Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention.
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Transcript of Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention.
Introduction
■ 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
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?
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
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.
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
Central Bank Interventionand the Money Supply
• Total assets = total liabilities + net worth
Central Bank Interventionand 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 assets
$1,500 Currency in circulation
$2,000
• Any central bank purchase (sale) of assets automatically results in an increase (decrease) in the domestic money supply.
Central Bank Interventionand the 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
Central Bank Interventionand 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
Foreign Exchange Intervention and the Money Supply
Central Bank Interventionand 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
Sterilization• Sterilized foreign exchange intervention
Central Bank Interventionand the Money Supply
Suppose central bank sells $100 bonds foreign assets and receives as payment a $100 check, then it purchase $100 government bonds with check
Central Bank Interventionand 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
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.
Central Bank Interventionand the Money Supply
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)
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?
Real money supplyM1
P
Real money demand, L(R, Y1)
Domestic-currency return on foreign-currency deposits, R* + (E0 – E)/E
Real domesticmoney holdings
DomesticInterest rate, R
Exchange rate, E
0
E0
R*
1
1'
L(R, Y2) L(R, Y2)
3
3'
M2
P 2
E’
How the Central Bank Fixes the Exchange Rate
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.
DD
Figure 17-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate
Output, Y
Exchange rate, E
E2
Y2
2
E0
Y1
1
AA2
AA1
Stabilization Policies With a Fixed Exchange Rate
Monetary policies only affect the international reserve when exchange rate is fixed
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.
Stabilization Policies With a Fixed Exchange Rate
DD1
Figure 17-3: Fiscal Expansion Under a Fixed Exchange Rate
Output, Y
Exchange rate, E
E0
Y1
1
AA2
AA1
DD2
E2
Y2
2
3
Y3
Stabilization Policies With a Fixed Exchange Rate
Output and the international
reserve will rise
Fiscal policy is more powerful than under floating exchange system
Comparison:
What is difference of effects of monetary and fiscal polices when exchange rate is floating and fixed ????
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
Stabilization Policies With a Fixed Exchange Rate
2
DD
Figure 17-4: Effects of a Currency Devaluation
Output, Y
Exchange rate, E
E0
Y1
1
AA2
AA1
Stabilization Policies With a Fixed Exchange Rate
Y2
E1
• Revaluation– It occurs when the central bank lowers E.– Cause
a decrease in output, international reserve and the money supply
Stabilization Policies With a Fixed Exchange Rate
When revaluation is necessary?
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.
Stabilization Policies With a Fixed Exchange Rate
Case study Figure 17-5: A Low-Output Liquidity Trap
DD
Output, Y
Exchange Rate, E
Y1
1 Ee
1 – R*
AA1
Yf
Stabilization Policies With a Fixed Exchange Rate
AA2
Figure 17-6: Fixing the Exchange Rate to Restore Full Employment
DD
Output, Y
Exchange Rate, E
Y1
1 Ee
1 – R*
AA1
Stabilization Policies With a Fixed Exchange Rate
E0
1 – R*
AA2
Yf
2
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.
M2
P
Suppose a sudden deterioration in CA
Real money supplyM1
P
R*
1Real domesticmoney holdings
DomesticInterest rate, R
Exchange rate, E
0R* + (E0 – E)/E
R* + (E1– E)/E
2
R* + (E1 – E0)/E0
L(R, Y)
2'E0
1'
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
Balance of Payments Crises and Capital Flight
If central bank lacks of international reserve for market intervention, what will happen?
An expected revaluation causes the opposite effects.
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.
Currency crisis arises in• Improper macro-economic policy
(e.g. Bankrolling the government deficit )
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
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
Managed Floating and Sterilized Intervention
The former model has predicted the sterilized intervention is ineffective.
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
Under fixed exchange rate system
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.
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
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.
Managed Floating and Sterilized Intervention
Ms
PReal money supply
Real domesticmoney holdings
DomesticInterest rate, R
Exchange rate, E
0R* + (Ee – E)/E + (B –A1)
Risk-adjusted domestic-currency return on foreign currency deposits,R* + (Ee– E)/E + (B –A2)
L(R, Y)
2'E2
E11'
R1
1
Sterilized purchase of foreign assets
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.
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.
Managed Floating and Sterilized Intervention
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(1870-1914)– Central banks peg the prices of their currencies in
terms of gold.
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.
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
Reserve Currencies in the World Monetary System
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.
The Gold Standard
Symmetric Monetary Adjustment Under a Gold Standard
Country A loses reserves and its money supply shrinks
Country B is gaining
reserves and its money supply expanded.
Country A expands its money supply
Finally
RA=RB
The Gold Standard
Benefits and Drawbacks of the Gold Standard• Benefits:
– It avoids the asymmetry inherent in a reserve currency standard.
– It places constraints on the growth of countries’ money supplies.
• 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.
The Gold Standard
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: 371.25 grains of silver or 23.22 grains of gold could be turned into a silver or a gold dollar. This made gold worth 371.25/23.22 = 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.
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.
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.
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.
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.
Summary