Professional Documents
Culture Documents
Exchange Rate Management
Exchange Rate Management
Finance
Currency
Union (Euro)
Commitment
Flexibility
With a hard peg, a currency’s price is held
permanently at a fixed level. For example, the
Flexibility
Chinese Yuan.
.1265 $1 = 7.90Yuan
e
$1 = 76 Dinar
.012
+2%
-2%
10%
5% Crawling Peg or
Band
Target Zone
14%
20%
Pure Peg
Dollarization
Currency Baskets
Some countries choose to peg to a “basket” of currencies rather
that a single currency. This basket will have a price equal to a
weighted average of the individual currencies
Latvia: SDR (Euro, JPY, GBP, USD)
currencies.
The central bank has a wider choice of options for official
reserves
Costs/Benefits of Fixed Exchange
Rates
Main Benefit
Reduces uncertainty with regard to cross border
trade in both goods and assets
Main Cost
Eliminates a country’s ability to use monetary
policy for domestic objectives
Full Employment
High Output Growth
Low Inflation
Suppose that the US decides to peg to the Euro at a price of $1.30 per
Euro – Our ability to maintain the peg depends on our foreign
exchange reserves.
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
M
*
P 1 i M
P* 1 i * *
y y
PPP
P eP *
M Y 1 i
*
e * *
M Y 1 i
This should give us the long run trend
The US is pegging at $1.30/Euro. This explicitly defines a
monetary policy!
M Y 1 i
*
1.30 e * *
M Y 1 i
M 1.30 M *
*
Y 1 i
*
Y 1 i
%M %M * %Y %Y * i * i
Note: All else equal, money growth rates should be the
same.
Y 1 i
M 1.30 M *
*
*
Y 1 i
Mexico’s crawling peg to the US was due to its high inflation rate
relative to the US (high inflation is a result of low economic growth
and high money growth
Suppose the Federal Reserve conducts an open market purchase of
$1,000,000 in Treasuries to increase the money supply, what will the short
run impact be?
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+ $1,000,000 (T-Bills)
i
LM
BOP 0
IS
y
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
- $1,000,000 X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+ $1,000,000 (T-Bills)
- $1,000,000 (Euros)
IS
y
If capital mobility is sufficiently high, the increase in domestic interest
rated creates sufficient capital inflow to finance the trade deficit. The
dollar begins to appreciate
i
LM
BOP 0
i
BOP CA KFA
IS
y
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
+$1,000,000 (Euros)
i BOP 0 LM
i
BOP CA KFA
IS
y
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
-$1,000,000 (Euros)
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000
+ $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
-$1,000,000 (Euros)
+$1,000,000 (T-Bills)
i
LM
Note: This would contract the money supply – raising interest rates and
lowering output.
The Fed Conducts an open market purchase of dollars to
stabilize the exchange rate
Liabilities Assets
$ 10,000,000 (Currency) E 2,000,000 (Euro)
E 3,000,000 (ECB Bonds)
- $1,000,000 E 5,000,000
X 1.30 $/E
$ 6,500,000
$ 3,500,000 (T-Bills)
$10,000,000
-$1,000,000 (Euros)
i
LM
Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.30 $/E
$ 2,600,000
$ 3,500,000 (T-Bills)
$6,100,000
Liabilities Assets
$ 6,100,000 (Currency) E 1,000,000 (Euro)
E 1,000,000 (ECB Bonds)
E 2,000,000
X 1.50 $/E
$ 3,000,000
$ 3,500,000 (T-Bills)
$6,500,000
“Daniel-san, must talk. Man walk on road. Walk left side, safe. Walk right
side, safe. Walk down middle, sooner or later, get squished just like
grape. Same here. You karate do "yes," or karate do "no." You karate do
"guess so," just like grape. Understand?”
Committed Floater
Committed Pegger
Uncertain Pegger