(20 points) 2. As a matter of pride, Argentinian government officials decide to
ID: 1117997 • Letter: #
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(20 points) 2. As a matter of pride, Argentinian government officials decide to fix the peso value at P125/51. However, the unpopularity of defective unmanned drone airplanes as Christmas gifts causes a sudden decline in the need for U.S. dollars to buy drones made in the U.S. If the exchange rate were still determined by supply and demand, then this would force the dollar down to P.75/S1 What options could officials use to defend the peso at P125/S1 (hint: what specific policy would the central bank use to directly defend or maintain the peso at P125/S1?)? a. Assuming the central bank defends the fixed exchange rate, how does it affect the domestie money supply and domestic interest rates in Argentina? b. Given the effect on the money supply and interest rates, what happens to the value of the peso and Argentina's net exports (i.e., X-IM)? c. From part d, if the central bank does not sterilize the effects in defense of its fixed exchange rate policy, then what happens to aggregate output (i.e., real GDP) in Argentina? d. From part d, if the central bank does sterilize the effects in defense of its fixed exchange rate policy, then what specific policy would they implement? e.Explanation / Answer
A) Under fixed exchange, to prevent Peso appreciation and Dollar depreciation, the central bank has to intervene and buy all the excess US diollars and release Pesos in exchange to maintain the exchanged rate.
B) Because it is releasing more Pesos in the economy, the supply of money in the economy will increase and this would bring down the rates of interest.
C) With lower interest rate, demand for money expands and this implies a fall in the value of Pesos and rise in the price Pesos that buys domestic goods . Hence Peso will experience domestic inflation. Now with higher domestic price, the real exchange rate will depreciate and net exports will increase.
D) Sterilization is the process through which the monetary authority of an economy tries to ensure that the interventions in the foreign exchange market is not influencing the monetary base. Note that monetary base or high powered money is a significant component of the overall money supply. When governments interfere in the foreign exchange market in order to buy or sell domestic currency against a foreign currency, the aim is to influence the exchange rate. When the monetary authority is selling the domestic currency, this open market operation will increase monetary base and so it will increase money supply. Sterilization involves domestic asset transactions (buying or selling) that are aimed at restoring the money base to its original level.
Now when there is no sterilization, monetary base will remain high, money supply will show an increase and so real GDP will rise as AD keeps shifted to the right.
e) As mentioned, it will be selling domestic currency and buying financial assets to offset the effect of increased money supply.
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