Why does an increase in the money supply not lead to a balance of payments (BOP) deficit in a freely floating exchange rate system?
Under a freely floating exchange rate system, an increase in the money supply will not cause a BOP deficit because the home country’s exchange rate will automatically depreciate and prevent the deficit.
What defines a fixed exchange rate system?
Fixed Exchange rate: In a fixed exchange rate system, the monetary authorities officially set the country’s exchange rate at a predetermined value that is not allowed to change.
Which exchange rate system does not permit central bank intervention in the foreign exchange market?
Floating (or Flexible) Exchange rate system does not permit central bank intervention in the foreign exchange market.
What components make up the money supply, or M1, in an economy?
Money supply or M1 equals the total stock of banknotes and coins issued by the central bank in circulation and the demand deposits held by the public.
What are the two main components of the central bank's liabilities?
The central bank’s liabilities can be grouped into currency in circulation (C) and bank reserves (BR).
Who holds the exclusive authority to issue currency and regulate circulation?
The central bank is the sole authority to issue currency and regulate circulation.
What condition ensures that the central bank's balance sheet remains balanced?
The central bank’s balance sheet always balances, that is:
Value of total assets of the central bank = Value of total liabilities of the central bank
What is the definition of required reserves?
Required reserves refer to the officially obliged amount the banks have to hold in their deposit accounts with the central bank.
What are the two main types of bank reserves?
The bank reserves can be grouped into required reserves and excess reserves.
What are the main categories of assets held by the central bank?
The assets held by the central bank can be categorized into domestic assets (DR) and foreign assets (IR).
What constitutes the monetary base, or high-powered money, in an economy?
The total value of bank reserves (BR) and currency in circulation (C) in an economy is called the monetary base (H) or high- powered money.
What is the definition of demand for money?
Demand for money is the aggregate quantity of M1 people wish to hold.
How is money demand affected by real income?
Money demand is positively affected by the real income, Y, in the economy. As real income or production increases, people would demand more money to purchase the additional goods and services produced.
What is the relationship between the interest rate and money demand?
The interest rate (i) affects the money demand negatively.
According to Classical economists, how does the change in interest rates affect the demand for money?
According to Classical economists, interest rates do not affect the demand for money.
How is money market equilibrium defined in terms of money supply and demand?
The money market equilibrium is established when the aggregate money supply equals the money demand, or in other words, when the total stock of money balances that households and firms wish to keep equals the actual available quantity.
What happens to the central bank’s official reserves and the balance of official reserve transactions when there is an excess supply of foreign currency under fixed exchange rates?
Under fixed exchange rates, an excess supply of foreign currency causes the central bank’s official reserves to increase, leading to an official reserve transactions surplus.
How is a balance of payments deficit corrected in a fixed exchange rate system?
With fixed exchange rates a BOP deficit is automatically corrected by a decrease in the official reserves of the home country’s central bank and a rise in its money demand.
When does the monetary approach predict that the home currency will depreciate against a trading partner's currency over the long term?
According to the monetary approach, the home currency depreciates against a trading partner’s currency over the long term when:
1. The home country’s money supply grows at a rate faster than that of its trading partner.
2. The home country’s real GDP grows at a rate slower than that of its trading partner.
What is identified as the primary cause of balance of payments imbalances in fixed exchange rate systems, according to the monetary approach?
The monetary approach under fixed exchange rates predicts that the main factor causing BOP imbalances is a disequilibrium in the money market.
What is the main reason behind exchange rate fluctuations in a flexible exchange rate system?
Under flexible exchange rates, exchange rate fluctuations are solely caused by monetary factors.