Suppose the central bank of a small open economy has foreign government bond hol

Question

Suppose the central bank of a small open economy has foreign government bond holdings worth 1600 and domestic government bond holdings worth 2400. Assume the central bank maintains a fixed exchange rate of E0 and wants to maintain the peg.  

If the country has been running persistent official-settlements-balance deficits (i.e., “balance-of-payments” deficits), what kind of pressure would mount on the currency?  

How does the central bank respond to this situation?  

After taking action, will its international reserves be greater, less than, or equal to 1600? What would be the effect on the money supply and domestic interest rates?  

Now suppose that the central bank decides to sterilize its foreign-exchange intervention. Will the central bank’s domestic assets be greater, less than, or equal to 2400?  

Explanation / Answer

If the country has been running persistent official-settlements-balance deficits (i.e., “balance-of-payments” deficits) and central bank has to maintain fixed exchange rate then there will pressure on the currency to depreciate. So that balance of payment comes in equilibrium.

The central bank respond to this situation by selling foreign government bond holdings.

After taking action, its international reserves will be less than 1600. The mmoney supply would increase and there will be fall in domestic interest rate.

Now suppose that the central bank decides to sterilize its foreign-exchange intervention. In this case central bank will buy domestic government bond holdings to keep the exchange rtae fixed. So in this case central bank domestic assets will be greater than 2400.

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