Assume the money supply is backed by bonds and reserves, and the exchange rate is pegged. If the demand for money rises, how might the central bank maintain the peg?
A) by selling back domestic bonds and foreign currency reserves
B) by selling domestic bonds equal to the increase in demand
C) by purchasing reserves equal to the increase in demand
D) by selling reserves equal to the increase in demand

Question

Quizplus · Accepted Answer

If the demand for money rises, the central bank can maintain the peg by purchasing reserves equal to the increase in demand. This will increase the supply of money in the economy, which can help meet the higher demand for money. By purchasing reserves, the central bank can also prevent the exchange rate from fluctuating, thus maintaining the peg. Selling back domestic bonds and foreign currency reserves (option A) would reduce the money supply, which might not be desirable if the demand for money is high. Selling domestic bonds equal to the increase in demand (option B) would not necessarily be effective in maintaining the peg, as the exchange rate can still fluctuate in response to changes in the supply and demand for the currency. Selling reserves equal to the increase in demand (option D) would reduce the central bank's ability to intervene in the foreign exchange market and maintain the peg.

Assume the Money Supply Is Backed by Bonds and Reserves