CHAPTER 6 F IXED E XCHENGE R ATES AND F OREIGN E XCHANGE I NTERVENTION

§1 WHY STUDY FIXED EXCHANGE RATES 1.1Managed floating. 1.1Managed floating. 1.2Regional currency arrangements. 1.2Regional currency arrangements. 1.3Developing countries and countries transition 1.3Developing countries and countries transition 1.4Lessons of the past for the future 1.4Lessons of the past for the future

§2 CENTRAL BANK INTERVENTION AND THE MONEY SUPPLY 2.1 The Central Bank Balance Sheet and the Money Supply 2.1 The Central Bank Balance Sheet and the Money Supply Foreign Exchange Intervention and the Money Supply 2.2 Foreign Exchange Intervention and the Money Supply Sterilization 2.3 Sterilization The Balance of Payments and the Money Supply 2.4 The Balance of Payments and the Money Supply §

2.1 The Central Bank Balance Sheet and the Money Supply

2.2 Foreign Exchange Intervention and the Money Supply

2.3 Sterilization

§3 HOW THE CENTRAL BANK FIXES THE EXCHANGE RATE 3.1 Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate 3.1 Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate The foreign exchange market is in equilibrium when the interest parity condition holds: The foreign exchange market is in equilibrium when the interest parity condition holds: R=R* +(E e - E )/E (1) R=R* +(E e - E )/E (1) R: the domestic interest rate R: the domestic interest rate R*:the foreign interest rate R*:the foreign interest rate (E e -E )/E:the expected rate of depreciation of the domestic currency against foreign currency (E e -E )/E:the expected rate of depreciation of the domestic currency against foreign currency

We assume that no exchange rate changes are expected by the market when exchange rates are fixed,so We assume that no exchange rate changes are expected by the market when exchange rates are fixed,so (E e -E)/E will be zero. (E e -E)/E will be zero. R=R* +0 (2) R=R* +0 (2) R=R* (3) R=R* (3)

A Diagrammatic Analysis

§4 STABILIZATION POLICIES WITH A FIXED EXCHANGE RATE 4.1 Monetary Policies 4.1 Monetary Policies By fixing the exchange rate, then, the central bank loses its ability to use monetary policy for the purpose of macroeconomic stabilization. However, the government ‘ second key stabilization tool, fiscal policy, is more effective under a fixed rate than a floating rate. By fixing the exchange rate, then, the central bank loses its ability to use monetary policy for the purpose of macroeconomic stabilization. However, the government ‘ second key stabilization tool, fiscal policy, is more effective under a fixed rate than a floating rate.fiscal policyfiscal policy Exchange Rate, E E2E2 E0E0 Y1Y1 Y2Y2 AA 2 AA 1 DD ● 2 Output, Y O 1

§4 STABILIZATION POLICIES WITH A FIXED EXCHANGE RATE 4.2 Fiscal Policy 4.2 Fiscal Policy Fiscal expansion (shown by the shift from DD 1 to DD 2 ) and the intervention that accompanies it (the shift from AA 1 to AA 2 ) move the economy from point 1 to point 3,where output is higher than originally, the exchange rate is unchanged,and official intervention reserves (and the money supply) are higher. Fiscal expansion (shown by the shift from DD 1 to DD 2 ) and the intervention that accompanies it (the shift from AA 1 to AA 2 ) move the economy from point 1 to point 3,where output is higher than originally, the exchange rate is unchanged,and official intervention reserves (and the money supply) are higher.

4.3 Changes in the Exchange Rate

§5 BALANCE OF PAYMENTS CRISES AND CAPITAL FLIGHT To hold the exchange rate fixed at E 0 after the market decides it will be devalued to E 1,the central bank must use its reserves to finance a private capital outflow that shrinks the money supply and raises the home interest rate. To hold the exchange rate fixed at E 0 after the market decides it will be devalued to E 1,the central bank must use its reserves to finance a private capital outflow that shrinks the money supply and raises the home interest rate.

§ 6 MANAGED FOATING AND STERILIZED INTERVENTION 6.1 Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention 6.1 Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention When domestic and foreign currency bonds are perfect substitutes, the foreign exchange market is in equilibrium When domestic and foreign currency bonds are perfect substitutes, the foreign exchange market is in equilibrium only if the interest parity condition holds: only if the interest parity condition holds: R=R* +(E e -E )/E (1) R=R* +(E e -E )/E (1)

6.2 Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability The equilibrium under imperfect asset substitutability requires: R=R* +(E e -E )/E+ ρ (2) R=R* +(E e -E )/E+ ρ (2) ρ : a risk premium, that reflects the difference between the ρ : a risk premium, that reflects the difference between the riskiness of domestic and foreign bonds riskiness of domestic and foreign bonds ρ depends positively on the stock of domestic government debt, devoted by B, less the domestic assets of the central bank, devoted by A: ρ depends positively on the stock of domestic government debt, devoted by B, less the domestic assets of the central bank, devoted by A: ρ= ρ ( B-A ) (3) ρ= ρ ( B-A ) (3)

§ 6 MANAGED FOATING AND STERILIZED INTERVENTION 6.3 The Effect of Sterilized Intervention with Imperfect Asset Substitutability (Figure 17-6 ) 6.4 Evidence on the Effects of Sterilized Intervention 6.5 The Signaling Effect of Intervention

§7 Reserve Currencies in the World Monetary System 7.1 The Mechanics of a Reserve Currency Standard Countries peg the prices of their currencies in terms of a reserve currency involving a striking asymmetry. Countries peg the prices of their currencies in terms of a reserve currency involving a striking asymmetry.

7.2 The Gold Standard All countries fix the prices of their currencies in terms of gold. All countries fix the prices of their currencies in terms of gold. The gold standard avoids the asymmetry inherent in a reserve currency standard and also places constraints on the growth of money supplies. The gold standard avoids the asymmetry inherent in a reserve currency standard and also places constraints on the growth of money supplies.

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