Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention

Kernel of the Chapter
 Central Bank Intervention and the Money Supply  How the Central Bank Fixes the Exchange Rates  Stabilization Policies with a Fixed Exchange Rate  Balance of Payments Crises and Capital Flight  Managed Floating and Sterilized Intervention  The Gold Standard

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Why Study Fixed Exchange Rates?
 Four reasons to study fixed exchange rates:
• • • •
Managed floating Regional currency arrangements Developing countries and countries in transition Lessons of the past for the future

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Central Bank Intervention and the Money Supply
 The Central Bank Balance Sheet and the Money
Supply

• Central bank balance sheet
– It records the assets held by the central bank and its liabilities. – It is organized according to the principles of doubleentry bookkeeping.

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Central Bank Intervention and the Money Supply • The assets side of a balance sheet lists two types of assets: – Foreign assets – Domestic assets • The liabilities side of a balance sheet lists as liabilities: – Deposits of private banks – Currency in circulation • Total assets = total liabilities + net worth 5 .

• Any central bank sale of assets automatically causes the money supply to decline. 6 .Central Bank Intervention and the Money Supply • Net worth is constant. • Any central bank purchase of assets automatically results in an increase in the domestic money supply. – The changes in central bank assets cause equal changes in central bank liabilities.

Central Bank Intervention and the Money Supply  Foreign Exchange Intervention and the Money Supply • Foreign exchange intervention affects the money supply because the central bank’s liabilities are the base of the domestic money supply process. • The central bank can negate the money supply effect of intervention though sterilization. 7 .

– With no sterilization. there is a link between the balance of payments and national money supplies that depends on how central banks share the burden of financing payments gaps.Central Bank Intervention and the Money Supply  Sterilization • Sterilized foreign exchange intervention – Central banks sometimes carry out equal foreign and domestic asset transactions in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply. 8 .

Central Bank Intervention and the Money Supply Table 17-2: Effects of a $100 Foreign Exchange Intervention: Summary 9 .

10 .Central Bank Intervention and the Money Supply  The Balance of Payments and the Money Supply • If central banks are not sterilizing and the home country has a balance of payments surplus: – An increase in the home central bank’s foreign assets implies an increased home money supply. – A decrease in a foreign central bank’s claims on the home country implies a decreased foreign money supply.

How the Central Bank Fixes the Exchange Rate  Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate • The foreign exchange market is in equilibrium when: R = R* + (Ee – E)/E – Ee=0 – The interest parity condition implies R = R*. 11 .

Y) 12 .How the Central Bank Fixes the Exchange Rate  Money Market Equilibrium Under a Fixed Exchange Rate • To hold the domestic interest rate at R*. the central bank’s foreign exchange intervention must adjust the money supply so that: MS/P = L(R*.

13 .How the Central Bank Fixes the Exchange Rate  A Diagrammatic Analysis • To hold the exchange rate fixed at E0 when output rises. the central bank must purchase foreign assets and thereby raise the money supply.

How the Central Bank Fixes the Exchange Rate Figure 17-1: Asset Market Equilibrium with a Fixed Exchange Rate. Y1) Real money supply 3 2 14 . E0 Exchange rate. E E0 1' 3' 0 M1 P M2 P Real domestic money holdings R* 1 Domestic-currency return on foreign-currency deposits. L(R. R Real money demand. R* + (E0 – E)/E Domestic Interest rate.

Stabilization Policies With a Fixed Exchange Rate  Monetary Policy • Under a fixed exchange rate. 15 . central bank monetary policy tools are powerless to affect the economy’s money supply or its output.

E DD 2 E2 1 E0 AA2 AA1 Y1 Y2 Output.Stabilization Policies With a Fixed Exchange Rate Figure 17-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate Exchange rate. Y 16 .

Stabilization Policies With a Fixed Exchange Rate  Fiscal Policy • How does the central bank intervention hold the exchange rate fixed after the fiscal expansion? • The effects of expansionary fiscal policy when the economy’s initial equilibrium is at point 1 are illustrated in Figure 17-3. 17 .

E DD1 DD2 1 E0 2 E2 3 AA2 AA1 Y1 Y2 Y3 Output.Stabilization Policies With a Fixed Exchange Rate Figure 17-3: Fiscal Expansion Under a Fixed Exchange Rate Exchange rate. Y 18 .

Stabilization Policies With a Fixed Exchange Rate  Changes in the Exchange Rate • Devaluation – It causes: – A rise in output – A rise in official reserves – An expansion of the money supply – It is chosen by governments to: – Fight domestic unemployment – Improve the current account – Affect the central bank's foreign reserves 19 .

20 .Stabilization Policies With a Fixed Exchange Rate • Revaluation – It occurs when the central bank lowers E. at the new exchange rate. in unlimited amounts. the central bank has to announce its willingness to trade domestic against foreign currency. • In order to devalue or revalue.

Stabilization Policies With a Fixed Exchange Rate Figure 17-4: Effects of a Currency Devaluation Exchange rate. E DD 2 E1 1 E0 AA2 AA1 Y1 Y2 Output. Y 21 .

22 . – There is no real appreciation in the short-run – There is real appreciation in the long-run • Devaluation is neutral in the long-run.Stabilization Policies With a Fixed Exchange Rate  Adjustment to Fiscal Policy and Exchange Rate Changes • Fiscal expansion causes P to rise.

Y 23 . E DD Ee 1 – R* 1 AA1 Y1 Yf Output.Stabilization Policies With a Fixed Exchange Rate Figure 17-5: A Low-Output Liquidity Trap Exchange Rate.

Stabilization Policies With a Fixed Exchange Rate Figure 17-6: Fixing the Exchange Rate to Restore Full Employment Exchange Rate. E E0 1 – R* Ee 1 – R* 1 AA2 2 DD AA1 Y1 Yf Output. Y 24 .

Balance of Payments Crises and Capital Flight  Balance of payments crisis • It is a sharp change in official foreign reserves sparked by a change in expectations about the future exchange rate. 25 .

Balance of Payments Crises and Capital Flight Figure 17-7: Capital Flight. the Money Supply. E 1' 2' R* + (E1– E)/E E0 0 M2 P R* R* + (E0 – E)/E R* + (E1 – E0)/E0 Domestic Interest rate. and the Interest Rate Exchange rate. R 2 Real money supply M1 P 1 Real domestic money holdings 26 .

Balance of Payments Crises and Capital Flight  The expectation of a future devaluation causes: • A balance of payments crisis marked by a sharp fall in reserves • A rise in the home interest rate above the world interest rate  An expected revaluation causes the opposite effects of an expected devaluation. 27 .

28 .  Self-fulfilling currency crises • It occurs when an economy is vulnerable to speculation. • The government may be responsible for such crises by creating or tolerating domestic economic weaknesses that invite speculators to attack the currency.Balance of Payments Crises and Capital Flight  Capital flight • The reserve loss accompanying a devaluation scare – The associated debit in the balance of payments accounts is a private capital outflow.

29 . its transactions leave the domestic money supply unchanged. monetary policy is  influenced by exchange rate change. Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention • When a central bank carries out a sterilized foreign exchange intervention.Managed Floating and Sterilized Intervention  Under managed floating.

Managed Floating and Sterilized Intervention • Perfect asset substitutability – Central banks cannot control the money supply and the exchange rate through sterilized foreign exchange intervention. 30 .

– Central banks may be able to control both the money supply and the exchange rate through sterilized foreign exchange intervention. 31 .Managed Floating and Sterilized Intervention • Imperfect asset substitutability – Assets’ expected returns can differ in equilibrium. – Risk is the main factor that may lead to imperfect asset substitutability in foreign exchange markets.

Managed Floating and Sterilized Intervention  Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability • Equilibrium in the foreign exchange market requires that: R = R* + (Ee – E)/E +  (17-2) • The risk premium depends positively on the stock of domestic government debt:  = (B – A) (17-3) 32 .

– The purchase of foreign assets is matched by a sale of domestic assets (from A1 to A2).Managed Floating and Sterilized Intervention  The Effects of Sterilized Intervention with Imperfect Asset Substitutability • A sterilized purchase of foreign assets leaves the money supply unchanged but raises the risk adjusted return that domestic currency deposits must offer in equilibrium. 33 . • Figure 17-8 illustrates the effects of a sterilized purchase of foreign assets by the central bank.

Managed Floating and Sterilized Intervention Figure 17-8: Effect of a Sterilized Central Bank Purchase of Foreign Assets Under Imperfect Asset Substitutability Exchange rate. E E2 E1 0 Sterilized purchase 2' of foreign assets Risk-adjusted domesticcurrency return on foreign currency deposits. R Ms P Real money supply 1 Real domestic money holdings 34 . 1' R* + (Ee– E)/E + (B –A2) R* + (Ee – E)/E + (B –A1) R1 Domestic Interest rate.

Managed Floating and Sterilized Intervention  Evidence on the Effects of Sterilized Intervention • Empirical evidence provides little support for the idea that sterilized intervention has a significant direct effect on exchange rates. 35 .

36 .Managed Floating and Sterilized Intervention  The Signaling Effect of Intervention • Signaling effect of foreign exchange intervention – An important complicating factor in econometric efforts to study the effects of sterilization – Sterilized intervention may give an indication of where the central bank expects (or desires) the exchange rate to move.

• Gold standard – Central banks peg the prices of their currencies in terms of gold. – The currency central banks hold in their international reserves.Reserve Currencies in the World Monetary System  Two possible systems for fixing the exchange rates: • Reserve currency standard – Central banks peg the prices of their currencies in terms of a reserve currency. 37 .

Reserve Currencies in the World Monetary System • The two systems have very different implications about: – How countries share the burden of balance of payments financing – The growth and control of national money supplies 38 .

39 .S. dollar set up at the end of World War II.Reserve Currencies in the World Monetary System  The Mechanics of a Reserve Currency Standard • The workings of a reserve currency system can be illustrated by the system based on the U.

• The purchase of domestic assets by the central bank of the reverse currency country leads to: – Excess demand for foreign currencies in the foreign exchange market – Expansionary monetary policies by all other central banks – Higher world output 40 .Reserve Currencies in the World Monetary System  The Asymmetric Position of the Reserve Center • The reserve-issuing country can use its monetary policy for macroeconomic stabilization even though it has fixed exchange rates.

The Mechanics of a Gold Standard  • Exchange rates between any two currencies were fixed. 41 . No single country occupies a privileged position within the system.The Gold Standard  Each country fixes the price of its currency in terms  of gold.

– It places constraints on the growth of countries’ money supplies.The Gold Standard  Symmetric Monetary Adjustment Under a Gold  Standard Benefits and Drawbacks of the Gold Standard • Benefits: – It avoids the asymmetry inherent in a reserve currency standard. 42 .

– It could give gold producing countries (like Russia and South Africa) too much power.The Gold Standard • Drawbacks: – It places undesirable constraints on the use of monetary policy to fight unemployment. – It ensures a stable overall price level only if the relative price of gold and other goods and services is stable. – It makes central banks compete for reserves and bring about world unemployment. 43 .

The Gold Standard  Bimetallic standard • The currency was based on both silver and gold. was bimetallic from 1837 until the Civil War. • It might reduce the price-level instability resulting from use of one of the metals alone. • In a bimetallic system. 44 .S. • The U. a country’s mint will coin specified amounts of gold or silver into the national currency unit.

but it allows more flexibility in the growth of international reserves.The Gold Standard  The Gold Exchange Standard • Central banks’ reserves consist of gold and currencies whose prices in terms of gold are fixed. • It can operate like a gold standard in restraining excessive monetary growth throughout the world. 45 .

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