Assume a reserve currency standard system. Reserve center is buying domestic assets. What is the most probable initial effect of this monetary measure on foreign exchange market? Select one – the most appropriate answer.

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The prompt describes a reserve currency standard system in which the reserve center purchases domestic assets. Such an operation injects liquidity into the domestic financial system, increasing the supply of domestic currency. When a central bank expands domestic money supply, the typical market response is a depreciation of the domestic currency due to higher supply, all else equal. This depreciation in the domestic currency implies that foreign currencies will appreciate in value relative to the domestic currency.

Option 1: 'Domestic currency will appreciate.' This conflicts with the standard monetary transmission mechanism here; easing domestic money supply tends to weaken the domestic currency, not strengthen it, so this statement is unlikely to be correct in this context.

Option 2: 'Gold will appreciate.' The action described affects exchange rates and monetary conditions, not directly the price of gold. Gold appreciation would require a specific change in demand for gold or a change in the monetary regime that directly targets gold, which is not the immediate outcome of a domestic-asset purchase by a reserve center.

Option 3: 'Foreign currencies will depreciate.' If the domestic currency depreciates due to higher domestic money supply, foreign currencies are typically observed as appreciating against the domestic currency, not depreciating. This option contradicts the expected direction of movement in most standard scenarios.

Option 4: 'No correct answer.' Given the conventional reasoning above, there is at least one plausible directional effect on exchange rates, so claiming no correct answer would be inappropriate unless all options were untenable.

Option 5: 'Foreign currencies will appreciate.' This aligns with the logic that an expansion of domestic money supply (via purchasing domestic assets) tends to weaken the domestic currency, resulting in foreign currencies strengthening (appreciating) relative to the domestic currency. This reads consistently with standard open-economy monetary effects under a reserve currency system when the reserve center uses foreign reserves to buy domestic assets.

econ_420_120255_249094 Lesson 16 Quiz

Assume a reserve currency standard system. Reserve center is buying domestic assets. What is the most probable initial effect of this monetary measure on foreign exchange market? Select one – the most appropriate answer.

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