Fixed Exchange Rates and Foreign Exchange Intervention Chapter 18 Krugman and Obstfeld 9e ECO41 International Economics Udayan Roy

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

Any central bank purchase of assets automatically results in an increase in the domestic money supply (M s ↑). – Example: If the US central bank (“The Fed”) buys some financial asset, it must pay for it with newly printed dollars. Therefore, the US money supply must increase. Central Bank Intervention and the Money Supply

Any central bank sale of assets automatically causes a decrease in the money supply (M s ↓). – Example: If the Fed sells some financial asset, the dollars paid by the buyer will no longer be in circulation. Therefore, the US money supply must decrease. In short, the central bank’s reserves of financial assets moves in the same direction as its money supply. Central Bank Intervention and the Money Supply

RECAP Fig. 17-8: Short-Run Equilibrium: The Intersection of DD and AA 17-5 The output market is in equilibrium on the DD curve The asset markets are in equilibrium on the AA curve The short run equilibrium occurs at the intersection of the DD and AA curves

Recap: Shifting the AA and DD Curves The AA curve shifts right if: – M s increases – P decreases – E e increases – R* increases – L decreases for some unknown reason (L 0 ↓) 16-6 The DD curve shifts right if:  G increases  T decreases  I increases  P decreases  P* increases  C increases for some unknown reason (C 0 ↑)  CA increases for some unknown reason (CA 0 ↑, CA q ↑) Knowing how some exogenous change shifts the DD and AA curves will help us predict the consequences of the exogenous change.

SHORT-RUN MACROECONOMICS UNDER FIXED EXCHANGE RATES

How a Central Bank Fixes the Exchange Rate E2E2 Y2Y2 2 Y3Y3 E3E3 3 Suppose the central bank wants to fix the value of the exchange rate at E 1. If, for whatever reason, the AA curve shifts left, then the short-run equilibrium shifts from point 1 to point 2 and the exchange rate falls. To return to the exchange rate to the target value of E 1, all that the central bank has to do is to increase the money supply and shift the AA curve back where it originally was. If, for whatever reason, the AA curve shifts right, then the short- run equilibrium shifts from point 1 to point 3 and the exchange rate rises. To return to the exchange rate to the target value of E 1, all that the central bank has to do is to decrease the money supply and shift the AA curve back where it originally was.

How a Central Bank Fixes the Exchange Rate E2E2 Y2Y2 2 Y3Y3 E3E3 3 Thus, we see that, under fixed exchange rate system, E becomes exogenous and M s becomes endogenous. (Recall from Ch. 17 that under a flexible exchange rate system, it is the reverse: E is endogenous and M s is exogenous.) As the central bank must continuously adjust the money supply to keep the exchange rate fixed at the target value, M s can no longer be used for other purposes. The usual sort of monetary policy you’ve seen before is no longer possible.

Ch. 17: The AA-DD Model

Summary: The Behavior of Output Exogenous ChangeEffect on Output (Y) Government Spending (G)+ Business Investment Spending (I)+ Net Tax Revenues (T)– Foreign Price Level (P*)+ C-shock (C 0 )+ CA-shocks (CA 0, CA q )+ Domestic Price Level (P)– Target Exchange Rate (E target )+ As our solution for Y is derived from the DD curve, it follows that only the exogenous variables that can shift the DD curve can affect output. The exogenous variables, such as E e, R* and L 0, that can only shift the AA curve can have no effect on Y.

Summary: The Behavior of Output Exogenous ChangeEffect on Output (Y) Government Spending (G)+ Business Investment Spending (I)+ Net Tax Revenues (T)– Foreign Price Level (P*)+ C-shock (C 0 )+ CA-shocks (CA 0, CA q )+ Domestic Price Level (P)– Target Exchange Rate (E target )+ We saw in Ch. 17 that in a system of flexible exchange rates, expansionary (contractionary) monetary policy is an increase (a decrease) in the money supply. Now we see that in a system of fixed exchange rates, expansionary monetary policy is devaluation (an increase in the exchange rate target, E target ↑). This makes the domestic currency cheaper. Conversely, contractionary monetary policy is revaluation (a decrease in the exchange rate target, E target ↓). This makes the domestic currency expensive.

How a Central Bank Fixes the Exchange Rate E2E2 Y2Y2 2 Y3Y3 E3E3 3 We have seen before that changes in E e, R* and L 0 affect only the AA curve. And now we see that, under fixed exchange rates, such changes will have no effect on E and Y.

How a Central Bank Fixes the Exchange Rate Y3Y3 E3E3 3 Let us return to the case in which the AA curve shifts right for some reason and moves the equilibrium from point 1 to point 3. To bring the exchange rate back to E1, the central bank must reduce the money supply to shift the AA curve back where it was. But there’s a slight problem. To reduce the money supply the central bank must sell financial assets from its reserves, as we saw earlier. But what if the central bank has exhausted its reserve of assets and has no assets left to sell? In this case, the central bank will no longer be able to keep the exchange rate fixed. The country will be forced to return to flexible exchange rates. More on this later!

Shift of the DD Curve Suppose the central bank wants to fix the value of the exchange rate at E 1. If, for whatever reason, the DD curve shifts left and the short-run equilibrium shifts from point 1 to point 2, then all that the central bank has to do is to decrease the money supply and shift the AA curve to the left and take the short-run equilibrium to point 3. 2 DD 2 3 AA 2 Y3Y3

Shift of the DD Curve We have seen before that the DD curve shifts left when there is a decrease in G, I, or P*, or changes in other unspecified factors that decrease C or CA, or an increase in T or P. We see now that, under fixed exchange rates, such changes will reduce Y, and by a bigger amount than under flexible exchange rates. 2 DD 2 3 AA 2 Y3Y3

Shift of the DD Curve Suppose the central bank wants to fix the value of the exchange rate at E 1. If, for whatever reason, the DD curve shifts right and the short-run equilibrium shifts from point 1 to point 2, then all that the central bank has to do is to increase the money supply and shift the AA curve to the right, thereby taking the short-run equilibrium to point 3. 2 DD 2 3 AA 2 Y3Y3

Shift of the DD Curve We have seen before that the DD curve shifts right when there is an increase in G, I, or P*, or changes in other unspecified factors that increase C or CA, or a decrease in T or P. We see now that, under fixed exchange rates, such changes will increase Y, and by a bigger amount than under flexible exchange rates. 2 DD 2 3 AA 2 Y3Y3

Devaluation (E↑) Suppose the exchange rate has been fixed at E 1 in the past. Now suppose the central bank wishes to continue to fix the exchange rate but at the higher value of E 2. This is called devaluation. The central bank can shift only the AA curve. So, it would have to increase the money supply and shift the AA curve to the right till the equilibrium exchange rate increases to the desired level of E 2. Y2Y2 E2E2 2 Therefore, we see that a devaluation raises output. Conversely, a revaluation—opposite of devaluation—reduces output.

Devaluation (E↑) The increase in the central bank’s target exchange rate will raise the expected exchange rate (E e ↑). This, we saw before, will shift the AA curve further to the right, taking the equilibrium to point 3. The central bank will therefore have to reduce the money supply a bit to shift the AA curve to the left till the economy returns to point 2. Y2Y2 E2E2 2 3

Summary: The Behavior of Output Exogenous ChangeEffect on Output (Y) Government Spending (G)+ Business Investment Spending (I)+ Net Tax Revenues (T)– Foreign Price Level (P*)+ C-shock (C 0 )+ CA-shocks (CA 0, CA q )+ Domestic Price Level (P)– Target Exchange Rate (E target )+ Expected Future Exchange Rate (E e )0 Foreign Interest Rate (R*)0 L-shock (L 0 )0 Only DD shifts Only AA shifts Both DD and AA shift

Summary: The Behavior of Output Exogenous ChangeEffect on Output (Y) Government Spending (G)+ Business Investment Spending (I)+ Net Tax Revenues (T)– Foreign Price Level (P*)+ C-shock (C 0 )+ CA-shocks (CA 0, CA q )+ Domestic Price Level (P)– Target Exchange Rate (E target )+ Expected Future Exchange Rate (E e )0 Foreign Interest Rate (R*)0 L-shock (L 0 )0 Whenever there is an effect on Y, the magnitude of the effect is bigger under fixed exchange rates than under flexible exchange rates.

THE INTEREST RATE

The Interest Rate Recall that the foreign exchange market is in equilibrium when: R = R* + (E e – E)/E – When the central bank fixes the exchange rate at E = E target, people will expect E to continue at that level. – So, E e = E target. – Therefore, (E e – E)/E = (E target – E target )/E target = 0. – Therefore, R = R*. – Under fixed exchange rates, the domestic interest rate will always be equal to the foreign interest rate.

Devaluation and the Interest Rate R = R* + (E e – E)/E = R* + (E e /E) – 1 If a devaluation occurs and takes everybody by surprise, then E will increase but E e will not. Therefore, R < R*. Eventually, however, E e will increase to the post- devaluation target value of E So, E and E e will again be equal and, therefore, we will again have R = R*.

The Interest Rate Fixed Exchange RatesYR Government Spending (G)+0 Business Investment Spending (I)+0 Net Tax Revenues (T)–0 Foreign Price Level (P*)+0 C-shock (C 0 )+0 CA-shocks (CA 0, CA q )+0 Domestic Price Level (P)–0 Target Exchange Rate (E target )+(–) Expected Future Exchange Rate (E e )0(+) Foreign Interest Rate (R*)0+ L-shock (L 0 )00 As R = R*, only R* affects R. The inverse effect of E target on R is true only when the change in E target takes people by surprise. When the surprise wears off the effect will disappear. If the change in E target is anticipated, then there will be an equal change in E e. As a result, R = R* will continue to hold. Therefore, the change in E target will have no effect on R. E e may change without a corresponding change in E target if people believe that the fixed exchange rate system will soon be abandoned

THE CURRENT ACCOUNT

The Current Account 16-28

The Current Account

Summary: The Behavior of Y and CA Exogenous ChangeOutput (Y)Current Account (CA) Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)– Foreign Price Level (P*)+ C-shock (C 0 )+– CA-shocks (CA 0, CA q )+ Domestic Price Level (P)– Target Exchange Rate (E target )+ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)00 L-shock (L 0 )00 We saw this column earlier

The Current Account

Summary: The Behavior of Y and CA Exogenous ChangeOutput (Y)Current Account (CA) Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)+ C-shock (C 0 )+– CA-shocks (CA 0, CA q )+ Domestic Price Level (P)– Target Exchange Rate (E target )+ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)00 L-shock (L 0 )00 We saw this column earlier

The Current Account

Summary: The Behavior of Y and CA Exogenous ChangeOutput (Y)Current Account (CA) Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Target Exchange Rate (E target )++ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)00 L-shocks (L 0 )00 We saw this column earlier

Summary: The Behavior of Y and CA Exogenous ChangeOutput (Y)Current Account (CA) Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Target Exchange Rate (E target )++ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)00 L-shocks (L 0 )00

The Current Account Note that, as under flexible exchange rates, contractionary fiscal policies (“fiscal austerity” or “belt tightening”) can raise a country’s current account balance in the short run. But so can protectionist policies such as tariffs and quotas.

COMPARING FLEXIBLE AND FIXED EXCHANGE RATE REGIMES

Comparing the Regimes As output (Y) and the current account (CA) are usually the two main topics, let us look at how the various exogenous variables affect Y and CA in the two exchange rate regimes

It’s Basically the Same! Fixed Exchange RatesYCA Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Target Exchange Rate (E target )++ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)00 L-shock (L 0 )00 Flexible Exchange Rates (Ch. 17)YCA Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Money Supply (M s )++ Expected Future Exchange Rate (E e )++ Foreign Interest Rate (R*)++ L-shock (L 0 )––

It’s Basically the Same! Fixed Exchange RatesYCA Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Target Exchange Rate (E target )++ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)00 L-shock (L 0 )00 Flexible Exchange Rates (Ch. 17)YCA Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Money Supply (M s )++ Expected Future Exchange Rate (E e )++ Foreign Interest Rate (R*)++ L-shock (L 0 )–– Recall that expansionary monetary policy is an increase in M s under flexible exchange rates and an increase in E target under fixed exchange rates. Note that their effects are the same: output and the current account both increase.

It’s Basically the Same! Fixed Exchange RatesYCA Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Target Exchange Rate (E target )++ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)00 L-shock (L 0 )00 Flexible Exchange Rates (Ch. 17)YCA Government Spending (G)+– Business Investment Spending (I)+– Net Tax Revenues (T)–+ Foreign Price Level (P*)++ C-shock (C 0 )+– CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–– Money Supply (M s )++ Expected Future Exchange Rate (E e )++ Foreign Interest Rate (R*)++ L-shock (L 0 )–– As we saw earlier, under fixed exchange rates, any variable that shifts the AA curve is totally reversed by the central bank in order to keep the exchange rate fixed. That explains the zeroes on the left table.

BALANCE OF PAYMENTS CRISES

Fig. 18-4: Effect of the Expectation of a Currency Devaluation If a devaluation (an increase in E) is widely expected, there is an increase in E e. As a result, the AA curve shifts right. To keep E fixed, the central bank must sell its foreign currency reserves and thereby reduce the domestic money supply and bring the AA curve back to where it was. So, the mere expectation of a devaluation may cause the central bank to lose a lot of its reserves. If its reserves are inadequate, the central bank may be forced to devalue or to simply abandon the fixed exchange rate system and switch to flexible exchange rates.

Balance of Payments Crises and Capital Flight Balance of payments crisis – It is a sharp fall in official foreign reserves sparked by a change in expectations about the future exchange rate.

The mere 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 An expected revaluation causes the opposite effects of an expected devaluation. Balance of Payments Crises and Capital Flight

Capital flight – The reserve loss accompanying a devaluation scare The associated debit in the balance of payments accounts 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 by creating or tolerating domestic economic weaknesses that invite speculators to attack the currency. Balance of Payments Crises and Capital Flight

THE MONEY SUPPLY

What is Monetary Policy Under Fixed Exchange Rates? As the central bank in a fixed exchange rate system must keep the money supply at the precise level necessary to keep the exchange rate fixed at the target rate, it becomes unable to use the money supply to pursue any other objective (such as fighting a recession)

The Money Supply is no longer a policy tool Under a fixed exchange rate, the money supply is an endogenous variable It is no longer a policy tool The monetary policy tool is now E target, the rate at which the exchange rate is pegged

What is Monetary Policy Under Fixed Exchange Rates? We saw in Chapters 16 and 17 that in an economy with flexible exchange rates, monetary policy consists of changes in the money supply (M s ) – M s ↑ is expansionary monetary policy – M s ↓ is contractionary monetary policy But in a fixed exchange rate system, the money supply is no longer controlled by the central bank

What is Monetary Policy Under Fixed Exchange Rates? The central bank does, however, control the target rate E target at which the exchange rate is kept fixed – E target ↑ (devaluation) is expansionary monetary policy – E target ↓ (revaluation) is contractionary monetary policy

Money Market Equilibrium Under a Fixed Exchange Rate

Behavior of Money Supply

Summary: The Behavior of Y and M s Fixed Exchange RatesYMSMS Government Spending (G)++ Business Investment Spending (I)++ Net Tax Revenues (T)–– Foreign Price Level (P*)++ C-shock (C 0 )++ CA-shocks (CA 0, CA q )++ Domestic Price Level (P)–? Target Exchange Rate (E target )++ Expected Future Exchange Rate (E e )00 Foreign Interest Rate (R*)0– L-shocks ( unspecified factors that increase L )0+

THE LONG RUN UNDER FIXED EXCHANGE RATES

Summary: Long-Run, Flexible Exchange Rates (Chapter 16) How will these results change under fixed exchange rates? The first two are real variables. Under the principle of monetary neutrality, they will not be affected by a change in the monetary system. We saw earlier that R = R *. Also, it is obvious that E = E target and E g = 0. Only P and π remain to be determined.

Inflation

The Price Level

Summary: Long-Run, Fixed Exchange Rates One major weakness of a fixed exchange rate system is that the country adopting such a system loses control of its inflation and interest rates.