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Chapter 17: motivation


In reality many countries do not allow their exchange rate to float absolutely freely. ... So studying fixed exchange rates isn't a pointless academic doodling. ... – PowerPoint PPT presentation

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Title: Chapter 17: motivation

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  • Chapter 17 motivation
  • Thus far we imagined a world where exchange rates
    float, and we developed models for that purpose.
  • In reality many countries do not allow their
    exchange rate to float absolutely freely.
  • Some try to keep E pegged, to the dollar, or
    euro, or maybe a basket of currencies.
  • Some try to manage their E so that it is
    flexible but doesnt move too much.

  • Chapter 17 motivation
  • Why do countries do this? What are the costs and
    benefits of a fixed exchange rate?
  • Theory We do not need to develop a whole set of
    new models to describe this scenario.
  • We just need to re-interpret our existing models

  • Chapter 17 outline
  • Examples of fixed exchange rates, past and
  • Central bank balance sheets
  • Central bank intervention
  • How do central banks fix?
  • Implications for asset approach model of E
  • How does policy work in this new environment

  • The state of play
  • Table 17-1 in the text show roughly how the world
    breaks down by exchange rate arrangement.
  • Who says they fix and who says they float?
  • Ask the IMF. Go to International Financial
    Statistics and see Table Exchange Rate
  • This is by no means an unchanging classification.
  • It might also be very misleading.

  • Who floats? who fixes? who cares?
  • Today, many developed countries ostensibly float.
    But in reality the /, /, /, /C, /A may
    be the only really floating rates (and even then
    youll hear Treasury Secretaries muttering about
    E concerns).
  • For almost all other countries, they report to
    the IMF that they are officially floating. This
    is a fib!
  • Data show that many countries are secretly
    fixing their E never wavers against the (or )
    more than a smidge. Coincidence?! We think not.
  • In addition there are many countries who freely
    admit they are fixers.

  • Who floats? who fixes? who cares?
  • From WWII until 1973 the entire world economy
    operated under a fixed exchange rate system, the
    so called Bretton Woods system. Countries pegged
    the value of their currencies relative to the
    U.S. dollar.
  • From circa 1870 to 1914 many parts of the world
    adopted the gold standard, a system where
    countries pegged the value of their currencies
    relative to and ounce of gold.
  • In terms of broad policy goals, what did such
    systems imply? Governments were committing to a
    nominal target. In this case to hold E fixed.
  • Hints at what is to come to maintain a target
    you have to use some kind of instrument for that
    purpose. Such an instrument is then useless for
    other purposes. This is a cost.

  • Who floats? who fixes? who cares?
  • So studying fixed exchange rates isnt a
    pointless academic doodling. Serious present day
  • Managed floaters
  • Most countries at times try to intervene and
    prevent the exchange rate from going wherever it
    wants. Sometimes called dirty floating as
    opposed to clean floating.

  • Who floats? who fixes? who cares?
  • Regional currency arrangements
  • Becoming increasingly relevant. Countries in a
    region may seek to jointly peg with their
    neighbors currencies (e.g. to promote trade and
    integration). This may happen without
    full-fledged currency union (e.g. Danish kroner
  • Developing countries
  • Here some kind of fear of floating has
    convinced most countries to try to maintain a peg
    (commonly to ). Aprox half of the world engages
    in some sort of currency peg. (Marocco pegs its
    currency to a basket, Barbados pegs to the US
    dollar, etc)
  • Understanding past lessons for the future
  • The present regime may not persist. What
    happens if we have a return to more fixing, as
    under the gold standard? Some serious
    commentators (and cranks) long for
    this.(1920-1931and 1945-1973 lessons)

  • How to fix prices?
  • The key insight here is that if the government
    wants to fix a price (in any market, whether
    foreign exchange, oil, pizza,) it had better be
    ready to intervene in that market.
  • That is, a government agency, usually the Central
    Bank, stands ready to freely buy or sell foreign
    exchange in return for domestic currency.
  • Obviously, theyd better have enough credibility
    to do this, meaning at least they need some
    buffer stock foreign exchange reserves on
    their balance sheet (in their vaults) with which
    to operate.

  • Central bank balance sheet and money supply
  • Like any other balance sheet, use double entry
    bookkeeping, track assets liabilities.
  • Use an example (assume constant net worth0).
  • Bank holds foreign assets (universally
    accepted means of payment e.g., ForEx reserves or
    gold) and domestic assets (e.g. govt T-bills).
  • Banks liabilities deposits of private
    banks (demandable) and (for vestigial reasons)
    public holdings of cash (each in domestic

  • Central bank operations domestic assets
  • A classic open market operation, familiar from
    closed-economy macro.
  • Bank buys 100 T-bills and pays cash.
  • Expands both sides of balance sheet.
  • Increases the money supply.

  • Central bank operations foreign assets
  • A foreign exchange market intervention offers a
    similar story.
  • Bank buys 100 of foreign exchange (say,
    euros) and pays cash.
  • Expands both sides of balance sheet.
  • Increases the M1 money supply (total

  • Central bank operations foreign assets
  • What if central bank sells 100 in foreign assets
    to a private buyer?
  • If buyers pays in cash (domestic currency)
    then currency in circulation will fall
  • If buyer pays by check, this will be cashed by
    central bank against its deposits of the private
    bank, and then the private bank will deduct the
    amount from the checking deposit.
  • Either way balance sheet shrinks, and M1

  • Central bank operations sterilized intervention
  • As we shall see, it might be troubling for a
    central bank to contract its money supply
    (adverse macro effects?) just because some
    private buyers want to purchase foreign exchange.
    Sterilization is a potential way out.
  • Bank sells foreign assets, M1 falls, as above.
  • Bank simultaneously buys same quantity
    domestic assets (OMO) and M1 rises, back to
    original level.

  • How do central banks fix E?
  • They have to stand ready to buy and sell ForEx
    for domestic currency at fixed E.
  • Suppose this is credible. If so, it must be
    consistent with asset market equilibrium.
  • Remember the asset approach, and UIP
  • R R (Ee E ) / E
  • Now the last term vanishes and interest parity
    under fixed rates becomes very simple indeed!
  • RR
  • It is now clear what central bank has to do. To
    ensure E is fixed requires central bank to hold
    RR .
  • But we know that R is determined in the domestic
    money market and there is a unique level of Ms
    that allows this. Interesting consequences

  • Money Market Equilibrium under a Fixed Exchange
  • Ms/P L(R,Y)
  • To hold the exchange rate fixed , the central
    bank must adjust the money supply so the money
    market is in equilibrium when R R
  • Lets look at an example Central bank fixes
    exchange rate and the asset market is initially
    in equilibrium. Suddenly output hold
    exchange rate fixed restore asset market
    equilibrium at that rate (R).
  • Question What are the monetary measures to keep
    exchange rate constant?

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  • Stabilization policies with a fixed exchange rate
  • Monetary Policy
  • Fiscal Policy
  • An abrupt change in the exchange rates fixed

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  • Changes in the exchange rate
  • Sometimes a country might decide on a sudden
    change in the foreign currency value of the
    domestic currency devaluation (central bank
    raises E) or revaluation (central bank lowers E).
  • Why devaluation?
  • - allows government to fight domestic
    unemployment despite the lack monetary policy
    effect or a convenient way to boost aggregate
    demand if a fiscal policy would be slow to be
  • - improvement in CA
  • - convenient if the central bank is running low
    on reserves

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