CHAPTER 6

FIXED EXCHENGE RATES AND

FOREIGN EXCHANGE

INTERVENTION

§1 WHY STUDY FIXED EXCHANGE RATES

1.1Managed floating.1.1Managed floating.

1.2Regional currency arrangements .1.2Regional currency arrangements .

1.3Developing countries and countries transition1.3Developing countries and countries transition

1.4Lessons of the past for the future1.4Lessons of the past for the future

§2 CENTRAL BANK INTERVENTION AND THE MONEY SUPPLY

2.1 2.1 The Central Bank Balance Sheet and the Money The Central Bank Balance Sheet and the Money SupplySupply

2.2 2.2 Foreign Exchange Intervention and the Money Foreign Exchange Intervention and the Money SupplySupply

2.3 2.3 SterilizationSterilization

2.4 2.4 The Balance of Payments and the Money Supply The Balance of Payments and the Money Supply

§

2.1 The Central Bank Balance Sheet and the Money Supply

Foreign assets $900 Deposits held by private banks $400

Domestic assets $1, 500 Currency in circulation $2, 000

2.2 Foreign Exchange Intervention and the Money Supply

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

Foreign assets $900 Deposits held by private banks $500

Central Bank Balance Sheet After ＄100 Foreign Asset Sale(Buyer Pays with Currency)

Assets Liabilities

2.3 Sterilization

Foreign assets $1, 000 Deposits held by private banks $500

Domestic assets $1, 500 Currency in circulation $2, 000

Foreign assets $900 Deposits held by private banks $500

Central Bank Balance Sheet

Assets Liabilities

Central Bank Balance Sheet After ＄100 Foreign Asset Sale(Buyer Pays with Currency)

Assets Liabilities

§3 HOW THE CENTRAL BANK FIXES THE EXCHANGE RATE

3.1 Foreign Exchange Market 3.1 Foreign Exchange Market Equilibrium Under a Fixed Exchange Equilibrium Under a Fixed Exchange RateRate

The foreign exchange market is in equilibrium when the The foreign exchange market is in equilibrium when the interest parity condition holds: interest parity condition holds:

R=R* +(ER=R* +(Eee--EE )/E (1) )/E (1) R: the domestic interest rateR: the domestic interest rate

R*:the foreign interest rateR*:the foreign interest rate (E(Eee-E-E )/E:the expected rate of depreciation of the domestic currency against foreign )/E:the expected rate of depreciation of the domestic currency against foreign

currencycurrency

We assume that no exchange rate We assume that no exchange rate changes are expected by the market changes are expected by the market when exchange rates are fixed ,sowhen exchange rates are fixed ,so

(E(Eee-E)/E will be zero.-E)/E will be zero.

R=R* +0 (2)R=R* +0 (2)

R=R* (3)R=R* (3)

A Diagrammatic Analysis

Figure 17-1 Asset Market Equilibrium with a Fixed

Exchange Rate, E 0

U.S. real moneysupply

M 1 /P

1'E 0

R*

1

2'

32

M 2 /P

Domestic interest rate, R

Exchangerate,E

Realdomesticmoney

holdings

Y

§4 STABILIZATION POLICIES WITH A FIXED EXCHANGE RATE

4.1 Monetary Policies4.1 Monetary Policies

By fixing the exchange rate, then, By fixing the exchange rate, then, the central bank loses its ability the central bank loses its ability to use monetary policy for the to use monetary policy for the purpose of macroeconomic purpose of macroeconomic stabilization. However, the stabilization. However, the government government ‘‘second key second key stabilization tool, stabilization tool, fiscal policyfiscal policy, is , is more effective under a fixed rate more effective under a fixed rate than a floating rate. than a floating rate.

ExchangeRate, E

E2

E0

Y1 Y2

AA2

AA1

DD

●

2

Output, YO

1

§4 STABILIZATION POLICIES WITHA FIXED EXCHANGE RATE

4.2 Fiscal Policy4.2 Fiscal Policy

Fiscal expansion (shown by the Fiscal expansion (shown by the shift from DDshift from DD1 1 to DD to DD22) and the ) and the intervention that accompanies intervention that accompanies it (the shift from AAit (the shift from AA1 1 to AAto AA22) ) move the economy from point 1 move the economy from point 1 to point 3,where output is to point 3,where output is higher than originally, the higher than originally, the exchange rate is exchange rate is unchanged ,and official unchanged ,and official intervention reserves (and the intervention reserves (and the money supply) are higher.money supply) are higher.

2

Figure 17-3 Fiscal Expansion Under a FixedExchange Rate

DD 2

DD 1

AA 1

AA 2

2

3E 0 1

Y 1 Y 2

E 2

Y 3 Output, Y

Exchangerate, E

FiscalExpansion

Intervention

4.3 Changes in the Exchange Rate4.3 Changes in the Exchange RateFigure 17-4 Effect of a Currency Devaluation

DD

AA 2

AA 1

E 12

E 0

1

Output,Y

Exchangerate,E

CurrencyDevalued

§5 BALANCE OF PAYMENTS CRISES AND CAPITAL FLIGHT

To hold the exchange To hold the exchange rate fixed at Erate fixed at E0 0 after the after the market decides it will be market decides it will be devalued to Edevalued to E11,the central ,the central bank must use its bank must use its reserves to finance a reserves to finance a private capital outflow private capital outflow that shrinks the money that shrinks the money supply and raises the supply and raises the home interest rate.home interest rate.

Figure 17-5 Capital Flight, the Money Supply,and the Interest Rate

L(R $ ,Y us )

M 2 /P 2

R'

M 1 /P 1

1'

R*

2'E 0

Exchangerate, E

Realdomesticmoney

holdings

M /P

§ 6 MANAGED FOATING AND STERILIZED INTERVENTION

6.1 Perfect Asset Substitutability and the 6.1 Perfect Asset Substitutability and the Ineffectiveness of Sterilized InterventionIneffectiveness of Sterilized Intervention

When domestic and foreign currency bonds are perfect When domestic and foreign currency bonds are perfect substitutes, the foreign exchange market is in equilibriumsubstitutes, the foreign exchange market is in equilibrium

only if the interest parity condition holds:only if the interest parity condition holds:

R=R* +(ER=R* +(Eee-E-E )/E )/E (1)(1)

6.2 Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability

The equilibrium under imperfect asset substitutability requires:The equilibrium under imperfect asset substitutability requires:

R=R* +(ER=R* +(Eee-E-E )/E+ )/E+ ρ ρ (2)(2) ρ :ρ :a a risk premiumrisk premium, , that reflects the difference between the that reflects the difference between the

riskiness of domestic and foreign bondsriskiness of domestic and foreign bonds

ρρ depends positively on depends positively on the stock of domestic government debtthe stock of domestic government debt, , devoted by B, less devoted by B, less the domestic assets of the central bankthe domestic assets of the central bank, devoted by , devoted by

A:A: ρ=ρ= ρ ρ ((B-AB-A)) (3)(3)

§ 6 MANAGED FOATING AND STERILIZED INTERVENTION6.3 The Effect of 6.3 The Effect of

Sterilized Intervention Sterilized Intervention with Imperfect Asset with Imperfect Asset Substitutability Substitutability (Figure 17-6 )(Figure 17-6 )

6.4 Evidence on the 6.4 Evidence on the Effects of Sterilized Effects of Sterilized InterventionIntervention

6.5 The Signaling Effect 6.5 The Signaling Effect of Interventionof Intervention

Figure 17-6 Effect of a Sterilized Central Bank Purchaseof Foreign Assets under Imperfect Assets Substitutability

1'E 1

R*

1M s/P

2'E 2

Domestic interest rate, R

Exchangerate,E

Realdomesticmoney

holdings

Return

§7 Reserve Currencies in the World Monetary System

7.1 The Mechanics of a 7.1 The Mechanics of a Reserve Currency Reserve Currency Standard Standard

Countries peg the prices of their currencies in Countries peg the prices of their currencies in terms of a terms of a reserve currencyreserve currency involving a involving a striking asymmetry.striking asymmetry.

7.2 The Gold Standard

All countries fix the prices of their All countries fix the prices of their currencies in terms of gold. currencies in terms of gold.

The gold standard avoids the asymmetry The gold standard avoids the asymmetry inherent in a reserve currency standard and inherent in a reserve currency standard and also places constraints on the growth of also places constraints on the growth of money supplies.money supplies.

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