Question

Consider this Central Bank balance sheet of a country with a fixed exchange rate. In order to maintain the​ peg, the bank intervenes in the foreign exchange market and sells​ $500 of foreign bonds for domestic currency.

​a) As a result of the​ intervention, has the domestic money supply increased or decreased​?

​b) By how​ much?  (no decimals)

​c) What must the Central Bank do to sterilize this​ intervention?

A. Buy​ $500 of foreign assets.

B. Sell​ $500 of foreign assets.

C. Sell​ $500 of domestic assets.

D. Buy​ $500 of domestic assets.

E. This intervention cannot be sterilized.

Before intervention: Assets Foreign assets Liabilities Deposits held by private banks Currency in circulation $1,000 $1,500 $500 Domestic assets $2,000 After intervention: Assets Foregin assets Domestic assets Liabilities $500 Deposits held by private banks $1,500 Currency in circulation $500 $1,500

Answer 1

a) The domestic money supply decrease.

Because through open market operation the central bank increases or decreases the money supply in the economy. When central bank sells foreign bond for domestic currency the Money supply decreases, on the other hand if central bank buy foreign bond for domestic currency the Money supply increases in the domestic country.

b) Money supply decrease by $500

Because central bank sell $500 foreign bond for domestic currency.

C) the correct answer is d. Buy $500 domestic assets.

Because when central bank buy $ 500 domestic assets it increases the money supply in the economy by $500 which sterilize the decrease in the Money supply of $500 in the economy.