Exchange Rate Systems
1. How can you quantify currency risk in a floating exchange rate system?
Answer: To characterize the risk of a currency position, you must try to characterize the conditional distribution of the future exchange rate changes. With floating exchange rates, historical information provides useful information about this distribution. For example, you can use data to measure the average historical dispersion (standard deviation or volatility) of the distribution. The higher this volatility, the riskier are positions in this currency. It is also possible to rely on more forward-looking information using the options markets (see Chapter ...view middle of the document...
Ultimately, one of the problem countries might withdraw from the EMU or the strong countries, like Germany and Finland, might withdraw rather than subsidize their inefficient neighbors.
4. How can a central bank create money?
Answer: First, because the central bank operates the only authorized printing press in the country, it can actually print money to pay its bills or to acquire assets, thereby increasing the money supply. Second, the central bank can create money by increasing the reserve accounts financial institutions hold with it. For example, if the central bank buys an asset (a government bond say) from a financial institution, it credits the financial institution’s reserve account at the central bank for the purchase price of the bond. Because this financial institution can now use this credit to its account to lend money to individuals and businesses, the central bank has, essentially, created money.
5. What are official international reserves of the central bank?
Answer: Official reserves consist of three major components: foreign exchange reserves, gold reserves, and IMF-related reserve assets, with the first being by far the most important component. Foreign exchange reserves are all the foreign currency denominated assets the central bank holds, and mostly consist of foreign government bonds.
6. What is likely to happen if a central bank suddenly prints a large amount of new money?
Answer: Whereas there are theories that predict that changes in the supply of money have real effects on the economy in the short run, it is likely that if the central bank showers the economy suddenly with money, the only result will be higher inflation. This is because the demand for money ultimately depends on the amount of real transactions in the economy and how much money is needed to facilitate these transactions. Additional supply of money is unlikely to make people consume more or work harder.
7. What is the effect of a foreign exchange intervention on the money supply? How can a central bank offset this effect and still hope to influence the exchange rate?
Answer: When a central bank buys (sells) foreign currency, its international reserves increase (decrease), and the money supply increases (decreases) simultaneously. To offset the effect on the money supply, the foreign exchange intervention can be sterilized; that is, the central bank can perform an open market operation that counteracts the effect on the money supply of the original foreign exchange intervention. The direct effects of a sterilized intervention are two-fold. First, it forces a portfolio shift on private investors, by replacing foreign bonds with domestic bonds (or vice versa). This may affect expectations and prices. Second, the actions of the central bank in the foreign exchange markets, while very small relative to the nominal trading volumes, may still manage to squeeze foreign exchange inventories at dealer banks and...