Question

ADVANCED ANALYSIS Return to problem 3 and assume that the exchange rate is fixed at 110. In year 1, what is the minimum initial size of the U.S. reserve of loonies such that the United States can maintain the peg throughout the year? What is the minimum initial size that is necessary at the start of year 2? Next, consider only the data for year 1. What peg should the United States set if it wants the fixed exchange rate to increase the domestic money supply by $1.2 trillion?

Qd	P	Qs	Q's
10	125	30	20
15	120	25	15
20	115	20	10
25	110	15	5

Short answer

The minimum initial size of the U.S. reserve of loonies will be 15 billion in year 1.

The minimum initial size of the U.S. reserve of loonies will be 05 billion in year 2.

The peg the United States should set if it wants the fixed exchange rate to increase the domestic money supply by $1.2 trillion will be 1 loonie = $190.

Step-by-step solution

Foreign exchange market replaced by government peg

As long as the U.S. government can come up with the necessary amounts of both dollars (to satisfy exchange requests for loonies) and loonies (to fulfill exchange requests for dollars), the fixed exchange rate will pre-empt the foreign exchange market.

The U.S. government can maintain the peg preferred by both buyers and sellers. Thus, there is no possibility of a given buyer and seller ever voluntarily agreeing to exchange dollars for loonies at any other exchange rate.

However, if the U.S. government ever stops honoring its pledge to exchange dollars for loonies and loonies for dollars at the fixed exchange rate, a private market for foreign exchange will instantly pop back into existence to connect the buyers and sellers of dollars and loonies. Because the exchange rate will be determined by supply and demand once again, it may end up at an equilibrium value substantially different from the fixed exchange rate that the government abandoned.

Minimum size of loonies in year 1

The exchange rate is fixed at 110, which means 1 loonie = $110.

For year 1, the minimum initial size of the U.S. reserve of loonies such that the United States can maintain the peg throughout the year should be 15 billion(quantities of loonies supplied).

Minimum size of loonies in year 2

The exchange rate is fixed at 110, which means 1loonie = $110.

For year 2, the minimum initial size of the U.S. reserve of loonies such that the United States can maintain the peg throughout the year should be 05 billion (quantities of loonies supplied).

Government’s new peg for year 1

Since $1.2 trillion = $1200 billion

At present peg the number of dollars available in the U.S. economy is:

110 x 15 = $1650 billion

The required supply is $(1650+1200) billion = $2850 billion

So the peg will be, $\frac{2850\times 110}{1650}=190$

The required peg is 1 loonie= $190 (The dollar has depreciated because the U.S. government is indirectly increasing the number of loonies or FOREX reserves).