Question

Using money supply-money demand and the interest rate parity relationship, show how the central bank can deal with a balance of payments crisis and capital flight.

Answer 1

To keep up a sound fixed conversion standard framework, a nation should purchase and sell the hold money at whatever point there is abundance request or flexibly in the private outside trade (Forex). To make deals of remote cash conceivable, a nation should keep up an outside trade save. The reserve is a store of advantages designated in the save money.

For the most part, a central bank holds these stores as Treasury bonds gave by the save nation government. The save property procure enthusiasm for the central bank and in this way the stores will develop in an incentive after some time. Holding reserve as cash would not acquire premium and in this manner are less attractive. In any case, a central bank will probably keep a portion of its stores fluid as cash to make foreseen everyday Forex exchanges. In case those bigger deals of stores become vital, the U.S. central bank can generally sell the remote Treasury securities on the security market and convert those possessions to money.

A few things may happen to pave the way to parity of installments emergency. One choice open to the central bank is to obtain extra amounts of the holding cash from the save nation central bank, government, or a global organization like the International Monetary Fund (IMF). The IMF was initially made to assist nations with equalization of installments issues inside the Bretton Woods fixed conversion standard framework. At the point when a nation was close to exhausting its stores, it could acquire save money from the IMF. For whatever length of time that the parity of installments shortages prompting save exhaustion would before long be turned around with equalization of installments surpluses, the nation would have the option to reimburse the credits to the IMF sooner rather than later. All things considered, the IMF "window" was proposed to give a security valve on the off chance that unpredictability in supply and request in the Forex was more prominent than a nation's save possessions could deal with.

There is one other conceivable reaction for a nation experiencing a parity of installments emergency. The nation could generally abandon the fixed conversion standard framework and permit its money to drift uninhibitedly. This implies the central bank no longer needs to intercede on the Forex and the conversion scale worth will be controlled by every day supply and request conditions on the private Forex. Since the explanation behind the BoP emergency was a nonstop weight for the money to devalue, moving to a drifting framework would without a doubt bring about a quickly deteriorating cash.