Financial Markets and Institutions (2-downloads)

overvalued, the central bank must purchase domestic currency to keep the

exchange rate fixed, but as a result it loses international reserves.

Panel (b) in Figure 16.2 describes the situation in which the demand curve has

shifted to the right to D

1

because the relative expected return on domestic assets has

risen and hence the exchange rate is undervalued: The initial demand curve D

1

inter-

sects the supply curve at exchange rate E

1

, which is above E

par

. In this situation, the

central bank must sell domestic currency and purchase foreign assets. This action

works like an open market purchase to increase the money supply and lower the inter-

est rate on domestic assets i

D

. The central bank keeps selling domestic currency and

lowering i

D

until the demand curve shifts all the way to D

2

, where the equilibrium

exchange rate is at E

par

—point 2 in panel (b). Our analysis thus leads us to the following

5

Because the exchange rate will continue to be fixed at E

par

, the expected future exchange rate

remains unchanged and so does not need to be addressed in the analysis.

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Chapter 16 The International Financial System

383

result: When the domestic currency is undervalued, the central bank must