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Fixed Exchange Rates and Foreign Exchange Intervention

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Title: Fixed Exchange Rates and Foreign Exchange Intervention


1
Fixed Exchange Rates and Foreign Exchange
Intervention
  • Chapter 18 Krugman and Obstfeld 9e
  • ECO41 International Economics
  • Udayan Roy

2
Why Study Fixed Exchange Rates?
  • 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

3
Central Bank Interventionand the Money Supply
  • The Central Bank owns two types of assets
  • Foreign assets
  • Mainly foreign currency bonds owned by the
    central bank (its official international
    reserves)
  • Domestic assets
  • Central bank holdings of claims to future
    payments by its own citizens and domestic
    institutions

4
Central Bank Interventionand the Money Supply
  • Any central bank purchase of assets automatically
    results in an increase in the domestic money
    supply.
  • Example If the US central bank (The Fed) buys
    Yen, it must pay for the Yen with newly printed
    dollars. Therefore, the US money supply (MUS)
    must increase

5
Central Bank Interventionand the Money Supply
  • Any central bank sale of assets automatically
    causes the money supply to decrease.
  • Example If the Fed sells its Yen reserves, the
    dollars paid by the buyer will no longer be in
    circulation. Therefore, the US money supply (MUS)
    must decrease
  • In short, a countrys reserves of foreign
    currencies moves in the same direction as its
    money supply

6
How Can Central Banks Keep Exchange Rates Fixed?
  • Simple!
  • When the value of the dollar starts to fall
    against the euro (that is, E starts to increase),
    a central bank (such as the US Fed) could push it
    back up
  • How? The Fed could sell euros from its reserves
    in exchange for dollars.
  • This will create an abundance of euros and a
    shortage of dollars and thereby reverse the fall
    in the dollars value.
  • Recall from the last slide that this decrease in
    US reserves of Euros must be accompanied by a
    decrease in US money supply.

Warning This strategy will not work if the Fed
runs out of Euros!
7
How Can Central Banks Keep Exchange Rates Fixed?
  • On the other hand, when the value of the dollar
    starts to rise against the euro (that is, E
    starts to fall), a central bank (such as the US
    Fed) could pull it back down
  • How? The Fed could buy euros with freshly printed
    dollars.
  • This will create an shortage of euros and a flood
    of dollars and thereby reverse the rise in the
    dollars value.
  • Recall from the last slide that this increase in
    US reserves of Euros must be accompanied by an
    increase in US money supply.

8
How Can Central Banks Keep Exchange Rates Fixed?
  • To summarize, a central bank can
  • raise the value of the domestic currency (E?) by
    reducing the money supply (Ms?)
  • reduce the value of the domestic currency (E?) by
    increasing the money supply (Ms?)
  • In this way, the central bank can keep the
    exchange rate fixed at the desired level, as long
    as it does not run out of foreign currency

9
Foreign Exchange Market Equilibrium Under a Fixed
Exchange Rate
  • Recall that the foreign exchange market is in
    equilibrium when R R (Ee E)/E
  • When the central bank fixes E at E0, the expected
    rate of domestic currency depreciation is zero
    (Ee E)/E 0.
  • Therefore, R R.
  • Under fixed exchange rates, the domestic interest
    rate is tied to the foreign interest rate.

10
Goods Market Equilibrium
  • Equilibrium is achieved in the goods market when
    the value of output Y equals aggregate demand D.
  • Y D(EP/P, Y T, I, G)
  • Note that P and P are fixed in the short run,
    that T, I, and G are exogenous and fixed, and
    that E is fixed after all, this is a fixed
    exchange rate system!
  • So, only Y can vary and only Y can ensure goods
    market equilibrium
  • Therefore, this equation determines the
    equilibrium value of Y.

11
Goods Market Equilibrium
  • We saw in Chapter 17 that
  • the goods markets equilibrium equation gives us
    the upward rising DD curve, and that
  • The DD curve shifts right if
  • G increases
  • T decreases
  • I increases
  • P decreases
  • P increases
  • C increases for some unknown reason
  • CA increases for some unknown reason

12
Goods Market Equilibrium
  • In this chapter, the exchange rate is fixed
  • So, whatever shifts DD right must also increase Y
  • The DD curve shifts right if
  • G increases
  • T decreases
  • I increases
  • P decreases
  • P increases
  • C increases for some unknown reason
  • CA increases for some unknown reason
  • Moreover, if the fixed level of E?, then Y?

13
Goods Market Equilibrium
Y

I, G
T -
C (other reasons)
CA (other reasons)
Note that an increase in the (fixed) value of the
foreign currency raises output. Such a
policywhich could be very useful in a
recessionis called a devaluation.
Among the CA (other reasons) factors would be
tariffs or other protectionist policies. The
theory suggests that such policies could also
help boost output so long as other countries
dont retaliate.
14
Goods Market Equilibrium
  •  

15
Goods Market Equilibrium
  •  

16
Goods Market Equilibrium
  •  

17
Goods Market Equilibrium
Y CA

I, G -
T -
C (other reasons)
CA (other reasons)
Note that, as under flexible exchange rates,
contractionary fiscal policies (fiscal
austerity or belt tightening) can raise a
countrys current account balance in the short
run. So can protectionist policies such as
tariffs and quotas.
18
Money Market Equilibrium Under a Fixed Exchange
Rate
  • Equilibrium in the money market requires
  • MS/P L(R, Y)
  • But equilibrium in the foreign exchange market
    determines R (R) and equilibrium in the goods
    market determines Y.
  • Therefore, L(R, Y) is already determined.
  • Moreover, P is exogenous and fixed in the short
    run.
  • So, this equation determines the equilibrium
    level of the money supply (Ms)

19
Monetary Policy Is Useless in a Fixed Exchange
Rate System
  • Under a fixed exchange rate, central bank
    monetary policy tools are powerless to affect the
    economys money supply or its output.

20
The DD and AA curves recap
  • Although Chapter 17 was about the flexible
    exchange rate system, the DD and AA curves
    introduced there continue to apply to the
    discussion of fixed exchange rates.
  • Just remember what we saw a few slides earlier E
    can be increased (decreased) by increasing
    (decreasing) Ms

21
Shifting the DD and AA Curves
  • The DD curve shifts right if
  • G increases
  • T decreases
  • I increases
  • P decreases
  • P increases
  • C increases for some unknown reason
  • CA increases for some unknown reason
  • The AA curve shifts right if
  • Ms increases
  • P decreases
  • Ee rises
  • R rises
  • L decreases for some unknown reason

22
Fig. 18-2 Monetary Expansion Is Ineffective
Under a Fixed Exchange Rate
The economys short-run equilibrium as point 1
when the central bank fixes the exchange rate at
the level E0.
An increase in Ms shifts AA right. This threatens
to raise E above E0. The central bank must
hastily reverse itself and decrease Ms in order
to keep E fixed. Monetary policy cannot work!
The result will be equally inconsequential if Ee
rises, R rises, or L falls.
23
Fiscal Policy is Very Effective in a Fixed
Exchange Rate System
  • How does the central bank intervention hold the
    exchange rate fixed after the fiscal expansion
    (G? and/or T?)?
  • The rise in output due to expansionary fiscal
    policy raises money demand.
  • To prevent an increase in the home interest rate
    and an appreciation of the currency, the central
    bank must buy foreign assets with money (i.e.,
    increasing the money supply).

24
Shifting the DD and AA Curves
  • The DD curve shifts right if
  • G increases
  • T decreases
  • I increases
  • P decreases
  • P increases
  • C increases for some unknown reason
  • CA increases for some unknown reason
  • The AA curve shifts right if
  • Ms increases
  • P decreases
  • Ee rises
  • R rises
  • L decreases for some unknown reason

25
Fig. 18-3 Fiscal Expansion Under a Fixed
Exchange Rate
A fiscal expansion shifts the DD curve to the
right, threatening to decrease E. To keep E
fixed, the AA curve must be moved to the right,
usually by increasing the money supply. As a
result the overall effectiveness of fiscal policy
is greater than under flexible exchange rates. As
under flexible exchange rates, expansionary
fiscal policies reduce net exports (CA).
26
It Might Help to Adjust the Fixed Exchange Rate
From Time to Time
  • Devaluation
  • It occurs when the central bank raises the
    domestic currency price of the foreign currency,
    E.
  • It causes
  • A rise in output
  • A rise in official reserves
  • An expansion of the money supply
  • It is chosen by governments to
  • Fight domestic unemployment
  • Improve the current account
  • Affect the central bank's foreign reserves

27
It Might Help to Adjust the Fixed Exchange Rate
From Time to Time
  • Revaluation
  • It occurs when the central bank lowers E.
  • In order to devalue or revalue, the central bank
    has to announce its willingness to trade domestic
    against foreign currency, in unlimited amounts,
    at the new exchange rate.

28
Shifting the DD and AA Curves
  • The DD curve shifts right if
  • G increases
  • T decreases
  • I increases
  • P decreases
  • P increases
  • C increases for some unknown reason
  • CA increases for some unknown reason
  • The AA curve shifts right if
  • Ms increases
  • P decreases
  • Ee rises
  • R rises
  • L decreases for some unknown reason

29
Fig. 18-4 Effect of a Currency Devaluation
If a devaluation from E0 to E1 is to be achieved,
the equilibrium value of E must be made to rise
to E1. This can be done by increasing the money
supply and moving the AA curve to the right. So,
devaluation raises GDP and reduces unemployment
and is, therefore, a tempting policy option in a
recession. This increases net exports (CA).
30
Shifting the DD and AA Curves
  • The DD curve shifts right if
  • G increases
  • T decreases
  • I increases
  • P decreases
  • P increases
  • C increases for some unknown reason
  • CA increases for some unknown reason
  • The AA curve shifts right if
  • Ms increases
  • P decreases
  • Ee rises
  • R rises
  • L decreases for some unknown reason

31
Fig. 18-4 Effect of the Expectation of a
Currency Devaluation
If a devaluation (an increase in E) is widely
expected, there is an increase in Ee. As a
result, the AA curve shifts right. To keep E
fixed, the central bank must sell its foreign
currency reserves and thereby reduce the domestic
money supply and bring the AA curve back to where
it was. So, the mere expectation of a
devaluation may cause the central bank to lose a
lot of its reserves. If its reserves are
inadequate, the central bank may be forced to
devalue or to simply switch to flexible exchange
rates.
32
Balance of Payments Crises and Capital Flight
  • Balance of payments crisis
  • It is a sharp fall in official foreign reserves
    sparked by a change in expectations about the
    future exchange rate.

33
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
  • An expected revaluation causes the opposite
    effects of an expected devaluation.

34
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.
  • 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.
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