Chapter 17 Chapter 17 Fixed Exchange Rates and Fixed Exchange Rates and Foreign Exchange Intervention Foreign Exchange Intervention Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy International Economics: Theory and Policy , Sixth Edition by Paul R. Krugman and Maurice Obstfeld
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Chapter 17Chapter 17Fixed Exchange Rates andFixed Exchange Rates and
– Central banks sometimes carry out equal foreign anddomestic asset transactions in opposite directions tonullify the impact of their foreign exchange operationson the domestic money supply.
– With no sterilization, there is a link between the balanceof payments and national money supplies that dependson how central banks share the burden of financingpayments gaps.
– Central banks sometimes carry out equal foreign anddomestic asset transactions in opposite directions tonullify the impact of their foreign exchange operationson the domestic money supply.
– With no sterilization, there is a link between the balanceof payments and national money supplies that dependson how central banks share the burden of financingpayments gaps.
Table 17-2: Effects of a $100 Foreign Exchange Intervention: Summary
Foreign Exchange Market Equilibrium Under aFixed Exchange Rate• The foreign exchange market is in equilibrium when:
R = R* + (Ee – E)/E– When the central bank fixes E at E0, the expected rate
of domestic currency depreciation is zero.
– The interest parity condition implies that E0 is today’sequilibrium exchange rate only if: R = R*.
Money Market Equilibrium Under a Fixed ExchangeRate• To hold the domestic interest rate at R*, the central
bank’s foreign exchange intervention must adjust themoney supply so that:
MS/P = L(R*, Y)– Example: Suppose the central bank has been fixing E at
E0 and that asset markets are in equilibrium. Anincrease in output would raise the money demand andthus lead to a higher interest rate and an appreciation ofthe home currency.
Money Market Equilibrium Under a Fixed ExchangeRate• To hold the domestic interest rate at R*, the central
bank’s foreign exchange intervention must adjust themoney supply so that:
MS/P = L(R*, Y)– Example: Suppose the central bank has been fixing E at
E0 and that asset markets are in equilibrium. Anincrease in output would raise the money demand andthus lead to a higher interest rate and an appreciation ofthe home currency.
– The central bank must intervene in the foreign exchangemarket by buying foreign assets in order to prevent thisappreciation.
– If the central bank does not purchase foreign assetswhen output increases but instead holds the moneystock constant, it cannot keep the exchange rate fixed atE0.
– The central bank must intervene in the foreign exchangemarket by buying foreign assets in order to prevent thisappreciation.
– If the central bank does not purchase foreign assetswhen output increases but instead holds the moneystock constant, it cannot keep the exchange rate fixed atE0.
A Diagrammatic Analysis• To hold the exchange rate fixed at E0 when output
rises, the central bank must purchase foreign assets andthereby raise the money supply.
– It occurs when the central bank raises the domesticcurrency price of foreign currency, E.
– 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
• Revaluation– It occurs when the central bank lowers E.
• In order to devalue or revalue, the central bank has toannounce its willingness to trade domestic againstforeign currency, in unlimited amounts, at the newexchange rate.
• Revaluation– It occurs when the central bank lowers E.
• In order to devalue or revalue, the central bank has toannounce its willingness to trade domestic againstforeign currency, in unlimited amounts, at the newexchange rate.
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 worldinterest rate
An expected revaluation causes the opposite effectsof an expected devaluation.
Capital flight• The reserve loss accompanying a devaluation scare
– The associated debit in the balance of paymentsaccounts is a private capital outflow.
Self-fulfilling currency crises• It occurs when an economy is vulnerable to
speculation.
• The government may be responsible for such crises bycreating or tolerating domestic economic weaknessesthat invite speculators to attack the currency.
Capital flight• The reserve loss accompanying a devaluation scare
– The associated debit in the balance of paymentsaccounts is a private capital outflow.
Self-fulfilling currency crises• It occurs when an economy is vulnerable to
speculation.
• The government may be responsible for such crises bycreating or tolerating domestic economic weaknessesthat invite speculators to attack the currency.
Managed Floatingand Sterilized Intervention
Under managed floating, monetary policy isinfluenced by exchange rate change.
Perfect Asset Substitutability and the Ineffectivenessof Sterilized Intervention• When a central bank carries out a sterilized foreign
exchange intervention, its transactions leave thedomestic money supply unchanged.
The Asymmetric Position of the Reserve Center• The reserve-issuing country can use its monetary
policy for macroeconomic stabilization even though ithas fixed exchange rates.
• The purchase of domestic assets by the central bank ofthe reverse currency country leads to:
– Excess demand for foreign currencies in the foreignexchange market
– Expansionary monetary policies by all other centralbanks
– Higher world output
The Gold Standard
Each country fixes the price of its currency in termsof gold. No single country occupies a privileged position
within the system. The Mechanics of a Gold Standard
• Exchange rates between any two currencies werefixed.
– Example: If the dollar price of gold is pegged at $35 perounce by the Federal Reserve while the pound price ofgold is pegged at £14.58 per ounce by the Bank ofEngland, the dollar/pound exchange rate must beconstant at $2.40 per pound.
Each country fixes the price of its currency in termsof gold. No single country occupies a privileged position
within the system. The Mechanics of a Gold Standard
• Exchange rates between any two currencies werefixed.
– Example: If the dollar price of gold is pegged at $35 perounce by the Federal Reserve while the pound price ofgold is pegged at £14.58 per ounce by the Bank ofEngland, the dollar/pound exchange rate must beconstant at $2.40 per pound.
The Gold Standard
Symmetric Monetary Adjustment Under a GoldStandard• Whenever a country is losing reserves and its money
supply shrinks as a consequence, foreign countries aregaining reserves and their money supplies expand.
Benefits and Drawbacks of the Gold Standard• Benefits:
– It avoids the asymmetry inherent in a reserve currencystandard.
– It places constraints on the growth of countries’ moneysupplies.
• Drawbacks:– It places undesirable constraints on the use of monetary
policy to fight unemployment.
– It ensures a stable overall price level only if the relativeprice of gold and other goods and services is stable.
– It makes central banks compete for reserves and bringabout world unemployment.
– It could give gold producing countries (like Russia andSouth Africa) too much power.
The Gold Standard
Bimetallic standard• The currency was based on both silver and gold.
• The U.S. was bimetallic from 1837 until the Civil War.
• In a bimetallic system, a country’s mint will coinspecified amounts of gold or silver into the nationalcurrency unit.
– Example: 371.25 grains of silver or 23.22 grains of goldcould be turned into a silver or a gold dollar. This madegold worth 371.25/23.22 = 16 times as much as silver.
• It might reduce the price-level instability resultingfrom use of one of the metals alone.
Bimetallic standard• The currency was based on both silver and gold.
• The U.S. was bimetallic from 1837 until the Civil War.
• In a bimetallic system, a country’s mint will coinspecified amounts of gold or silver into the nationalcurrency unit.
– Example: 371.25 grains of silver or 23.22 grains of goldcould be turned into a silver or a gold dollar. This madegold worth 371.25/23.22 = 16 times as much as silver.
• It might reduce the price-level instability resultingfrom use of one of the metals alone.
The Gold Standard
The Gold Exchange Standard• Central banks’ reserves consist of gold and currencies
whose prices in terms of gold are fixed.– Each central bank fixes its exchange rate to a currency
with a fixed gold price.
• It can operate like a gold standard in restrainingexcessive monetary growth throughout the world, butit allows more flexibility in the growth of internationalreserves.
The Gold Exchange Standard• Central banks’ reserves consist of gold and currencies
whose prices in terms of gold are fixed.– Each central bank fixes its exchange rate to a currency
with a fixed gold price.
• It can operate like a gold standard in restrainingexcessive monetary growth throughout the world, butit allows more flexibility in the growth of internationalreserves.
Summary
There is a direct link between central bankintervention in the foreign exchange market and thedomestic money supply.• When a country’s central bank purchases (sells)
foreign assets, the country's money supplyautomatically increases (decreases).
The central bank balance sheet shows how foreignexchange intervention affects the money supply.
The central bank can negate the money supply effectof intervention through sterilization.
There is a direct link between central bankintervention in the foreign exchange market and thedomestic money supply.• When a country’s central bank purchases (sells)
foreign assets, the country's money supplyautomatically increases (decreases).
The central bank balance sheet shows how foreignexchange intervention affects the money supply.
The central bank can negate the money supply effectof intervention through sterilization.
Summary
A central bank can fix the exchange rate of itscurrency against foreign currency if it tradesunlimited amounts of domestic money against foreignassets at that rate. A commitment to fix the exchange rate forces the
central bank to sacrifice its ability to use monetarypolicy for stabilization. Fiscal policy has a more powerful effect on output
under fixed exchange rates than under floating rates. Balance of payments crises occur when market
participants expect the central bank to change theexchange rate from its current level.
A central bank can fix the exchange rate of itscurrency against foreign currency if it tradesunlimited amounts of domestic money against foreignassets at that rate. A commitment to fix the exchange rate forces the
central bank to sacrifice its ability to use monetarypolicy for stabilization. Fiscal policy has a more powerful effect on output
under fixed exchange rates than under floating rates. Balance of payments crises occur when market
participants expect the central bank to change theexchange rate from its current level.
Self-fulfilling currency crises can occur when aneconomy is vulnerable to speculation. A system of managed floating allows the central bank
to retain some ability to control the domestic moneysupply. A world system of fixed exchange rates in which
countries peg the prices of their currencies in terms ofa reserve currency involves a striking asymmetry. A gold standard avoids the asymmetry inherent in a
reserve currency standard.• A related arrangement was the bimetallic standard
Self-fulfilling currency crises can occur when aneconomy is vulnerable to speculation. A system of managed floating allows the central bank
to retain some ability to control the domestic moneysupply. A world system of fixed exchange rates in which
countries peg the prices of their currencies in terms ofa reserve currency involves a striking asymmetry. A gold standard avoids the asymmetry inherent in a
reserve currency standard.• A related arrangement was the bimetallic standard
based on both silver and gold.
Appendix I: Equilibrium in the Foreign ExchangeMarket with Imperfect Asset Substitutability
Figure 17AI-1: The Domestic Bond Supply and the Foreign ExchangeRisk Premium Under Imperfect Asset Substitutability
Demand fordomestic bonds, Bd
Risk premium on domesticBonds, ( = R - R* - (Ee– E)/E)