1. Fixed Exchange Rates and Foreign Exchange Intervention
Chapter 17
Fixed Exchange Rates and
Foreign Exchange Intervention

2. Introduction Four reasons to study fixed exchange rates
■ In the last few chapters we assume a completely flexible exchange rate
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

3. How do macroeconomic policies work when exchange rates are fixed?
Introduction
The purpose of the chapter
How do central banks intervene in the foreign exchange market to keep exchange rates stable?
How do macroeconomic policies work when exchange rates are fixed?

4. Chapter Organization Central Bank Intervention and the Money Supply
How the Central Bank Fixes the Exchange Rates
Stabilization Policies with a Fixed Exchange Rate
Balance of Payments Crises and Capital Flight
Managed Floating and Sterilized Intervention
Reserve Currencies in the World Monetary System
The Gold Standard

5. Central Bank Intervention and the Money Supply
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.

6. Central Bank Intervention and the Money Supply
The assets side
Foreign assets (claims or widely accepted means of payment, e.g. gold)
Domestic assets (government bonds or loans to private banks)
The liabilities side
Deposits of private banks
Currency in circulation
Total assets = total liabilities + net worth

7. Central Bank Intervention and the Money Supply
Net worth is constant. (assumption)
The changes in central bank assets cause equal changes in central bank liabilities. (like open market operation)
Central bank balance sheet
Assets
Liabilities
Foreign
assets
$1,000
Deposits
held by private banks
$500
Domestic
$1,500
Currency
in circulation
$2,000

8. Central Bank Intervention and the Money Supply
Any central bank purchase (sale) of assets automatically results in an increase (decrease) in the domestic money supply.
The central bank balance sheet shows how foreign exchange intervention affects the money supply because the central bank’s liabilities are the base of the domestic money supply process

9. Central Bank Intervention and the Money Supply
Foreign Exchange Intervention and the Money Supply
Suppose the central bank goes to the foreign exchange market and sells $100 worth of foreign bonds for home money.
Central bank balance sheet (pays with currency)
Assets
Liabilities
Foreign
assets
$900
Deposits
held by private banks
$500
Domestic assets
$1,500
Currency
in circulation
$1,900

10. Central Bank Intervention and the Money Supply
Central bank balance sheet (pays with check)
Assets
Liabilities
Foreign
assets
$900
Deposits
held by private banks
$400
Domestic assets
$1,500
Currency
in circulation
$2000

11. Central Bank Intervention and the Money Supply
Sterilization
Sterilized foreign exchange intervention
Suppose central bank sells $100 bonds foreign assets and receives as payment a $100 check, then it purchase $100 government bonds with check

12. Central Bank Intervention and the Money Supply
Central bank balance sheet (before transaction)
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 (after sterilized $100 foreign asset sale)
Assets
Liabilities
Foreign assets
$900
Deposits held by private banks
$500
Domestic assets
$1600
Currency in circulation
$2,000

13. Central Bank Intervention and the Money Supply
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.

14. 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:
R = R* + (Ee – E)/E
If E = E0
Then R = R*.
Money Market Equilibrium Under a Fixed Exchange Rate
To hold the domestic interest rate at R*,
MS/P = L(R*, Y)

15. How the Central Bank Fixes the Exchange Rate
Suppose the central bank has been fixing E at E0 and that asset markets are in equilibrium. An increase in output takes place, then what shall the central bank do to keep the exchange rate fixed?

16. How the Central Bank Fixes the Exchange Rate
Real money supply M1 P
Real money demand, L(R, Y1)
Domestic-currency return
on foreign-currency deposits,
R* + (E0 – E)/E
Real domestic
money holdings
Domestic
Interest rate, R
Exchange
rate, E E0 R* 1 1'
L(R, Y2) 3 3' E’
L(R, Y2) M2 P 2

17. 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.

18. Stabilization Policies With a Fixed Exchange Rate
Figure 17-2: Monetary Expansion Is Ineffective Under a Fixed
Exchange Rate
Output, Y
Exchange
rate, E DD
AA2
Monetary policies only affect the international reserve when exchange rate is fixed
AA1 E2 Y2 2 E0 Y1 1

19. Stabilization Policies With a Fixed Exchange Rate
Fiscal Policy
How does the central bank’s intervention hold the exchange rate fixed after the fiscal expansion?
The rise in output due to expansionary fiscal policy raises money demand.

20. Stabilization Policies With a Fixed Exchange Rate
Figure 17-3: Fiscal Expansion Under a Fixed Exchange Rate
Output, Y
Exchange
rate, E
DD1
AA2
DD2
AA1
Output and the international reserve will rise 3 Y3 E0 Y1 1 E2 Y2 2
Fiscal policy is more powerful than under floating exchange system

21. Stabilization Policies With a Fixed Exchange Rate
Comparison:
What is difference of effects of monetary and fiscal polices when exchange rate is floating and fixed ????

22. Stabilization Policies With a Fixed Exchange Rate
Changes in the Exchange Rate
The central bank announce its willingness to trade domestic against foreign currency, in unlimited amounts, at the new exchange rate.
Devaluation
Causes a rise in output, official reserves and the money supply
Aims to:
Fight unemployment, Improve the CA and increase the central bank's foreign reserves

23. Stabilization Policies With a Fixed Exchange Rate
Figure 17-4: Effects of a Currency Devaluation
Output, Y
Exchange
rate, E DD
AA2
AA1 2 E1 Y2 E0 Y1 1

24. Stabilization Policies With a Fixed Exchange Rate
Revaluation
It occurs when the central bank lowers E.
Cause
a decrease in output, international reserve and the money supply
When revaluation is necessary?

25. Stabilization Policies With a Fixed Exchange Rate
Adjustment to Fiscal Policy and Exchange Rate Changes
Fiscal expansion causes P to rise in long term.
There is no real appreciation in the short-run
There is real appreciation in the long-run
Devaluation is neutral in the long-run.

26. Figure 17-5: A Low-Output Liquidity Trap
Stabilization Policies With a Fixed Exchange Rate
Case study
Figure 17-5: A Low-Output Liquidity Trap
Output, Y
Exchange
Rate, E DD Y1 1 Ee
1 – R*
AA1
AA2 Yf

27. Stabilization Policies With a Fixed Exchange Rate
Figure 17-6: Fixing the Exchange Rate to Restore Full Employment
Output, Y
Exchange
Rate, E DD E0
1 – R* Yf 2
AA2 Y1 1 Ee
1 – R*
AA1

28. Balance of Payments Crises and Capital Flight
Balance of payments crisis
To fix exchange rate may be undesirable, and market expectation may be changed
A sharp change in official foreign reserves may be sparked by a change in expectations about the future exchange rate.

29. Balance of Payments Crises and Capital Flight
Suppose a sudden deterioration in CA
Real domestic
money holdings
Domestic
Interest rate, R
Exchange
rate, E
R* + (E1– E)/E
R* + (E0 – E)/E E0 1' 2' R* 1 2
R* + (E1 – E0)/E0
L(R, Y) M2 P
Real money supply M1 P

30. Balance of Payments Crises and Capital Flight
The 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.
If central bank lacks of international reserve for market intervention, what will happen?

31. Balance of Payments Crises and Capital Flight
The reserve loss accompanying a devaluation scare
The associated debit in the balance of payments accounts is a private capital outflow.
Currency crisis arises in
Improper macro-economic policy
(e.g. Bankrolling the government deficit )

32. Balance of Payments Crises and Capital Flight
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.

33. Managed Floating and Sterilized Intervention
Under managed floating system the central bank faces :
domestic objectives
Stable exchange rate
trade-off
PROBLEM: Sterilized intervention is effective or not ?
Central bank
1. Sell domestic assets to fight inflation
2. Then purchase foreign assets to keep exchange rate stable

34. Managed Floating and Sterilized Intervention
The former model has predicted the sterilized intervention is ineffective.
Under fixed exchange rate system
fiscal expansion
to buy foreign assets and enlarge domestic money supply to keep exchange rate stable
inflation
Sterilized intervention to sell domestic assets to decrease domestic money supply
buy more foreign assets and enlarge domestic money supply to keep exchange rate stable

35. Managed Floating and Sterilized Intervention
Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention
Perfect asset substitutability
Risk difference between home assets and foreign assets is out of consideration
R=R＊+(Ee-E)/E
Central banks cannot control the money supply and the exchange rate through sterilized foreign exchange intervention.

36. Managed Floating and Sterilized Intervention
Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability
Equilibrium in the foreign exchange market :
R = R* + (Ee – E)/E + 
 depends positively on the stock of domestic government debt:
 = (B – A)
B is the stock of domestic government debt
A is domestic assets held by the central bank

37. Managed Floating and Sterilized Intervention
The Effects of Sterilized Intervention with Imperfect Asset Substitutability
A sterilized purchase of foreign assets leaves the money supply unchanged but raises the risk adjusted return of domestic currency deposits in equilibrium.

38. Managed Floating and Sterilized Intervention
Real domestic
money holdings
Domestic
Interest rate, R
Exchange
rate, E
Sterilized purchase of foreign assets
Risk-adjusted domestic-currency return on foreign currency deposits,
R* + (Ee– E)/E + (B –A2) 2' E2
R* + (Ee – E)/E + (B –A1) 1' E1 1 R1
L(R, Y) Ms P
Real money supply

39. Managed Floating and Sterilized Intervention
Evidence on the Effects of Sterilized Intervention
Empirical evidence provides little support for the idea that sterilized intervention has a significant direct effect on exchange rates.

40. Managed Floating and Sterilized Intervention
The Signaling Effect of Intervention
Signaling effect of foreign exchange intervention
Sterilized intervention may give an indication of where the central bank expects (or desires) the exchange rate to move.

41. Reserve Currencies in the World Monetary System
Two possible systems for fixing the exchange rates:
Reserve currency standard
Central banks peg the prices of their currencies in terms of a reserve currency.
The currency central banks hold in their international reserves.
Gold standard( )
Central banks peg the prices of their currencies in terms of gold.

42. Reserve Currencies in the World Monetary System
The Mechanics of a Reserve Currency Standard
The system based on the U.S. dollar set up at the end of World War II.
Every central bank fixed the dollar exchange rate of its currency through foreign exchange market trades of domestic currency for dollar assets.
Exchange rates between any two currencies were fixed.

43. Reserve Currencies in the World Monetary System
The Asymmetric Position of the Reserve Center
The reserve-issuing country can use its monetary policy for macroeconomic stabilization even though it has fixed exchange rates.
N-1 exchange rates
Export its monetary policies

44. The Gold Standard
Each country fixes the price of its currency in terms of gold.
No single country occupies a privileged position within the system.
The Mechanics of a Gold Standard
Exchange rates between any two currencies were fixed.

45. The Gold Standard Symmetric Monetary Adjustment Under a Gold Standard
Country A loses reserves and its money supply shrinks
Country A expands its money supply
Country B is gaining reserves and its money supply expanded.
Finally
RA=RB

46. The Gold Standard Benefits and Drawbacks of the Gold Standard
It avoids the asymmetry inherent in a reserve currency standard.
It places constraints on the growth of countries’ money supplies.

47. The Gold Standard Drawbacks:
Constraints on the use of monetary policy to fight unemployment.
The relative price of gold and other goods and services should be stable.
Central banks compete for reserves and bring about world unemployment.
Confer gold producing countries (like Russia and South Africa) too much power.

48. The Gold Standard Bimetallic standard
The currency was based on both silver and gold.
A country’s mint will coin specified amounts of gold or silver into the national currency unit.
Example: grains of silver or grains of gold could be turned into a silver or a gold dollar. This made gold worth /23.22 = 16 times as much as silver.
Gresham's law
It might reduce the price-level instability resulting from use of one of the metals alone.

49. The Gold Standard The Gold Exchange Standard
Central banks’ reserves consist of gold and currencies whose prices in terms of gold are fixed.
Each central bank fixes its exchange rate to a currency with a fixed gold price.
Operate like a gold standard in restraining excessive monetary growth throughout the world, but it allows more flexibility in the growth of international reserves.

50. Summary
There is a direct link between central bank intervention in the foreign exchange market and the domestic money supply.
The central bank balance sheet shows how foreign exchange intervention affects the money supply.
The central bank can negate the money supply effect of intervention through sterilization.

51. Summary
A central bank can fix the exchange rate of its currency against foreign currency if it trades unlimited amounts of domestic money against foreign assets at that rate.
A commitment to fix the exchange rate forces the central bank to sacrifice its ability to use monetary policy for stabilization.
Fiscal policy has a more powerful effect on output under fixed exchange rates than under floating rates.
Balance of payments crises occur when market participants expect the central bank to change the exchange rate from its current level.

52. Summary
Self-fulfilling currency crises can occur when an economy is vulnerable to speculation.
A system of managed floating allows the central bank to retain some ability to control the domestic money supply.
A world system of fixed exchange rates in which countries peg the prices of their currencies in terms of a reserve currency involves a striking asymmetry.
A gold standard avoids the asymmetry inherent in a reserve currency standard.