Fixed Exchange Rate Regime

Central Bank Balance Sheet

Assets Liabilities
Foreign Asset $1000 Deposits held by Pvt. Banks $500
Domestic Assets $1500 Currency in Circulation $2000

 Assets = Liabilities

 Deposits are liabilities because they can withdraw

whenever needed

 Currency for historical reason: one can give up currency and

CB is liable to pay up in gold/silver

 Net worth: assumed to be zero (interest earning on assets).

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CB Sells $100 Foreign Asset
 Suppose payment received in domestic currency – that amount goes to
vault and reduces same amount from circulation

Assets Liabilities
Foreign Asset $900 Deposits held by Pvt. Banks $500
Domestic Assets $1500 Currency in Circulation $1900

 CB receives cheque of some Pvt. Bank: It will encash that from the
deposit held by the Pvt. Bank
Assets Liabilities
Foreign Asset $900 Deposits held by Pvt. Banks $400
Domestic Assets $1500 Currency in Circulation $2000

 CB purchase of asset increases domestic money supply and sale results

in decline in money supply automatically.

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Sterilization
 CB makes purchase of domestic asset to nullify the MS effect of a sale of
foreign asset of an equivalent amount

 CB sells foreign asset worth $100

Assets Liabilities
Foreign Asset $900 Deposits held by Pvt. Banks $500
Domestic Assets $1500 Currency in Circulation $1900

 To nullify the drop in money supply CB buys $100 worth domestic bond

Assets Liabilities
Foreign Asset $900 Deposits held by Pvt. Banks $500
Domestic Assets $1600 Currency in Circulation $2000

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How to Fix?
 Exchange rate peg can be sustained in a way to maintain asset
and money market equilibria.

 Asset market (IPC) boils down to: R = R* as Ee = E0 = E

MS
 Money market: L( R * , Y )
P
 Suppose there is an increase in output. That raises money
demand. Which in turn will raise interest rate. To maintain IPC,
exchange rate should appreciate.

 CB purchase foreign asset. Domestic money supply increases.

Interest and exchange rates come back to original position.

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Increase in Output

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Monetary Expansion

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Fiscal Expansion

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Devaluation

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BOP Crisis
 Suppose there is a pressure on the currency towards devaluation
due to continuing CA deficit

 To maintain exchange rate at a particular level CB continues to

sell forex to decrease money supply in the domestic market.

 Forex reserve keeps on dwindling

 CB cannot continue with the present exchange rate

 CB finally may succumb to the pressure and devalue

 So domestic players sell off domestic Currency for foreign

Currency.
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BOP Crisis
 Thus a present expectation of future devaluation leads to –

1. Fall in forex reserve (Capital Flight)

2. Rise in domestic interest rate

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Capital Flight

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