Read the following brief text carefully before starting to answer the questions.
In response to the 2007-08 Global Financial Crisis and the subsequent economic recession in the rest of the world, central banks in most advanced economies conducted expansionary monetary policies. This often involved cutting policy rates and increasing domestic money supplies. As a result, capital inflows by international investors, who were searching for higher return and safe haven currencies, increased significantly to other economies with stronger macroeconomic fundamentals, Switzerland being one of them.
This had an impact on the Swiss national currency (franc), which appreciated significantly between 2008 and 2011. For example, the exchange rate fell from 1.6 in 2008 to almost 1.1 in 2011 against Euro. In response, the Swiss National Bank (SNB – the central bank of Switzerland) announced that it would set a floor at 1.2 francs per Euro, thus effectively pegging the national currency to Euro. While announcing the new policy, the SNB also stated that it would “no longer tolerate” further appreciation and would enforce the floor with “utmost determination”. The franc exchange rate remained stable at around 1.2 per Euro for about four years. But, in January 2015, the SNB suddenly abandoned the exchange rate floor. As a result, the franc exchange rate fell to less than 1.0 per Euro before it settled down at around 1.1 per Euro.
Before starting your analysis, you also need to take into account the following information.
Treat Switzerland as the “home” country and the rest of the economies in question as the “rest of the world”.
Assume the slope of the Balance of Payments (BP) line, which your textbook calls “the FE line”, is horizontal to start with.
Assume Switzerland’s Balance of Payments (BP) is equal to zero (BP=0) before the start of the expansionary monetary policy by the rest of the world.
Assume the exchange rate regime in Switzerland was originally flexible.
Key acronyms to remember: BP – balance of payments, SNB – the central bank of Switzerland.
You must answer ALL questions below.
Question 1
Using an appropriate version of the IS/LM/BP model, demonstrate which of the curves in the model would shift in response to the fall in the world interest rates (iw). Also, show how this would affect Switzerland’s BP position: you must clearly explain if it is a BP surplus or a BP deficit. (15 Marks)
Question 2
Briefly explain the main economic rationale behind the Swiss National Bank’s (SNB) decision to intervene in the foreign exchange market in response to such a strong demand for franc. (15 Marks)
Question 3
The IS/LM/FE model predicts that the BP disequilibrium (i.e. BP≠0) in Question 1 should eventually disappear and BP must return to zero (BP=0). Explain the underlying transmission mechanism that ensures this adjustment when:
SNB decides to peg the national currency as explained in the introduction, and
(15 Marks)
SNB decides not to intervene, i.e. it allows the value of franc to be determined by market forces.
(15 Marks)
Question 4
In addition to the two scenarios in Question 3, what other policy options are available for the Swiss authorities if they want to achieve BP=0? Discuss the pros and cons of each approach.
(15 Marks)
Question 5
Explain why SBN abandoned its policy in 2015 and why the franc/Euro exchange rate fell so sharply as a result.
(10 Marks)
Some economists argue SNB’s intervention in the exchange market was successful while others disagree about the success of the intervention policy. Critically discuss both sides of the arguments.
(15 Marks)
