International Monetary Economicsecon.sciences-po.fr/sites/default/files/file/lect_8.pdf · Pierre-Olivier Gourinchas . ... • Against: Cottet, Devoize, ... Sterilization is usually

International Monetary Economics

Lecture 8: Monetary and Fiscal Policy under Fixed Exchange Rates

Master d’Affaires Publiques SciencesPo Spring 2013

Pierre-Olivier Gourinchas

Slide 8-2

§  April 2: Non conventional monetary policy •  For: de Miguel, Moreaux, Triebe •  Against: Lala, Libene, Saint-Martin

§  April 9: Capital controls •  For: Depraz, Hopmeier, Le Roy, Moukkadem •  Against: Alheritiere, Gosset, Ranger

§  April 16: Expansionary fiscal austerity •  For: Lang, Petrescu, Vicquery •  Against: Cottet, Devoize, Fischer

§  April 23: Restoring EZ competitiveness •  For: Goger, Mariaud, Vandewoestyne •  Against: Lemseffer, Tournoux, Wager

Group Presentations

Slide 8-3

§  Fixed Exchange Rates: •  Why study fixed exchange rates? •  Central Bank Intervention and the Money Supply

– Sterilization •  How the Central Bank Fixes the Exchange Rate •  Stabilization Policies with a Fixed Exchange Rate

– Monetary policy – Fiscal policy – Devaluation

•  The ineffectiveness of sterilization

Roadmap

Slide 8-4

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

Slide 8-5


§  In reality, the assumption of complete exchange rate flexibility is rarely accurate. •  Industrialized countries operate under a hybrid system of

managed floating exchange rates. – A system in which governments attempt to moderate

exchange rate movements without keeping exchange rates rigidly fixed.

•  A number of developing countries have retained some form of government exchange rate fixing.

Slide 8-6

Monetary Policy Frameworks §  Exchange rate anchor

•  The monetary authority stands ready to buy or sell foreign exchange at given quoted rates to maintain the exchange rate at its preannounced level or range; the exchange rate serves as the nominal anchor or intermediate target of monetary policy. This type of regime covers exchange rate regimes with no separate legal tender; currency board arrangements; fixed pegs with and without bands; and crawling pegs with and without bands.

§  Monetary aggregate anchor •  The monetary authority uses its instruments to achieve a target growth rate for a monetary

aggregate, such as reserve money, M1, or M2, and the targeted aggregate becomes the nominal anchor or intermediate target of monetary policy.

§  Inflation targeting framework •  This involves the public announcement of medium-term numerical targets for inflation with

an institutional commitment by the monetary authority to achieve these targets. Additional key features include increased communication with the public and the markets about the plans and objectives of monetary policymakers and increased accountability of the central bank for attaining its inflation objectives. Monetary policy decisions are guided by the deviation of forecasts of future inflation from the announced target, with the inflation forecast acting (implicitly or explicitly) as the intermediate target of monetary policy.

§  Other •  The country has no explicitly stated nominal anchor but rather monitors various indicators in

conducting monetary policy, or there is no relevant information available for the country.

Slide 8-7

Table 8-1: Exchange Rate Arrangements (As of April 31, 2008)


Slide 16-8

Slide 8-9


Slide 8-10


Slide 8-11


Slide 8-12

§  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

Slide 8-13

Table 8-2: The 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

Central Bank Balance Sheet


Slide 8-14

•  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: – Reserves of private banks – Currency in circulation

Liability = monetary base (M0)


Slide 8-15

•  Total assets = total liabilities + net worth •  Net worth is usually unimportant. Assume equal to zero:

– The changes in central bank assets cause equal changes in central bank liabilities.

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

•  Any central bank sale of assets automatically causes the money supply to decline.


Slide 8-16

§  Foreign Exchange Intervention and the Money Supply •  The central bank balance sheet shows how foreign

exchange intervention affects the money supply (M) 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.


Slide 8-17

Assets Liabilities

Foreign Assets $900 Deposits held by private banks $500


Central Bank Balance Sheet (buyer pays with currency)

Table 8-3: A $100 foreign asset sale


Slide 8-19

§  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.

– 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.


Slide 8-20

Assets Liabilities

Foreign Assets $900 Deposits held by private banks $500


Central Bank Balance Sheet (sterilized)

Table 8-4: A sterilized $100 foreign asset sale


Slide 8-22

§  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.


Slide 8-23

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:

i = i* + (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’s equilibrium exchange rate only if: i = i*

Slide 8-24

§ Money Market Equilibrium Under a Fixed Exchange Rate •  To hold the domestic interest rate at i*, the central bank’s

foreign exchange intervention must adjust the money supply so that:

MS/P = L(i*, Y)


Slide 8-25

Real money supply M1 P

Real money demand, L(i, Y1)

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

Figure 8-1: Asset Market Equilibrium with a Fixed Exchange Rate, E0

Real domestic money holdings

Domestic Interest rate, i

Exchange rate, E

0

M2 P

3

2

i*

1

E0 1'

L(i, Y2)


3'

Slide 8-26

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.

•  Monetary policy is entirely ineffective!!

Slide 8-27

DD

Figure 8-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate

Output, Y

Exchange rate, E

E2

Y2

2

E0

Y1

1

AA2

AA1


Slide 8-28

§  Fiscal Policy •  How does the central bank intervention hold the exchange

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

money demand. –  To prevent an increase in the home interest rate and an appreciation

of the currency, the central bank must buy foreign assets with money (i.e., ease monetary policy).

•  Large effects of expansionary fiscal policy under a fixed exchange rate.


Slide 8-29

DD1

Figure 8-3: Fiscal Expansion Under a Fixed Exchange Rate

Output, Y

Exchange rate, E

E0

Y1

1

AA1


Slide 8-31

§ Changes in the Exchange Rate •  Devaluation

–  It occurs when the central bank raises the domestic currency 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


Slide 8-32

DD

Figure 8-4: Effects of a Currency Devaluation

Output, Y

Exchange rate, E

E0

Y1

1

AA1


Slide 8-34

Managed Floating and Sterilized Intervention

§  Under a fixed exchange rate, no ability to influence output through monetary policy.

§  Often, governments try to sterilize the foreign exchange intervention to retain control on the money supply

§  Why sterilization cannot work:

Slide 8-35

Real money supply M1 P

Real money demand, L(i, Y1)

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

Figure 8-5: The impact of a sterilized intervention

Real domestic money holdings

Domestic Interest rate, i

Exchange rate, E

0 i*

1

E0 1'


Slide 8-36

Figure 8-6: Unpleasant Monetary Arithmetic, Mexico, 1994


Mexican Spread and Central Bank Reserves, January-December 1994

0

5

10

15

20

25

30

Jan-94 Feb-94 Mar-94 Apr-94 May-94 Jun-94 Jul-94 Aug-94 Sep-94 Oct-94 Nov-94 Dec-94

Central Bank Reserves (billions of US dollars)

0

5

10

15

20

25

30

3-month peso-dollar spread (percent per year)

Spread Reserves

Slide 8-37

§  The central bank fixes the exchange rate through foreign exchange interventions

§  These foreign exchange interventions affect the money supply, unless they are sterilized.

§  Without sterilization, monetary policy loses its effectiveness. §  Under fixed exchange rates, fiscal policy is very effective: it triggers

an accompanying monetary expansion §  Devaluation is another tool at the disposal of the policymaker. §  Sterilization is usually ineffective since it does not allow the

underlying monetary conditions to adjust.

Summary

International Monetary Economicsecon.sciences-po.fr/sites/default/files/file/lect_8.pdf · Pierre-Olivier Gourinchas . ... • Against: Cottet, Devoize, ... Sterilization is usually

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