Answer to Question #278164 in Macroeconomics for Injun

Question

Should countries intervene to stabilize the exchange rate? And explain the reason

Answer 1

On the perspective of aggregate demand side, when a country runs a balance-of-payments deficits, the demand for foreign exchange is by definition larger than the amount being supplied by the private banks, and central bank has to sell the difference.

When the central bank sells foreign exchange, it reduces domestic high-powered money and therefore the money stock-unless it sterilizes its foreign exchange intervention by buying bonds as it sells foreign exchange.

By the following diagram it can be that, Ruling out the possibility, the deficit at point E implies that the central bank is pegging the exchange rate, selling foreign exchange to keep the exchange rate from depreciating, and reducing the domestic money stock.

Once point E’ is reached, the country has automatically achieved long-run equilibrium. Because the trade balance is in equilibrium, there is no pressure on the exchange rate and therefore no need for exchange market intervention. So there are no further changes in the money supply.

On the supply side, wages and costs are constant, so the supply schedule is not shifting. Thus, at E the country has successfully and automatically adjusted to the initial balance-of-payments deficits. It has achieved trade balance equilibrium combined with full employment.