THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 553

CHAPTER 20
Exchange Rate, Et
(euros/$)

E1

The International Financial System

521

S

1

E3

3

E2

2
D2

D3 D1

Quantity of Dollar Assets

FIGURE 20-1

Effect of a Sale of Dollars and a Purchase of Foreign Assets

A sale of dollars and the consequent open market purchase of foreign assets increase the
monetary base. The resulting rise in the money supply leads to a decline in domestic interest
rates and a higher domestic price level in the long run, which produces a lower expected future
exchange rate. The decline in both the expected appreciation of the dollar and the domestic
interest rate lowers the relative expected return on dollar assets, shifting the demand curve
leftward from D1 to D2. In the short run, the equilibrium exchange rate falls from E1 to E2.
In the long run, the interest rate rises back to its initial level and the demand curve shifts
rightward to D3. The exchange rate rises from E2 to E3 in the long run.

lead to a higher real money supply in the short run, which causes the interest
rate on dollar assets to fall, also lowering the relative expected return on dollar
assets, and providing another reason for the demand curve to shift to the left.
The demand curve shifts from D1 to D2, and the exchange rate falls to E2.
Because the domestic interest rate will rise back to its initial level in the long
run, the relative expected return of dollar assets will increase somewhat, sending the demand curve to D3, but not all the way back to D1 because the price
level will still be higher in the long run. The exchange rate thus rises from E2 to
E3, which is still below the initial value of E1. The result is the same one we
found in the previous chapter, in which there is exchange rate overshooting
that is, the exchange rate falls by more in the short run than in the long run.
Our analysis leads us to the following conclusion about unsterilized interventions in the foreign exchange market: An unsterilized intervention in which
domestic currency is sold to purchase foreign assets leads to a gain in
international reserves, an increase in the money supply, and a depreciation of the domestic currency.
The reverse result is found for an unsterilized intervention in which domestic
currency is purchased by selling foreign assets. The purchase of domestic currency by selling foreign assets (reducing international reserves) works like an
open market sale to reduce the monetary base and the money supply. The
decrease in the money supply raises the interest rate on dollar assets and lowers
the long-run price level, thereby increasing the future expected exchange rate.
The resulting increase in the relative expected return on dollar assets means that
people will buy more dollar assets, so the demand curve shifts to the right and