The authority sells foreign bonds in a contractionary foreign exchange operation to private investors.
*
a
dB , change in the foreign bond holdings by the authority is negative; so is dM , change in money supply, indicating the monetary base
is shrinking. In the meantime, the foreign bond holdings by private investors increase. Figure 10.7 demonstrates the effect. Accordingly, the MM line shifts leftupwards to M’M’ and the B*
B*
line shifts left-downwards to B*
’B*
’. The directions of these movements are suggested by the illustrations in Figure 10.2 and Figure 10.4. These shifts are accompanied by the rise of the interest rate, to a less extent in comparison with a contractionary open market operation; and the
appreciation of the domestic currency, to a greater extent relative to a contractionary open market operation. Note that the decrease in money supply occurs initially
in the foreign currency. In the process of conversion of the foreign currency into
the domestic currency, there may pressure put on the foreign currency to depreciate also. The decrease in the monetary base and the excess supply in foreign bonds
caused by the sale by the authority lead to reduced demand for foreign bonds, so
foreign bond prices fall in terms of the domestic currency value. The domestic
currency appreciates or the exchange rate decreases while the demand for foreign
bonds, as well as foreign bond prices in terms of the domestic currency value,
falls. The interest rate rises while money in circulation shrinks. The BB line is unchanged since this open market operation in foreign exchange is between foreign
bonds and money, involving no changes in domestic bonds. The new general equilibrium is settled down at point E’ with an increased interest rate of ' r and a reduced exchange rate of ' S .