Suppose that a small open economy begins to use credit cards, starting from monetary equilibrium, allowing households to hold more of their wealth in interest bearing assets. Discuss the effect on real and nominal money supply, foreign-exchange reserves given:
A) Fixed exchange rates
B) Flexible exchange rates.
THANKS!
To analyze the effects of credit card use on the real and nominal money supply and foreign-exchange reserves, we need to consider both fixed exchange rates and flexible exchange rates separately.
A) Fixed Exchange Rates:
When a small open economy introduces credit cards with fixed exchange rates, a few things happen:
1. Real and Nominal Money Supply: Credit cards allow households to hold more of their wealth in interest-bearing assets rather than in money. As a result, the demand for money decreases. However, the central bank intervenes to maintain the fixed exchange rate by adjusting the money supply. To offset the decrease in money demand, the central bank will need to decrease the real and nominal money supply.
2. Foreign-Exchange Reserves: With fixed exchange rates, the central bank of the small open economy must intervene to maintain the peg. As the use of credit cards increases and the demand for money decreases, the central bank will sell foreign exchange reserves to decrease the money supply. This will help maintain the fixed exchange rate.
In summary, credit card use in a small open economy with fixed exchange rates leads to a decrease in real and nominal money supply, and the central bank sells foreign-exchange reserves to maintain the fixed exchange rate.
B) Flexible Exchange Rates:
With flexible exchange rates, credit card use in a small open economy will result in different effects:
1. Real and Nominal Money Supply: As households use credit cards, the demand for money decreases as they shift their wealth into interest-bearing assets. This decrease in money demand will not be directly offset by the central bank, as there is no fixed exchange rate to defend. Therefore, the real and nominal money supply will decrease as in the case of fixed exchange rates.
2. Foreign-Exchange Reserves: In a flexible exchange rate regime, the central bank does not have to actively intervene to maintain a specific exchange rate. As credit card use reduces the money supply, there is no need for the central bank to buy or sell foreign-exchange reserves. The rate of exchange will be determined by market forces.
In summary, credit card use in a small open economy with flexible exchange rates also leads to a decrease in real and nominal money supply. However, there is no direct impact on foreign-exchange reserves due to the absence of central bank intervention for exchange rate stability.
Please note that the effects described above are simplified assumptions and actual outcomes could be influenced by other factors and dynamics in a real-world economy.