23 May THIS TIME, WILL THE CENTRAL BANK’S DOMESTIC ASSETS INCREASE OR DECREASE?
Imagine that oil prices have recently dropped to $48 per barrel. Suppose you are a member of the monetary policy committee of a small open economy, dependent on oil exports, which also wants to maintain a currency peg to the dollar.
(a) Describe the pressures (in the form of appreciation or depreciation) that the domestic currency would face due to the decrease in oil prices. (Hint: Think about the effects of the lower oil prices−export prices−on the current account). How would the central bank have to respond in order to maintain the currency peg? Will this response by the central bank increase or decrease foreign reserves?
(b) Describe the impact of the Central Bank actions on the money supply, output, and domestic interest rates. If the economy is in a mild recession or below potential output, describe
the dilemma that policymakers face.
(c) Suppose the central bank decides to sterilize its foreign-exchange intervention. Answer questions (a) and (b) once more. This time, will the central bank’s domestic assets increase or decrease?
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