central banks official reserves is to absorb demand for domestic/foreign currency denominated assets and accumulate domestic/foreign reserves. If domestic interest rates fall in a country, the currencys demand will drop and thus under a floating exchange rate will want to depreciate. However, because the currency is under a fixed exchange rate regime it will stay the same at the current exchange rate, people will want to sell domestic currency for foreign currency, so official reserves of the domestic currency will be accumulated, and money supply overall decreases because there is less domestic currency in circulation. Question 3: Contrast the effects of monetary expansion under a flexible and a fixed exchange rate regime Monetary expansion under a flexible exchange rate regime would increase the monetary base and by doing so decrease interest rates and thus cause a depreciation in the domestic currency and overall an increase in net demand for domestic goods. Under a fixed exchange rate regime with a pegged exchange rate, the excess supply of domestic currency denominated assets is absorbed. In effect, the central bank runs down foreign reserves and money supply shrinks. Overall, monetary policy is useless when the central bank tries to enact monetary expansion under a fixed exchange rate regime.

Question 4: What is a liquidity trap, and what implications does it have for exploiting the traditional interest rate channel for monetary policy? Do you think a liquidity trap has the same implications for other channels of monetary policy? Explain A liquidity trap is when the interest rate has gotten so low to the point where increasing money supply through traditional interest rate channels has no effect. If the government tries to exploit the traditional interest rate channels under the situation of a liquidity trap, it will be useless. The liquidity trap does not have quite the same implications for the other alternative channels of monetary policy such as asset price channels and credit channels because providing lower interest rates and increased monetary funding available to corporations that wish to invest in new projects, for example, will increase the likelihood for investing in those projects. Overall, it reduces lending risks, improves the real value of firms, and of borrowers wealth.