Under fixed exchange rates, how do domestic asset transactions by the central bank affect foreign reserves, employment, and output?
Understand the Problem
The question is asking about the effects of domestic asset transactions (buying or selling domestic government bonds) by a central bank under a fixed exchange rate regime. It wants to know if these transactions can affect the level of foreign reserves and/or the state of employment and output. The key is understanding how a fixed exchange rate limits a central bank's monetary policy options.
Answer
Buying domestic assets increases money supply, decreases foreign reserves, with limited impact on employment and output under fixed exchange rates.
Under fixed exchange rates, when a central bank buys domestic assets, it increases the domestic money supply and decreases foreign reserves. This action has limited impact on employment and output because the exchange rate must remain fixed.
Answer for screen readers
Under fixed exchange rates, when a central bank buys domestic assets, it increases the domestic money supply and decreases foreign reserves. This action has limited impact on employment and output because the exchange rate must remain fixed.
More Information
The central bank's intervention in domestic asset markets is offset by changes in foreign reserves to maintain the fixed exchange rate, neutralizing the intended impact on employment and output.
Tips
A common mistake is assuming that domestic asset transactions have the same impact on employment and output under fixed exchange rates as they do under floating exchange rates. Under fixed exchange rates, the central bank's actions are constrained by its commitment to maintain the exchange rate.
Sources
- Solved Under fixed exchange rates, domestic asset | Chegg.com - chegg.com
- [PDF] PP542 Topics Introduction Central Bank Balance Sheet Central ... - personal.umich.edu
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