Fixed Exchange Rates and foreign Exchange Intervention

Lecture 8
Chapter 18
Exchange Rate Determination
Long Run
• Based on PPP “Purchasing Power Parity” theory.
• Compares different countries' currencies through a "basket of goods" approach.
• That is, PPP is the exchange rate at which one nation's currency would be converted into
another to purchase the same and same amounts of a large group of products.
Short Run
• Based on the output of the economy.
• Theory of AD and AS.
• Consumption, investment, government, net trade.
• Fiscal and monetary policies are used to alter changes in exchange rates in both short and
long runs.

Types of Exchange Rate Regimes

Fixed
Exchange rate is fixed according to the dynamics of the central bank.
Pegged Floating
Exchange rate is fixed within a range of values determined by central bank according to the
market forces.
Dirty floating.
Floating
Exchange rate is floating according to the market dynamics.
Clean floating.

Developing Countries and Exchange Rates

• Majority of transactions taking place in exchange rate market are based on dollar.
• Even they called exchange rate dollarization.
 • Many developing countries try to peg the values of their currencies, often in terms of the
dollar, but sometimes in terms of a non-dollar currency or some “basket” of currencies
chosen by the authorities.

How the Central Bank Fixes the Exchange Rate

• To hold the exchange rate constant, a central bank must always be willing to trade
currencies at the fixed exchange rate with the private actors in the foreign exchange
market.
• For example, to fix the Egyptian pound/dollar rate at LE50 per dollar, the Bank of
Egypt must be willing to:
 Buy LE with its dollar reserves, and in any amount the market desires, at a rate of
LE50 per dollar.
 Sell LE with its dollar reserves, and in any amount the market desires, at a rate of LE50
per dollar.
• If the central bank did not remove such excess supplies or demands for LE by
intervening in the market, the exchange rate would have to change to restore
equilibrium.
Direct Intervention

Monetary Policy

• Higher i, lower money supply.

• Lower i, increase money supply.

Purchase/Selling Assets

Any central bank purchase of assets automatically results in an increase in the domestic money
supply, while any central bank sale of assets automatically causes the money supply to decline.

Indirect Intervention

Open Market Operations

 Selling Securities:

• Decrease assets, decrease money in circulation.

 Buying Securities:
• Increase assets, increase money in circulation

Reserve Ratio

 Fraction of deposits that central banks require a bank to hold in reserves and not loan out
 Increase RRR, decrease money in circulation.
 Decrease RRR, increase money in circulation.

Central Bank Changes Money Supply  Interest Affected → Exchange Rate Affected

Stabilization Policies

 When the economy faces any shocks or changes in domestics economic variables, exchange
rate is affected.
 However, the effect as well as the magnitude are affected by the type of exchange rate
regime.
 Some policies are active under fixed regime and others are inactive.
 So, it is of a great importance to identify the regime first and then start stabilize by the
suitable policy.
 Policies available are monetary and fiscal policies.
Stabilization Policies under Fixed Exchange Rate Regime

Monetary Policy

• Under a fixed exchange rate, central bank monetary policy tools are powerless to affect the
economy’s money supply or its output.

Fiscal Policy

• Fiscal policy stabilizes the exchange rate under fixed regime.

How does Devaluation Work?

• Devaluation = depreciation
• Evaluation = appreciation

• Devaluation therefore causes a rise in output, a rise in official reserves, and an expansion of
the money supply

What happens when we expect devaluation?

 The central bank can’t maintain the fixed exchange rate. ; due to any reason.
 Sharp decrease in the reserves and/or high unemployment.
 People know that the current exchange rate can’t hold forever, CB should devaluate.
 Devaluation will deepen the crisis of balance of payment.
 People will invest internationally “capital flight”.
 CB decrease money supply, leading to increase in interest rate.
 Capital will fly back in if the new domestic interest rate is higher than the foreign interest
rate, taking into consideration the depreciation effect.

Reserve Currencies in the World Monetary System

 There are 195 countries in the world; so, it is not fixing my currency against 1 currency but
rather 194.
 However, there is 1 currency or a set of powerful currencies in which countries keep reserves
from.
 Between the end of World War II and 1973, the U.S. dollar was the main reserve currency
and almost every country pegged the dollar exchange rate of its money.
 Gold standards was used between 1870 and 1914, although many countries attempted
unsuccessfully to restore a permanent gold standard after the end of World War I in 1918.
 Cross rates imply that even when CB is fixing currency/dollar exchange rate, it will
consequently fix the rest currencies.

What would be the effect of a purchase of domestic assets by the central bank of the reserve
currency country?

 Ms increase, Interest decrease, Depreciating the currency.

 This means that all the currencies will appreciate compared to the reserve currency.
 Which resulted in higher prices in the world.
 Therefore, countries will start to demand more of the reserve currency.
 Which will depreciate the domestic currencies compared to reserve currency.
 Reserve country will expand and benefited without paying any cost or bearing any negative
circumstances.
 The reserve country has the power to affect its own economy, as well as foreign economies,
by using monetary policy.
 Other central banks are forced to relinquish monetary policy as a stabilization tool, and
instead must passively “import” the monetary policy of the reserve center because of their
commitment to peg their currencies to the reserve currency “asymmetric information”.

Questions:

1. How do you determine the exchange rate in the short as well as long run?

Exchange Rate in Short Run

 Based on PPP “Purchasing Power Parity” theory.

 Compares different countries' currencies through a "basket of goods" approach.
 That is, PPP is the exchange rate at which one nation's currency would be converted into
another to purchase the same amounts of a large group of products.

Exchange Rate in the Long Run

 Based on the output of the economy.

 Theory of AD and AS.
 Consumption, investment, government, net trade.
 Fiscal and monetary policies are used to alter changes in exchange rates in both short and
long runs.

2. Explain the three types of exchange rate regimes.

Fixed → Exchange rate is fixed according to the dynamics of the central bank.
Pegged Floating (Dirty Floating) → Exchange rate is fixed within a range of values determined
by central bank according to the market forces.

Floating (Clean Floating) → Exchange rate is floating according to the market dynamics.

3. How could the central bank intervene in the domestic economy?

Direct Intervention

1. Monetary Policy (Interest Rate i)

 Higher Interest, Lower Money Supply
 Lower Interest, Increase Money Supply
2. Purchase/Selling of assets
 Central bank purchase of assets automatically causes the domestic money supply to
increase.
 Central bank sale of assets automatically causes the money supply to decline.

Indirect Intervention

1. Open Market Operations

 Selling Securities → Decreases assets, decrease money in circulation.
 Buying Securities → Increase assets, increase money in circulation.

2. Reserve Ratio
 Increase RRR → Decrease money in circulation.
 Decrease RRR → Increase money in circulation.

4. Explain the open market operations.

Open market operations allow the central banks in other countries to prevent price inflation or
deflation without directly interfering in the market economy, Instead of using regulations to
control lending, the central bank can simply raise or lower the cost of borrowing money.

Selling Securities:
Decrease assets, decrease money in circulation.

Buying Securities:

Increase assets, increase money in circulation.

5. Explain the required reserve ratio.

 The required reserve ratio is the ratio of money that a commercial bank must hold in reserve
to the amount of money it has on deposit. This money, which is the required bank reserves, is
held on reserve and is not allowed to be used in lending or investing activities.
 Fraction of deposits that central banks require a bank to hold in reserves and not loan out
 Increase RRR, decrease money in circulation.
 Decrease RRR, increase money in circulation.

6. How could we stabilize the exchange rate under the fixed exchange rate regime?

1. Foreign exchange reserves: Accumulating an adequate level of foreign exchange reserves

can help stabilize the exchange rate. These reserves can be used to intervene in the foreign
exchange market by buying or selling domestic currency to maintain the desired exchange rate.

2. Monetary policy: The central bank can adjust its monetary policy to influence the exchange
rate. For example, increasing interest rates can attract foreign investors, leading to an inflow of
foreign currency and strengthening the exchange rate.

7. What happens to the domestic economy when we expect devaluation?

 The central bank can’t maintain the fixed exchange rate. ; due to any reason.
 Sharp decrease in the reserves and/or high unemployment.
 People know that the current exchange rate can’t hold forever, CB should devaluate.
 Devaluation will deepen the crisis of balance of payment.
 People will invest internationally (capital flight).
 CB decrease money supply, leading to increase in interest rate.
 Capital will fly back in if the new domestic interest rate is higher than the foreign interest
rate, taking into consideration the depreciation effect.