Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention.

Chapter 17Fixed Exchange Rates and

Foreign Exchange Intervention

Introduction

■ In the last few chapters we assume a completely flexible exchange rate

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

Introduction

The purpose of the chapter

How do central banks intervene in the foreign exchange

market to keep exchange rates stable?

How do macroeconomic policies work when exchange

rates are fixed?

Chapter Organization

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 Reserve Currencies in the World Monetary

System The Gold Standard

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 double-entry bookkeeping.

Central Bank Intervention and the Money Supply

• The assets side– Foreign assets (claims or widely accepted means

of payment, e.g. gold)– Domestic assets (government bonds or loans to

private banks)

• The liabilities side– Deposits of private banks– Currency in circulation

Central Bank Interventionand the Money Supply

• Total assets = total liabilities + net worth


• Net worth is constant. (assumption)– The changes in central bank assets cause equal

changes in central bank liabilities. (like open market operation)

Central bank balance sheet

Assets 　 Liabilities 　

Foreign assets

$1,000 Deposits held by private banks

$500

Domestic assets

$1,500 Currency in circulation

$2,000

• Any central bank purchase (sale) of assets automatically results in an increase (decrease) in the domestic money supply.


The central bank balance sheet shows how foreign exchange intervention affects the money supply because the central bank’s liabilities are the base of the domestic money supply process


Suppose the central bank goes to the foreign exchange market and sells $100 worth of foreign bonds for home money.

Central bank balance sheet (pays with currency)

Assets 　 Liabilities 　Foreign assets

$900 Deposits held by private banks

$500

Domestic assets

$1,500

Currency in circulation

$1,900

Foreign Exchange Intervention and the Money Supply


Central bank balance sheet (pays with check)

Assets 　 Liabilities 　

Foreign assets

$900 Deposits held by private banks

$400

Domestic assets

$1,500

Currency in circulation

$2000

Sterilization• Sterilized foreign exchange intervention


Suppose central bank sells $100 bonds foreign assets and receives as payment a $100 check, then it purchase $100 government bonds with check


Central bank balance sheet (before transaction)

Assets　

Liabilities　

Foreign assets $1,000 Deposits held by private banks $500

Domestic assets $1,500 Currency in circulation $2,000

Central bank balance sheet (after sterilized $100 foreign asset sale)

Assets　

Liabilities　

Foreign assets $900 Deposits held by private banks $500

Domestic assets $1600 Currency in circulation $2,000

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

– If E = E0

– Then R = R*.

Money Market Equilibrium Under a Fixed Exchange Rate• To hold the domestic interest rate at R*,

MS/P = L(R*, Y)


Suppose the central bank has been fixing E at E0 and that asset markets are in equilibrium. An increase in output takes place, then what shall the central bank do to keep the exchange rate fixed?

Real money supplyM1

P

Real money demand, L(R, Y1)

Domestic-currency return on foreign-currency deposits, R* + (E0 – E)/E

Real domesticmoney holdings

DomesticInterest rate, R

Exchange rate, E

0

E0

R*

1

1'

L(R, Y2) L(R, Y2)

3

3'

M2

P 2

E’


Stabilization Policies With a Fixed Exchange Rate

Monetary Policy• Under a fixed exchange rate, central bank

monetary policy tools are powerless to affect the economy’s money supply or its output.

DD

Figure 17-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate

Output, Y

Exchange rate, E

E2

Y2

2

E0

Y1

1

AA2

AA1


Monetary policies only affect the international reserve when exchange rate is fixed

Fiscal Policy• How does the central bank’s intervention hold the

exchange rate fixed after the fiscal expansion?– The rise in output due to expansionary fiscal policy

raises money demand.


DD1

Figure 17-3: Fiscal Expansion Under a Fixed Exchange Rate

Output, Y

Exchange rate, E

E0

Y1

1

AA2

AA1

DD2

E2

Y2

2

3

Y3


Output and the international

reserve will rise

Fiscal policy is more powerful than under floating exchange system

Comparison:

What is difference of effects of monetary and fiscal polices when exchange rate is floating and fixed ????


Changes in the Exchange Rate• The central bank announce its willingness to trade

domestic against foreign currency, in unlimited amounts, at the new exchange rate.

• Devaluation

– Causes a rise in output, official reserves and the money supply

– Aims to:

– Fight unemployment, Improve the CA and increase the central bank's foreign reserves


2

DD

Figure 17-4: Effects of a Currency Devaluation

Output, Y

Exchange rate, E

E0

Y1

1

AA2

AA1


Y2

E1

• Revaluation– It occurs when the central bank lowers E.– Cause

a decrease in output, international reserve and the money supply


When revaluation is necessary?

Adjustment to Fiscal Policy and Exchange Rate Changes• Fiscal expansion causes P to rise in long term.

– There is no real appreciation in the short-run– There is real appreciation in the long-run

• Devaluation is neutral in the long-run.


Case study Figure 17-5: A Low-Output Liquidity Trap

DD

Output, Y

Exchange Rate, E

Y1

1 Ee

1 – R*

AA1

Yf


AA2

Figure 17-6: Fixing the Exchange Rate to Restore Full Employment

DD

Output, Y

Exchange Rate, E

Y1

1 Ee

1 – R*

AA1


E0

1 – R*

AA2

Yf

2

Balance of Payments Crises and Capital Flight

Balance of payments crisis• To fix exchange rate may be undesirable, and

market expectation may be changed

• A sharp change in official foreign reserves may be sparked by a change in expectations about the future exchange rate.

M2

P

Suppose a sudden deterioration in CA

Real money supplyM1

P

R*

1Real domesticmoney holdings


Exchange rate, E

0R* + (E0 – E)/E

R* + (E1– E)/E

2

R* + (E1 – E0)/E0

L(R, Y)

2'E0

1'


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


If central bank lacks of international reserve for market intervention, what will happen?

An expected revaluation causes the opposite effects.


Capital flight• The reserve loss accompanying a devaluation scare

– The associated debit in the balance of payments accounts is a private capital outflow.

Currency crisis arises in• Improper macro-economic policy

(e.g. Bankrolling the government deficit )

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.


Managed Floating and Sterilized Intervention

Under managed floating system the central bank faces :

domestic objectives

Stable exchange rate

trade-off

PROBLEM: Sterilized intervention is effective or not ?

Central bank

1. Sell domestic assets to fight inflation

2. Then purchase foreign assets to keep exchange rate stable


The former model has predicted the sterilized intervention is ineffective.

fiscal expansion

to buy foreign assets and enlarge domestic money supply to keep exchange rate stable

inflation

Sterilized

intervention to sell

domestic assets to decrease domestic money supply

buy more foreign assets and enlarge domestic money supply to keep exchange rate stable

Under fixed exchange rate system


Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention• Perfect asset substitutability

– Risk difference between home assets and foreign assets is out of consideration

– R=R ＊ +(Ee-E)/E

– Central banks cannot control the money supply and the exchange rate through sterilized foreign exchange intervention.

Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability• Equilibrium in the foreign exchange market :

R = R* + (Ee – E)/E +

depends positively on the stock of domestic government debt:

= (B – A) B is the stock of domestic government debt

A is domestic assets held by the central bank


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 of domestic currency deposits in equilibrium.


Ms

PReal money supply

Real domesticmoney holdings


Exchange rate, E

0R* + (Ee – E)/E + (B –A1)

Risk-adjusted domestic-currency return on foreign currency deposits,R* + (Ee– E)/E + (B –A2)

L(R, Y)

2'E2

E11'

R1

1

Sterilized purchase of foreign assets


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.


The Signaling Effect of Intervention• Signaling effect of foreign exchange

intervention– Sterilized intervention may give an indication of

where the central bank expects (or desires) the exchange rate to move.


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.

– The currency central banks hold in their international reserves.

• Gold standard(1870-1914)– Central banks peg the prices of their currencies in

terms of gold.

The Mechanics of a Reserve Currency Standard• The system based on the U.S. dollar set up at the

end of World War II.– Every central bank fixed the dollar exchange rate

of its currency through foreign exchange market trades of domestic currency for dollar assets.

– Exchange rates between any two currencies were fixed.


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.

• N-1 exchange rates

• Export its monetary policies


The Gold Standard

Each country fixes the price of its currency in terms of gold.

No single country occupies a privileged position within the system.

The Mechanics of a Gold Standard• Exchange rates between any two currencies

were fixed.

The Gold Standard

Symmetric Monetary Adjustment Under a Gold Standard

Country A loses reserves and its money supply shrinks

Country B is gaining

reserves and its money supply expanded.

Country A expands its money supply

Finally

RA=RB

The Gold Standard

Benefits and Drawbacks of the Gold Standard• Benefits:

– It avoids the asymmetry inherent in a reserve currency standard.

– It places constraints on the growth of countries’ money supplies.

• Drawbacks:

– Constraints on the use of monetary policy to fight unemployment.

– The relative price of gold and other goods and services should be stable.

– Central banks compete for reserves and bring about world unemployment.

– Confer gold producing countries (like Russia and South Africa) too much power.

The Gold Standard

The Gold Standard

Bimetallic standard• The currency was based on both silver and gold.

• A country’s mint will coin specified amounts of gold or silver into the national currency unit.

– Example: 371.25 grains of silver or 23.22 grains of gold could be turned into a silver or a gold dollar. This made gold worth 371.25/23.22 = 16 times as much as silver.

• Gresham's law

• It might reduce the price-level instability resulting from 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.

• Operate like a gold standard in restraining excessive monetary growth throughout the world, but it allows more flexibility in the growth of international reserves.

Summary

There is a direct link between central bank intervention in the foreign exchange market and the domestic money supply.

The central bank balance sheet shows how foreign exchange intervention affects the money supply.

The central bank can negate the money supply effect of intervention through sterilization.

Summary

A central bank can fix the exchange rate of its currency against foreign currency if it trades unlimited amounts of domestic money against foreign assets at that rate.

A commitment to fix the exchange rate forces the central bank to sacrifice its ability to use monetary policy 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 the exchange rate from its current level.

Self-fulfilling currency crises can occur when an economy is vulnerable to speculation.

A system of managed floating allows the central bank to retain some ability to control the domestic money supply.

A world system of fixed exchange rates in which countries peg the prices of their currencies in terms of a reserve currency involves a striking asymmetry.

A gold standard avoids the asymmetry inherent in a reserve currency standard.

Summary

Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention.

Documents

central bank assets

central bank liabilities

central bank fixes

central banks

central bank s liabilities

money supply slide

money supply total assets

bonds foreign assets