1. FIXED EXCHANGE RATES and Foreign Exchange Intervention Central Bank Balance Sheet Assets (1) Foreign Assets (2) Domestic Assets H = Base Money Liabilities (1) Deposits held by Private Banks (2) Currency in circulation H = Base Money Foreign Assets Sale Foreign Assets Purchase Base Money contracts Base Money Expands 1

2. 2 return 2 1 1,2 S = fixed exchange rate Fixed Exchange Rate output shock Automatic increase in M following CB intervention in the foreign exchange market. Result: Base Money is endogenous

3. 3 The Sustainability of Fixed Exchange Rate Regime demand for money (1) interest parity (2)

4. Purchasing Power Parity (3) Substitute (2) & (3) into (1): (4) 4

5. Fixed Exchange Rate 5 money supply is totally endogenous A Simple Model (Krugman 1979) fixed exchange rate flexible exchange rate

6. 6 International Reserves

7. 7 Central Bank Balance Sheet Domestic Credit Expands Indefinitely rate of expansion “Shadow” Exchange Rate

8. 8 Logarithmic Approximation + f(x 0 )

9. 9 The “Shadow” exchange rate is: a market-based exchange rate when the central bank has no international reserves:

10. 10 Implications: (1) Instantaneous Collapse 0 time s (2) Calculations:

11. time s T T T T T”T’ i 11

12. Sustainability of Fixed Exchange Rate (1) time fixed “shadow” no budget deficit (  =0) (2) imperfect asset substitutability (a) regulating capital inflows (b) risk premium  is a function of external debt 12

13. 13 if  is a function of external debt (B) minus domestic assets (A) a sterilized intervention which keeps M constant switches reserves (negative external debt) for domestic assets would change the risk premium, and change domestic interest rate. Sales of reserves accompanied by purchase of domestic bonds will raise  and i.