The International System Monetary Policy

Exchange Rates An exchange rate is the price of one currency in terms of another. Exchange rates are important because exports, imports and all international financial transactions are affected by the prices at which currencies exchange for one another.

Exchange Rate Systems Flexible Exchange Rates A flexible exchange rate system is one in which exchange rates are determined by conditions of supply and demand in the foreign exchange market. Flexible exchange rate systems are also known as floating exchange rate systems

Exchange Rate Systems Fixed Exchange Rates A fixed exchange rate system is one in which exchange rates are set at officially determined levels and are changed only by direct governmental action.

Foreign Exchange Market and the Government The foreign exchange market is not free of government intervention. Central banks engage in international financial transactions called foreign exchange interventions in order to influence exchange rates. The first step in understanding how this works is to see how exchange market intervention affects the monetary base.

Intervention in the Foreign Exchange Market If a central bank does not want the currency to fall, it must follow a contractionary monetary policy. A decrease in the money supply given demand supports the currency’s value.

Intervention in the Foreign Exchange Market If a central bank does not want the currency to rise, it must follow an expansionary monetary policy. An increase in the money supply given demand tends to decrease the currency’s value.

Intervention in the Foreign Exchange Market Conclusion: If a central bank intervenes in the foreign exchange market, it gives up some control over its money supply. The sale of foreign assets results in a decrease in the currency worldwide. The purchase of foreign assets results in an increase in the currency worldwide.

Exchange Market Intervention Unsterilized: The Fed sells $1 billion of foreign assets in exchange for $1 billion dollars (cash transaction). Federal Reserve Assets Liabilities Foreign Assets -$1b Currency -$1b

Exchange Market Intervention Results: A central bank’s purchase of domestic currency and corresponding sale of foreign assets leads to an equal decline in its international reserves and the monetary base.

Exchange Market Intervention Unsterilized: The Fed sells $1 billion of foreign assets in exchange for $1 billion dollars (check transaction). Federal Reserve Assets Liabilities Foreign Assets -$1b Reserves -$1b

Exchange Market Intervention Results: A central bank’s purchase of domestic currency and corresponding sale of foreign assets leads to an equal decline in its international reserves and the monetary base. International reserves decrease. Bank reserves fall when Fed deducts $1 billion from the bank’s accounts with the Fed.

Exchange Market Intervention Unsterilized: The Fed buys $1 billion of foreign assets in exchange for $1 billion dollars. Federal Reserve Assets Liabilities Foreign Assets +$1b Currency +$1b Foreign Assets +$1b Reserves +$1b

Exchange Market Intervention Results: A central bank’s sale of domestic currency and corresponding purchase of foreign assets leads to an equal increase in its international reserves and the monetary base. International reserves increase. Bank reserves rise when Fed increases currency in circulation or adds $1 billion to the bank’s accounts with the Fed.

Exchange Market Intervention and the Exchange Rate An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency.

Exchange Market Intervention and the Exchange Rate An unsterilized intervention in which domestic currency is bought by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency.

Sterilized Intervention If the central bank does not want the domestic money supply to change, it can sterilize the transaction by buying or selling government bonds. The Fed would buy bonds to increase base to its former level. The Fed would sell bonds to decrease base to its former level.

Exchange Market Intervention Sterilized: The Fed buys $1 billion of foreign assets in exchange for $1 billion dollars and sells bonds. Federal Reserve Assets Liabilities Foreign Assets +$1b Currency or Reserves +$1b Government Bonds -$1b Currency or Reserves -$1b

Exchange Market Intervention Sterilized: The Fed sells $1 billion of foreign assets in exchange for $1 billion dollars and buys bonds. Federal Reserve Assets Liabilities Foreign Assets -$1b Currency or Reserves -$1b Government Bonds +$1b Currency or Reserves +$1b

Sterilized Exchange Market Intervention Conclusions: A central bank’s sale or purchase of foreign assets and corresponding purchase or sale of domestic currency leads to an equal decrease or increase in its international reserves and the monetary base. But, if the central bank buys or sells and equal amount of government bonds at the same time, the monetary base does not change.

Money Supply and the Exchange Rate Et RETD2 RETD1 A sale of dollars and purchase of foreign assets cause RETD to shift left from RETD1 to RETD2 The increase in the money supply also causes RETF to shift right from RETF1 to RETF2. Therefore, in the short run the exchange rate falls from E1 to E2. In the long run, as the domestic rate of interest rises, RETD shifts right and the exchange rate rises to E3 RETF1 RETF2 1 E1 E3 3 E2 2 RET$ Unsterilized

The Money Supply and the Exchange Rate The story: A sale of dollars and consequent open market purchase of foreign assets increase base, causing the money supply to rise. The increase in the money supply results in a higher domestic price level in the long run, which leads to a lower expected future exchange rate.

The Money Supply and the Exchange Rate The story: The resulting decline in the expected appreciation of the dollar raises the expected return on foreign deposits. In the short run, domestic interest rates fall because of the increase in the money supply. The combination of higher expected returns on foreign deposits and lower domestic interest rates, causes the exchange rate to fall.

The Money Supply and the Exchange Rate The story: In the long run, however, as the domestic economy expands, domestic interest rates rise, and the exchange rate rises.

Money Supply and the Exchange Rate Et RETD1 RETD2 A purchase of dollars and sale of foreign assets cause RETD to shift right from RETD1 to RETD2 in the short run. The decrease in the money supply also causes RETF to shift left from RETF1 to RETF2. Therefore, in the short run, the exchange rate rises from E1 to E2. In the long run, as the domestic rate of interest falls, RETD shifts left and the exchange rate falls to E3 RETF2 RETF1 E2 E3 E1 2 3 1 RET$ Unsterilized

Sterilized Intervention In this model, where the domestic and foreign deposits are perfect substitutes, and the foreign asset transaction is sterilized, the exchange rate does not change. Why?

Sterilized Intervention If the money supply does not change, domestic interest rates do not change. If the money supply does not change, expectations about inflation and future exchange rates do not change. If the future expected value of the dollar does not change, the expected return on foreign deposits also does not change.

Sterilized Intervention Theoretically, if the deposits are not perfect substitutes, the exchange rate can change even if the foreign asset transaction is sterilized. But empirical studies do not find evidence of this happening to any great extent.

Fixed Exchange Rates In a system of fixed exchange rates, each country’s central bank intervenes in the foreign exchange market to prevent that country’s exchange rate from going outside a narrow band on either side of its par value. The bank must be prepared to offset imbalances in demand and supply by government sales or purchases of foreign exchange.

Fixed Exchange Rates: Example Let the exchange value of the Hong Kong dollar be set such that it is overvalued relative to its current market value. Hong Kong must drive up the value of the HK$ by buying HK$s in the world market. Hong Kong loses international reserves.

Fixed Exchange Rates: Example Let the exchange value of the Hong Kong dollar be set such that it is undervalued relative to its current market value. Hong Kong must drive down the value of the HK$ by selling HK$s in the world market. Hong Kong gains international reserves.

Fixed Exchange Rate: Example S $/HK$ $/HK$ Market S Loss of Reserves Peg Peg Gain of Reserves Market D D Q Q Overvalued Undervalued

Fixed Exchange Rates: Overvalued Currency Et RETD1 RETD2 RETF1 At the exchange rate Epar, the currency is overvalued. To keep the currency at Epar, the central bank must purchase domestic currency, shifting RETD1 to RETD2. Epar 2 E2 1 RET$

Fixed Exchange Rates: Undervalued Currency Et RETD2 RETD1 RETF1 At the exchange rate Epar, the currency is undervalued. To keep the currency at Epar, the central bank must sell domestic currency to shift RETD1 to RETD2. E2 1 Epar 2 RET$

Consequences of Exchange Rate Intervention When a country attempts to maintain an overvalued exchange rate, it loses international reserves. If the country runs out of international reserves, it can no longer support its currency and must devalue.

Consequences of Exchange Rate Intervention When a country attempts to maintain an undervalued exchange rate, it gains international reserves. If the country does not want to accumulate international reserves, it may decide to revalue its currency.

Consequences of Exchange Rate Intervention If domestic and foreign currencies are perfect substitutes, a sterilized exchange rate intervention would not be able to maintain the exchange rate at Epar. RETD will not shift. No change in domestic interest rates. RETF will not shift No change in expectations about the future value of the current.

Consequences of Exchange Rate Intervention When smaller countries tie their exchange rate to that of a larger country, they lose control of their monetary policy. If the larger country pursues a more contractionary monetary policy, inflation expectations in the larger country will fall, causing the larger country’s currency to appreciate and the smaller country’s currency to become overvalued.

Consequences of Exchange Rate Intervention The smaller country will now have to buy its own currency and sell the currency of the larger country. As a result, the smaller country’s international reserves, base, and money supply will contract.

Foreign Exchange Crisis: Mexico Et RETD = the expected return on the peso. RETF = the expected return on the dollar. After the assassination of the ruling party’s presidential candidate, investors became concerned that the government would devalue the peso, the expected return on the dollar rose to RETF2 ,and the value of the peso fell. To maintain Epar, the Mexican government bought pesos and shifted RETD to the right. RETD1 RETF1 RETF2 Epar 1 2 1’ RET Peso Mexico

Foreign Exchange Crisis: Mexico RETD = the expected return on the peso. RETF = the expected return on the dollar. An uprising in Chiapas, another assassination, and concerns about the current account deficit led to more rumors about devaluation. RETF shifted to RETF3. The Mexicans intervened, buying pesos. As the speculators realized that Mexico was running out of foreign reserves and would have to devalue, RETF shifted further right. Et RETD1 RETF1 RETF3 RETF2 Epar 1 2 3 1’ RET Peso

Foreign Exchange Crisis: Thailand RETD = the expected return on the baht. RETF = the expected return on the dollar. Concerns about Thailand’s current account deficit and weak financial system caused speculators to suspect that Thailand would devalue. RETF shifted to the right, putting pressure on the baht. Thailand intervened and bought baht. The collapse of Finance One caused another shift of RETF to the right. Ultimately, Thailand ran out of international reserves and devalued. Et RETD1 RETF1 RETF3 RETF2 Epar 1 2 3 1’ RET Baht Thailand