Fixed Exchange Rate & Foreign Exchange Intervention.

Fixed Exchange Rate & Foreign Fixed Exchange Rate & Foreign Exchange InterventionExchange Intervention

FixedFixed exchange rate: end of World War II-1973

HybridHybrid system (managed floating): after 1973

feature: central banks routinely intervening

Chinese version

Fixed exchange ratesFixed exchange rates?

1. Managed floating

2. Regional currency arrangements

3. Developing countries and countries in transition

4. Lessons of the past for the future

Central bank intervention Central bank intervention & the money supply& the money supply

• central bank transactions in asset markets

• the central bank balance sheet

• according to the principles of double-entry bookkeeping

double-entry double-entry bookkeepingbookkeeping

AssetsAssets LiabilitiesLiabilitiesAny acquisition of an asset by the central bank (a positive change)

Any increase in the bank’s liabilities (a positive change)

increase +reduce ––

+

––

Changes in the central bank’s assetsassets cause changes in the domestic money supplymoney supply

• When the central bank buys an asset from the public, its payment (cash/check) enters the money supply.

• the asset purchase →money supply to money supply to expandexpand.

• the asset sale →receive cash or check →money supply shrinksmoney supply shrinks

upshotupshot

• Changes in the level of central bank asset holdings cause the money supply to change in the same directionsame direction because they require equal changes in the central bank’s liabilities.

• Any central bank purchase of assets automatically automatically results in an increase in the domestic money supply, while any central bank sale of assets automaticallyautomatically causes the money supply to decline.

Money multiplier EffectMoney multiplier Effect

• When the central bank buys assets, the accompanying increase in the money supply is larger than the initial asset purchase because of multiple deposit multiple deposit creationcreation within the private banking system.

Central Bank Balance Central Bank Balance SheetSheet

AssetsAssets LiabilitiesLiabilitiesForeign assets $1000 Deposits held by priva

te banks $500

Domestic assets

$1500

Currency in circulation $2000

$2500 $2500

Exchange interventionExchange intervention

AssetsAssets LiabilitiesLiabilitiesForeign assetsForeign assets $1000 Deposits held by Deposits held by

private banksprivate banks $500

Domestic assetsDomestic assets

$1500

Currency in Currency in circulationcirculation $2000

$2500 $2500

① ① sell $100 for sell $100 for ￥￥

② ② pay $100 in pay $100 in ￥￥

Decline in Money SupplyDecline in Money Supply

AssetsAssets LiabilitiesLiabilitiesForeign assetsForeign assets $900$900 Deposits held by Deposits held by



$1500

Currency in Currency in circulationcirculation $1900$1900

$2400$2400 $2400$2400

private citizen’s actionprivate citizen’s action




$1500


$2400 $2400

① ① buyer of foreign asset paysbuyer of foreign asset paysa a $$100 check drawn on deposit100 check drawn on deposit

②②Private bank deposits with the Private bank deposits with the central bank fall by central bank fall by $$100100

result of such actionresult of such action




$1500


$2400 $2400

Sterilization

• Sterilized foreign exchange intervention:

Central banks carry out equal foreign equal foreign and domestic asset transactions and domestic asset transactions in opposite directionsin opposite directions to nullify the impact of their foreign exchange operation on domestic money supplydomestic money supply.

Before Sterilized $ 100 Before Sterilized $ 100 SaleSale

AssetsAssets LiabilitiesLiabilitiesForeign assetsForeign assets $1000 Deposits held by privaDeposits held by priva

te bankste banks $500


$1500

Currency in circulationCurrency in circulation $2000

减少减少 check $100→check $100→

货币供应量减少货币供应量减少 $2500 $2500

① ① sell $100sell $100

Sterilized ProcessSterilized Process




$1600

Currency in circulationCurrency in circulation $2000

增加增加 check $100→check $100→

货币供应量增加货币供应量增加 $2500 $2500

②②buy $100 of domestic Abuy $100 of domestic A

① ① sell $100sell $100

After Sterilized $ 100 SaleAfter Sterilized $ 100 Sale

AssetsAssets LiabilitiesLiabilitiesForeign assetsForeign assets $900$900 Deposits held by Deposits held by



$1600$1600


$2500 $2500

Table 17-2 Summary 简译本国央行的行为

对本国货币货币供给供给的影响

对央行本国本国资产资产的影响

对央行外国外国资产资产的影响

不冲销的外汇购买 +$100 0 +$100

冲销的外汇购买 0 -$100 +$100

不冲销的外汇购买 -$100 0 -$100

冲销的外汇购买 0 +$100 -$100

Balance of Payments & Money SupplyBalance of Payments & Money Supply

• Different definition:

• BOPBOP is the sum of the current accountcurrent account and the non-reserve component of non-reserve component of capital accountcapital account, that is, the international payment gap that central banks must finance through their reserve transaction.

BOPBOP & Growth of Money SupplyMoney Supply• If central banks are not sterilizing and the home

country has balance of payments surplus, any associated increase in the home increase in the home central bank’s foreign assetscentral bank’s foreign assets implies an increased home money supplyincreased home money supply. Similarly, any associated decrease in a foreign central bank’s claims on the home country implies a decreased foreign money supply.

Burden of BOP adjustment

1. Macroeconomic goalsgoals of the central banks and institutional arrangement governing intervention;

2. Central banks may be sterilizingsterilizing to counter the monetary effects of reserve changes;

3. Some central bank transactions indirectly indirectly helphelp to finance a foreign country’s BOP deficit.

How the central bank fixes the exchange rate?

• Through foreign exchange interventionintervention.• Condition: only if its financial transactions

ensure the asset marketasset market remain in equilibrium when the exchange rate is at its fixed level.

1. Foreign exchange marketexchange market equilibrium

2.2. Money marketMoney market equilibrium

Exchange market equilibrium

• Interest rate parity must hold

*

/)(*

RR

EEERR e

Expectation of domestic

currency is zero!

Money market equilibrium

)*,(/

*),(/

YRLPM

RRYRLPMs

s

R* equates aggregate real domestic money demand and real money supply.

Given PP and YY, the above equilibrium condition tells what the money supply must be if a permanently fixed exchange rate is consistent with asset market equilibrium at foreign exchange rate of R*R*.

• A rise in output raises the demand for domestic money…

• This foreign asset purchase (by the central bank) eliminates the excess demand for domestic money because the central bank issues money to pay for the foreign assets it buys.

*

0

RR

EE

RR

EE

0E

P

M 1

P

M 2

EEER /)(* 0

),( 1YRL),( 2YRL

● ●

●

●

●

维持固定汇率维持固定汇率

实际货币供给实际货币供给

外币储蓄的本币收益外币储蓄的本币收益

实际国内货币持有实际国内货币持有

①① 产出增加产出增加

②② 货币供应增加货币供应增加

Stabilization Policies

Alternatives:

1. Monetary policy

2. Fiscal policy

3. An abrupt change in the exchange rate’s fixed level, E0

Two alternatives under the fixed

• By fixing the exchange rate, the central bank gives up its ability to influence the economy through monetary policy. Fiscal Fiscal policy becomes a more potent policy becomes a more potent tooltool for affecting output and employment.

Analysis approaches

• DD-AADD-AA model

• Add the assumption that the expected future exchange rate (EEee) equalsequals the rate EE00 at which the central bank is pegging.

1. Monetary Policy

• Under a fixed exchange rate, central bank monetary policy tools are powerlesmonetary policy tools are powerlesss to affect the economy’s money supply or its output.

EE

YY

DDDD

AAAA11

AAAA22

EE00

EE22

YY11 YY22

①

②

中央银行通过购中央银行通过购买国内资产扩大买国内资产扩大国内货币供给来国内货币供给来增加产出增加产出

维持固定汇率维持固定汇率

央行不得不出央行不得不出售外国资产来售外国资产来换回本币换回本币

在固定汇率制下货币扩张是无效的在固定汇率制下货币扩张是无效的

2. Fiscal Policy

• Fiscal policy can be used to affect can be used to affect outputoutput under a fixed exchange rate.

• In comparison with under a floating rate, fiscal expansion is accompanied by an appreciation of domestic currencyappreciation of domestic currency and the central bank is forced to expand the money supply through foreign exchange purchases.

EE

YY

DDDD11

AAAA11

AAAA22

EE00

EE22

YY11 YY22

①

②

DDDD22

YY33

③

财政扩张政策移动财政扩张政策移动 DDDD为了避免过度的为了避免过度的货币需求造成利货币需求造成利率上升率上升 ,,引起本币引起本币升值升值 ,,央行购买外央行购买外国资产国资产 ,,从而增加从而增加了本币的供给了本币的供给 ,,这这种干预移动了种干预移动了 AAAA曲线曲线

本币升值压力

干预结果产出增加而汇率不变干预结果产出增加而汇率不变

3. Changes in the exchange rate

• Devaluation (or revaluation) is a last last resortresort for the central bank…

• Devaluation causes a rise in outputoutput, a rise in official reserves, and an expansion of the money supply. A private capital inflow matches the central bank’s reserve gain (an official outflow) in the balance of payments account.

EE

YY

DDDD

AAAA11

AAAA22

EE11

EE00

YY11 YY22

①

②

本币贬值本币贬值

Both output & Both output & money supply money supply expandexpand

Why choose to devaluate?

1. Devaluation allows the government to fight fight domestic unemploymentdomestic unemployment despite the lack of effective monetary policy.

2. Devaluation is the most convenient way of boosting aggregate demandboosting aggregate demand. (government spending and budget deficit unpopular)

3. Central bank is running low on running low on reservesreserves, devaluation is a kind of tax on holders of government bonds and money.

Balance of payments crises & capital flight

• The market’s belief in an impending impending changechange in the exchange rate gives rise to a balance of payments crisisbalance of payments crisis, a sharp change in official foreign exchange reserves sparked by a change in expectations about the future exchange rate.

RR

EE

0E

P

M 1

P

M 2

EEER /)(* 0

),( YRL

●

●

● ●

实际货币供给实际货币供给

外币储蓄的本币收益外币储蓄的本币收益

实际国内货币持有实际国内货币持有

①①

EEER /)(* 1

②

⑴ ⑵

R 001 /)(* EEER

本币贬值预期右移外币储蓄的本币收益曲线

央行必须出售外汇储央行必须出售外汇储备备 ,, 紧缩国内货币供紧缩国内货币供给。给。

Upshot

• The expectation of a future expectation of a future devaluationdevaluation causes a balance of payment crisis marked by a sharp fall a sharp fall in reservesin reserves and a rise in the a rise in the home interest ratehome interest rate above the world interest rate and vice versa.

Capital flight

• The reserve loss accompanying a devaluation scare is often labeled capital capital flightflight because the associated debt debt in the balance of payments accounts is a private capital outflowprivate capital outflow.

What causes currency crisescurrency crises?

• Central bank is compelled to buy bonds form the domestic government to allow the government to run continuing fiscal deficits.

• Central bank’s purchases of domestic assets cause losses of foreign exchange reserves.

• Central bank can not support of rise of domestic interest rate.

Solution to the currency crises

• The central bank should stop bankrolling the government deficit, hopefully forcing the government to live within its means.

• Independence of central bankIndependence of central bank.

Self-fulfilling currency Self-fulfilling currency crisescrises

• An economy can be vulnerable to currency speculationcurrency speculation without being in such bad shape that a collapse of its fixed exchange regime is inevitable.

• An economy in which domestic commercial banks’ liabilities are mainly short-liabilities are mainly short-term depositsterm deposits. The central bank has to lend money to the commercial banks.

Managed floating & sterilized intervention

• Under managed floating, monetary policy is influenced by exchange rate changes without being completely subordinate to the requirements of a fixed rate.

• The central bank faces a trade-off trade-off between domestic objectivesbetween domestic objectives (employment or the inflation rate) and exchange rate stability.

• Such efforts are usually ended in sterilization or nullificationsterilization or nullification.

Intervention=sterilization?

• Tools of intervention: money supplymoney supply & interest rateinterest rate.

• Empirical studies confirm that such intervention are sterilized throughout the 20th century and earlier.

Perfect asset substitutability & Ineffectiveness of sterilized

intervention

• Without change in the domestic money money supplysupply, any intervention by the central bank will not affect the domestic interest rateinterest rate and therefore will not affect the exchange exchange raterate.

Mexico’s 1994 Balance of Payments CrisisMexico’s 1994 Balance of Payments Crisis

利率被迫拉升利率被迫拉升

储备不断减少储备不断减少

Sterilization is fruitless under the fixed exchange rate

• The ineffectiveness of monetary policy under a fixed exchange rate implies that sterilization is a self-defeating policy.

PerfectPerfect asset substitutability• All interest-bearing (non-money) assets denominated in

the same currency, whether illiquid time deposits or government bonds, are perfect substitutes in perfect substitutes in portfoliosportfolios.The single term “bonds” will generally be used to refer to all assets.

• Interest Parity ConditionInterest Parity Condition holds• Nothing a central bank can do through intervention.

ImperfectImperfect asset substitutability

• RiskRisk in the foreign exchange market.

• Risk preferenceRisk preference is different to investors.

• Perfect asset substitutability: expected rate of returnreturn that matters

• Imperfect asset substitutability: both returnreturns and riskrisk that matters.

Exchange market equilibrium under imperfectimperfect asset substitutability

• Comparison:• Perfect asset substitutability: 利率平价论成立利率平价论成立

• Imperfect asset substitutability: 附加附加风险贴水风险贴水

EEERR e /)(*

EEERR e /)(*

)( AB

本国政府债务存量本国政府债务存量

中央银行的本国资产中央银行的本国资产

Skip over page 508-Skip over page 508-510510

• With imperfect asset substitutability, even sterilized purchasessterilized purchases of foreign exchange cause the home currency to depreciatedepreciate. Similarly, sterilized sales of foreign exchange cause the home currency to appreciate.

The signalingsignaling effect of intervention

• If market participants are unsure about the future direction of macroeconomic policies, sterilized intervention may give an give an indication of where the central indication of where the central bank expectsbank expects (desires) the exchange rate to move.

• Is the signaling effect “crying ‘wolf!’crying ‘wolf!’”?

• If governments do not follow up on their exchange market signals with concrete policy moves, the signals soon become ineffective.

Reserve currencies in the world monetary system

• Reserve currencyReserve currency: the currency central banks hold in their international reserves, and each nation’s central banks fixes its currency’s exchange rate against the reserve currency by standing ready to trade domestic money for reserve assets at that rate.

The mechanics of a reserve currency standard

• Even though each central bank tied its currency’s exchange rate only to dollar, market forces automatically held all other exchange rates (cross rates) constant at the values implied by the dollar rate.

Fixed Exchange Rates under currency-circulation system

• 纸币流通下的布雷顿森林体系。 1944

• Bretton Woods agreement

• 英国向美国妥协的结果“双挂钩双挂钩”体系。

金块金块

美元 dollar

各国货币

日元…

里拉…

1盎司 =35美元

1%幅度波动

The asymmetric position of the reserve center

• The country whose currency is held as reserves occupies a special position because it never has to intervenenever has to intervene in the foreign exchange market.

• If there are NN countries with NN currencies in the world, there are only N-1N-1 exchange rates against the reserve currency, there is no exchange rate for the reserve center to fix. Thus the center countries need never intervene and bears none of the burden of financing its balance of payments.

• 各国货币钉住美元各国货币钉住美元 ,, 而美元钉住什么而美元钉住什么 ?? 美国用美国用不着干预外汇市场不着干预外汇市场。

Reserve center’s privilege

• The reserve center is the one country in the system that can enjoy fixed exchange rates without the need to intervene, it is still able to use monetary policy for stabilizing purposes.

The Gold Standard

• An international gold standard avoids the asymmetry inherent in a reserve currency standard by avoiding the “Nth currency” problem. Under a gold standard, each country fixes the price of its currency in terms of gold by standing ready to trade domestic currency for gold whenever necessary to defend the official price.

Two kinds of the fixed exchange rates

1. 金本位制度下的固定汇率制2. 纸币流通制度下的固定汇率制Gold Standard:规定货币单位的含金量。含金量的的对比决定汇率含金量的的对比决定汇率。金币可以自由自由铸造；自由自由兑换；自由自由输出入。

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除此之外，时间除此之外，时间不够时，还要跳不够时，还要跳过更多的页数。过更多的页数。

Fixed Exchange Rate & Foreign Exchange Intervention.

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