Draw a diagram showing the short-run, market equilibrium determination of a bilateral nominal spot exchange rate in the market for bank deposits. Label your diagram carefully. Now suppose that the domestic central bank decides to raise the domestic interest rate through open market operations.
a) Graphically illustrate the short-run effect of the open market operations for the domestic money market, label, and explain your diagram. Describe in words what the open market operation is that the central bank must conduct,and how exactly this open market operation accomplishes the desired increase in the interest rate.
b) Combine your diagram of the money market with your initial diagram of the determination of the spot exchange rate and show the effect for the equilibrium exchange rate of the higher domestic interest rate. Describe in words how this exchange rate effect comes about.
c) Whether deliberately or not, the central bank?s monetary policy is likely to affect this country?s trade balance in the short-run. Explain how and why this is the case.
d) What would the goal(s) of a central bank be in raising the domestic interest rate through open market operations? Can you relate your answer to recent Federal Reserve Bank policy in the United States? Does the effect that this policy has for the nominal exchange rate and trade balance increase or decrease the likelihood of the central bank achieving its goal(s)?
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