Topic 8 Fixed Exchange Rates and Foreign Exchange Intervention

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Topic 8Fixed Exchange Rates and Foreign
Exchange Intervention

• Textbook Chapter 17

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Learning objectives

• Consider how central bank intervention influences
  money supply
• Learn the fixed-exchange-rate mechanism and its
  impact on monetary and fiscal policies
• Examine balance of payment crisis
• Learn managed floating and sterilized
  intervention

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Central Bank Balance Sheet

• The central banks balance sheet contains the
  information on the monetary base (so-called
  high-power money)
• Monetary base is the sum of reserve deposits held
  in the central bank and currency. It also equals
  the sum of foreign assets and domestic assets
  held in the central bank.

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Central Bank Balance Sheet
Assets Liabilities
Foreign Assets 1000 Domestic Assets 1500
Reserve Deposits 500 Currency in
circulation 2000
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Money supply and monetary base

• Denote money supply by M, monetary base by B, and
  money multiplier by m. We have
• MmB, (mgt1)
• where m is determined by the reserve deposit
  ratio and currency deposit ratio.
• Given the money multiplier, M changes
  proportionally with B.

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Two open market operations

• Open-market operations involve the purchase or
  sale of domestic assets.
• Official transactions in foreign assets is just
  the open market operations in the foreign asset
  market.
• Any central bank purchase of assets increases
  money supply, and any central bank sale of assets
  reduces money supply.

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Foreign exchange intervention

• The central banks sale of 100 worth of foreign
  bonds to the public.
• If paid by cash, both foreign assets and currency
  in circulation fall in the central banks balance
  sheet by 100.
• If paid by check, both foreign assets and reserve
  deposits fall in the central banks balance sheet
  by 100.

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Sterilized foreign exchange intervention

• Sterilized foreign exchange intervention is an
  equal foreign and domestic asset transactions in
  opposite directions to nullify the impact of
  their foreign exchange operations on the domestic
  money supply.

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Effects of a 100 foreign exchange intervention
Action Monetary base Domestic assets
Foreign assets
NST. forex Purchase 100 0 100 ST.
forex Purchase 0 -100 100 NST.
forex Sale -100 0 -100 ST. forex Purchase
0 100 -100
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Balance of payments and money supply

• Balance of payments (official settlement balance)
• net purchases of foreign assets by the home
  central bank
• net purchases of domestic assets by foreign
  central banks

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Balance of payments and money supply

• BOP surplus implies an increased home money
  supply and/or a decreased foreign money supply.
• Uncertainties in the linkage
• How the BOP adjustment burden is divided among
  central banks
• Whether sterilization is undertaken

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Foreign exchange market equilibrium under a fixed
exchange rate

• When the exchange rate is fixed permanently at
  E0, EeE0 then, the central bank must manipulate
  money supply by either buying or selling foreign
  assets so that R is held equal to R.
• IRP under a fixed exchange rate becomes
• RR.

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Figure 17-1 Asset Market Equilibrium with a
Fixed Exchange Rate, EO
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Monetary policy with a fixed exchange rate

• Under a fixed exchange rate, monetary policy can
  affect international reserves but nothing else
  therefore its powerless.
• The central banks commitment to the fixed
  exchange rate forces it to resist any tendency
  for the currency to either depreciate or
  appreciate by sales or purchases of foreign
  assets.

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Figure 17-2 Monetary Expansion Is Ineffective
Under a Fixed Exchange Rate
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Fiscal policy with a fixed exchange rate

• Under a fixed exchange rate, an expansionary
  fiscal policy causes money supply to increase
  (via the central banks purchase of foreign
  assets) so that its even more effective in
  increasing output than under a floating rate.
• An contractionary fiscal policy causes money
  supply to decrease (via the central banks sale
  of foreign assets) so that its even more
  effective in reducing output than under a
  floating rate.

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Figure 17-3 Fiscal Expansion Under a Fixed
Exchange Rate
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Changes in the exchange rate

• A devaluation occurs when the central bank
  officially lowers the exchange value of the
  domestic currency.
• A revaluation occurs when the central bank
  officially raises the exchange value of the
  domestic currency.
• In either case, the central bank announces its
  willingness to trade domestic against foreign
  currency, in unlimited amounts, at the new
  exchange rate.

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Exchange rate policy of devaluation

• A devaluation increases output and thus money
  demand. To back up the exchange rate at its new
  fixed level, the central bank must buy foreign
  assets and expand the money supply.
• Devaluation causes a rise in output, a rise in
  official reserves, and a monetary expansion.

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Figure 17-4 Effect of a Currency Devaluation
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Why choose a devaluation?

• Devaluation allows the government to fight
  unemployment despite the lack of effective
  monetary policy.
• Devaluation improves the current account and
  reduces the risk of balance-of-payment crisis.
• Devaluation helps accumulate the central banks
  foreign reserves.

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Financing the BOP deficit under the fixed
exchange rate

• A BOP deficit is caused by
• either a home current account deficit not fully
  matched by net non-reserve capital inflows or
• a home current account surplus that falls short
  of net non-reserve capital outflows.
• A BOP deficit means the international payment gap
  that central banks must finance through reserve
  transactions (reducing foreign reserve assets or
  raising foreign reserve liabilities).

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Financing the BOP deficit under the fixed
exchange rate

• It is sometimes undesirable or infeasible to
  maintain the fixed exchange rate under the BOP
  deficit pressure.
• Running short on foreign reserves
• Facing high domestic unemployment
• Under this circumstances, the market could
  naturally expect a devaluation.

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Balance of payment crisis

• A balance of payment crisis is a sharp change in
  official foreign reserves sparked by a change in
  expectations about the future exchange rate.
• Capital flight refers to large and sudden private
  capital outflow and the resulting reserve loss.

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Balance of payment crisis

• A common cause for the currency crisis is for the
  central bank to finance the government budget
  deficit (buy government bonds) or financial
  sector deficit (lending to banks), which forces
  the central bank to sell foreign reserves to
  maintain the fixed exchange rate until the
  central bank loses its ability to do so.

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Figure 17-5 Capital Flight, the Money Supply,
and the Interest Rate
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Asias devaluations and depreciations from 1997
to 1998

• Cumulative change in the exchange rate measured
  by US/unit local currency.
• Indonesia (rupiah) -73.8 Korea, Rep. of (won)
  -36.2 Thailand (baht) -36.0 Malaysia
  (ringgit) -33.6 Philippines (peso) -33.0
  Taiwan (dollar) -13.8 Singapore (dollar)
  -11.6 Hong Kong (dollar) 0.0.

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Managed floating

• Unlike the fixed exchange rate, under which
  monetary policy is totally ineffective in
  affecting output, managed floating opens the
  possibility for the central bank to face a
  trade-off between domestic objectives and
  exchange rate stability.

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How fixed exchange rate responds to a BOP deficit
S1
E/
The distance ab reflects the BOP deficit at the
fixed exchange rate E/1.
S2
a
b
1
D2
D1

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How floating exchange rate responds to a BOP
deficit
S1
E/
The distance ab reflects the BOP deficit at the
fixed exchange rate E/1.
2
a
b
1
D2
D1

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How managed floating exchange rate responds to a
BOP deficit
S1
E/
The distance ab reflects the BOP deficit at the
fixed exchange rate E/1.
S2
1.4
a
b
1
D2
D1

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Perfect vs. imperfect asset substitutability

• Under perfect asset substitutability, different
  countries assets have the same expected returns
  in equilibrium at which the interest rate parity
  holds.
• Under imperfect asset substitutability, domestic
  assets may have different expected returns so
  that the interest rate parity no longer holds in
  general.

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Foreign exchange market equilibrium under
imperfect asset substitutability

• Under imperfect asset substitutability, a risk
  premium (?) measures the difference between the
  domestic interest rate and the expected domestic
  currency return on foreign assets.
• Formally,
• RR (Ee-E)/E ?.

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Foreign exchange market equilibrium under
imperfect asset substitutability

• The risk premium on domestic assets rises when
  the stock of domestic government bonds available
  to be held by the public (B) rises or when the
  central banks domestic assets (A) fall, and vice
  versa.
• Formally, ? ?(B-A), where ?() is an increasing
  function.

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Sterilized intervention under imperfect asset
substitutability

• Q Can the central bank affect the exchange rate
  without changing money market conditions?
• A No if under perfect asset substitutability
  but Yes if under imperfect asset substitutability

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Figure 17-6 Effect of a Sterilized Central Bank
Purchase of Foreign Assets under Imperfect Asset
Substitutability
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Sterilized intervention under imperfect asset
substitutability

• Sterilized purchases of foreign exchange cause
  the home currency to depreciate because the
  associated sale of domestic assets held by the
  central bank increases the exchange rate
  vulnerability.
• Similarly, sterilized sales of foreign exchange
  cause the home currency to appreciate.

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Summary

• When the central bank purchases (sells) foreign
  reserves, the money supply rises (falls) except
  the foreign exchange purchase (sale) is
  sterilized.
• The fixed exchange rate is backed up by the
  central banks willingness and ability to stand
  ready to trade unlimitedly in foreign exchange
  market.

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Summary

• Under the fixed exchange rate, monetary policy is
  ineffective, fiscal policy and exchange rate
  policy (devaluation or revaluation) are
  effective.
• Excessive money expansion may evolve into a
  balance of payment crisis under the fixed
  exchange rate.
• Managed float retains monetary autonomy and
  imperfect asset substitutability grants the
  sterilized foreign exchange intervention a
  control of both money supply and the exchange
  rate.