Title: Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention ?????????
1Chapter 17 Fixed Exchange Rates and Foreign
Exchange Intervention ?????????
2Chapter 17
- Chapter Organization
- 1.Why Study Fixed Exchange Rates?
- 2.Central Bank Intervention and the Money
- Supply
- 3.How Central Bank Fixes the Exchange Rate
- 4.Stabilization Policies with a Fixed Exchange
- Rates
- 5.Balance of Payments Crises and Capital
- Flight
3Chapter 17
- 6.Managed Floating and Sterilized Intervention
- 7.Reserve Currencies in the World Monetary
- System
- 8.The Gold Standard
- Appendix IEquilibrium in the Foreign
- Exchange Market with Imperfect Asset
- Substitutability
- Appendix IIThe Monetary Approach to the
4Chapter 17
- Balance Payments
- Appendix IIIThe Timing of Balance of
- Payments Crises
5Chapter 17
- The Main Goals
- We study
- (1)how central banks intervene in the foreign
- exchange market to fix exchange rates
- and
- (2)how macroeconomic policies work when
- exchange rates are fixed
6Chapter 17
- This chapter will help us understand the role
- of central bank foreign exchange intervention
- in the determination of exchange rates under a
- system of managed floating.
- DefinitionManaged floating exchange rate
- is a system in which governments may
- attempt to moderate exchange rate
- movements without keeping exchange rates
- rigidly fixed.
7Chapter 17
- Key Point
- 1.managed floating exchange rates??????
- 2.central bank balance sheet ?????????
- 3.sterilized foreign exchange intervention ????
- ???
- 4.revaluation ??
- 5.devaluation ??
- 6.balance of payments crises ??????
- 7.capital flight ????
8Chapter 17
- 8.self-fulfilling currency crises ????????
- 9.perfect asset substitutability ??????
- 10.imperfect asset substitutability ???????
- 11.risk premium ????
- 12.signaling effect of foreign exchange
intervention ????????? - 13.reserve currency ????
- 14.gold standard???
- 15.gold exchange standard ????
9Chapter 17
- Why Study Fixed Exchange Rates?
- 1.Managed floating
- 2.Regional currency arrangements
- 3.Developing countries and countries in
transition - 4.Lessons of the past for the future
10Chapter 17
- The Policy of the Central Bank
- 1.Foreign Exchange Intervention????
- the sale or purchase of foreign assets
(international reserve) , that can change the
domestic money supply, gets to the target
exchange rate - 2.Open-Market Operation??????
- the sale or purchase of domestic assets, that
- can change the domestic money supply
11Chapter 17
- Central Bank Intervention and the Money Supply
- 1.The Central Bank Balance Sheet and the
- Money Supply
- (1)Changes in the central banks assets cause
- changes in the domestic money supply.
- The accompanying changes in the money
- supply is larger than the initial asset
sale
12Chapter 17
- or purchase through the money multiplier
- effect.
- (2)the central bank balance sheet
- the central bank balance sheet of Pecunia
- Central Bank Balance Sheet
Assets Liabilities
Foreign assets 1000 Domestic assets 1500 Deposits held by private banks 500 Currency in circulation 2000
13Chapter 17
- (3)assumptionThe central banks total
- assets equal its total liabilities plus its
net - worth(0).
- (4)central banks assets v.s. money supply
- Any central bank purchase of assets
- automatically results in an increase in
the - domestic money supply, while any central
- bank sale of assets automatically causes
- the money supply to decline.
14Chapter 17
- 2.Foreign Exchange Intervention and the money
supply - (1)an example The Bank of Pecunia goes
- to the foreign exchange market and sells
- 100 worth of foreign bonds for Pecunian
- money. Whether the Bank of Pecunia is
- paid with domestic currency or a check at
- the private domestic bank, there will be a
- fall in the domestic money supply.
15Chapter 17
- Central Bank Balance Sheet
Assets Liabilities
Foreign assets 900 Domestic assets 1500 Deposits held by private banks 500 Currency in circulation 1900
Assets Liabilities
Foreign assets 900 Domestic assets 1500 Deposits held by private banks 400 Currency in circulation 2000
16Chapter 17
- 3.Sterilization (foreign exchange intervention)
- (1)DefinitionCentral banks carry out equal
- foreign and domestic asset transactions
in - opposite direction to nullify the impact
of - their foreign exchange operations on the
- domestic money supply. Sterilization has
no - effect on the money supply.
- (2)Examplea 100 sale of foreign assets
- and a purchase of domestic assets
17Chapter 17
- Central Bank Balance Sheet before Sterilization
- Central Bank Balance Sheet after Sterilization
Assets Liabilities
Foreign assets 1000 Domestic assets 1500 Deposits held by private banks 500 Currency in circulation 2000
Assets Liabilities
Foreign assets 900 Domestic assets 1600 Deposits held by private banks 500 Currency in circulation 2000
18Chapter 17
Central Bank Intervention and the Money Supply
19Chapter 17
- 4.The Balance of Payments and the Money
- Supply
- (1)DefinitionThe balance of payments is the
sum of the current account and the nonreserve
component of the capital account, that is, the
international payments gap that central banks
must finance through their reserve transactions. -
20Chapter 17
- (2)ConclusionIf central banks are not
- sterilizing and the home country has a
- balance of payments surplus(deficit), any
- associated increase(decrease) in the home
- central banks foreign assets implies an
- increased(a decreased) home money supply.
- (3)The extent to which a measured balance of
- payments disparity will affect home and
- foreign money supplies is quite uncertain
in - practice.
21Chapter 17
- How the Central Bank Fixes
- the Exchange Rate
- 1.To hold the exchange rate constant, a central
bank must always be willing to trade currencies
at the fixed exchange rate with the private
actors in the foreign exchange market. - 2.The central bank can succeed in holding the
exchange rate fixed only if its financial
22Chapter 17
- transactions ensure that asset markets remain
- in equilibrium when the exchange rate is at
- its fixed level.
- 3.the conception
- fixing exchange rate (EEºEe , IRPRR)
- the foreign exchange market
equilibrium - determining R Ms / P L ( R,Y ), P,Y
given - the money market equilibrium
- affecting Ms intervening
23Chapter 17
- 4.questionWhat monetary measures keep the
current exchange rate constant given unchanged
expectations about the future rate when the
output rises suddenly ? - if Y L(R,Y) R
E - To prevent the appreciation of the home
- currency that would occur, the central
bank - must intervene in the foreign exchange
- market by buying foreign assets. Ms
24Chapter 17
Figure 17-1 Asset Market Equilibrium with a
Fixed Exchange Rate, EO
25Chapter 17
- Stabilization Policies with
- a Fixed Exchange Rate
- 1.Monetary Policy
- (1)ConclusionUnder a fixed exchange
- rate, central bank monetary policy tools
- are powerless to affect the economys
- money supply or its output.
- (2)an examplehoping to increase output
26Chapter 17
- Figure 17-2
- Hoping to increase output, the central bank
- decides to increase the money supply through
- a purchase of domestic assets. That will
push - AA1 rightward to AA2 . E and Y would rise.
- For holding the exchange rate fixed, the
- central bank sells foreign assets for
domestic - money. It makes AA² turn back to AA1 .
27Chapter 17
Figure 17-2 Monetary Expansion Is Ineffective
Under a Fixed Exchange Rate
28Chapter 17
- (3)Because any increase in the domestic money
- supply will cause the domestic currency
to - depreciate, the central bank must
continue - selling foreign assets until the money
supply - has returned to its original level to
keep - RR fixed.
- (4)the resultdomestic assets increase, foreign
- assets (international reserve) decrease
29Chapter 17
- 2.Fiscal Policy
- (1)ConclusionUnder a fixed exchange
- rate, governments fiscal policy tools
- are powerful to affect the economys
- money supply or its output.
- (2)an examplehoping to increase output
- G or T Y L(R,Y)
R E - DD1 rightward to DD²
- Figure 17-3
30Chapter 17
- For holding the exchange rate fixed, the
- central bank buys foreign assets for
domestic - money. It makes AA1 rightward to AA².
- (3)the resultthe money supply and output rise
- foreign assets (international reserve)
increase -
31Chapter 17
Figure 17-3 Fiscal Expansion Under a Fixed
Exchange Rate
32Chapter 17
- 3.Changes in the Exchange Rate
- (1)policy
- The central bank announces to trade
domestic - against foreign currency at the new
exchange - rate
- devaluationrising E
- revaluationfalling E
- (2)exampledevaluation
- A rise in the level of the fixed exchange
rate, - from Eº to E¹ .
33Chapter 17
- Figure 17-4
- announce E CA D
Y - Output moves on the DD schedule , from
- point 1 to point 2.
- Y L(R,Y) R
E - For holding the new exchange rate fixed at
E¹, - the central bank buys foreign assets for
domestic - money. It makes AA1 rightward to AA².
- (3)the result the money supply and output
rise - foreign assets increase
34Chapter 17
Figure 17-4 Effect of a Currency Devaluation
35Chapter 17
- 4.Adjustment to Fiscal Policy and Exchange Rate
Changes - (1)Suppose the economy is initially at full
- employment.
- (2)fiscal expansion
- It rises output over its full employment
level - causes, and that causes P to begin rising.
As P - rises, aggregate demand falls, returning
output - to the full-employment level. Regardless
of
36Chapter 17
- whether the exchange rate is floating or
fixed, - the real exchange rate appreciates in the
long - run. A rise in P is rather than a fall in
E. - (3)The adjustment to a devaluation is similar
to - the fiscal expansion. A devaluation under
a - fixed rate has the same long-run effect as
a - proportional increase in the money supply
- under a floating rate.
37Chapter 17
- Balance of Payments Crisis and Capital Flight
- 1.Balance of Payments Crisis
- (1)definitiona sharp change (fall) in
official - foreign reserves sparked by a change in
the - market expectations about future exchange
- rate (expect to depreciate)
- (2)evidencea sudden deterioration in the
- current account
38Chapter 17
- This evidence leads the foreign exchange
- market to expect the government to devalue
- in the future and adopt a new fixed
exchange - rate E¹ .
- Figure 17-5The change in the expectation
- of the future rate makes the curve of
expected - return on foreign currency shift rightward.
- The exchange rate would rise without any
- intervention. To maintain the fixed rate,
the
39Chapter 17
- domestic interest rate must rise to keep
the - foreign exchange equilibrium at point 2.
- Thus the central bank must sell foreign
assets - and shrink the domestic money supply from
- M¹ to M² for rising the domestic interest
rate. - (3)If the expectation of devaluation remain,
the - central bank must sell its foreign assets
- continually. The large loss of the
official - reserves of the central bank is called a
40Chapter 17
Figure 17-5 Capital Flight, the Money Supply,
and the Interest Rate
41Chapter 17
- balance of payments crisis.
- 2.Capital Flight
- The reserve loss accompanying a devaluation
scare is often labeled capital flight because the
associated debit in the balance of payments
accounts is a private capital outflow. - 3. Self-Fulfilling Currency Crises
- A economy can be vulnerable to currency
- speculation without being in a bad shape that
- a collapse of its fixed exchange rate regime
- is inevitable.
42Chapter 17
- Managed Floating and Sterilized Intervention
- 1.The Role of the Sterilized Intervention
- (1)the trade-off
- Under managed floating monetary policy is
- influenced by exchange rate changes
without - being completely subordinate to the
require- - ments of a fixed rate. The central bank
faces - a trade-off between domestic objectives
such - as employment or the inflation rate and
43Chapter 17
- exchange rate stability.
- (2)Whether the sterilized intervention affects
- the money supply depends on the
- substitutability of assets.
- 2.Perfect Asset Substitutability and the
Ineffectiveness of Sterilized Intervention - (1)perfect asset substitutabilityInvestors
only - care the difference of the expected return
- between the currencies.
44Chapter 17
- (2)With perfect asset substitutability in the
- foreign exchange market, the exchange rate
- is determined so that the interest parity
- condition holds.
- (3)In a world of perfect asset
substitutability, - participants in the foreign exchange
market - care only about expected return since
these - rates are determined by monetary policy,
- actions such as sterilized intervention
that do
45Chapter 17
- not affect money supply also do not affect
the - exchange rate.
- 3.Foreign Exchange Market Equilibrium
- Under Imperfect Asset Substitutability
- (1)imperfect asset substitutability
- Investors care about the expected returns
and - relative risk between assets.
- a risk premium
46Chapter 17
- The risk premium on the domestic bonds
- rises when the private sectors net supply
- (B-A) rises. B is the stock of the
government - bonds. A is the domestic assets(bonds)
hold - of the central bank.
- (2)the adjusted interest parity condition
-
(17-2) - The relation between the risk premium and
47Chapter 17
- the central banks domestic assets holding
- allows the bank to affect the exchange
rate - through sterilized foreign exchange
- intervention.
-
- 4.The Effects of Sterilized Intervention with
- Imperfect Asset Substitutability
- (1)the risk premium is assumed not to depend
- on the exchange rate
48Chapter 17
- (2)Figure 17-6the effects of sterilized
purchase - of foreign assets with a sale domestic
assets by - the central bank
- the money supply is
unchanged -
- With imperfect asset substitutability
, even - sterilized purchases of foreign
exchange cause - the home currency to depreciate.
49Chapter 17
Figure 17-6 Effect of a Sterilized Central Bank
Purchase of Foreign Assets under Imperfect Asset
Substitutability
50Chapter 17
- 5.Evidence on the Effects of Sterilized
Intervention - 6.The Signaling Effects of Intervention
- If market participants are unsure about about
the future macroeconomic policies, sterilized
intervention may give an indication of the
central bank expects the exchange arte to move.
This signal can alter the markets view of the
future (expectations) and cause an immediate
exchange rate change.
51Chapter 17
- Reserve Currencies in the World Monetary System
- 1.The Reserve-Currency Fixed Rate System
- (1)DefinitionEach nations central bank fixes
- its currencys exchange rate against the
- reserve currency, the currency central
bank - hold in the their international
reserves, by - standing ready to trade domestic money
for - reserve assets at that rate.
52Chapter 17
- (2)the mechanics of a reserve currency standard
- The working of a reserve currency system
are - illustrated by the system based on the U.S.
- dollar set up at the end of World War II.
- Under the system, every central bank fixed
- the dollar exchange rate of its currency.
- Because each currencys dollar price was
- fixed by its central bank, the exchange
rate - between any two currencies was fixed.
53Chapter 17
- (3)the asymmetric position of the reserve
currency - The country holding the reserve currency
- occupies a special position because it
never has - to intervene in the foreign exchange
market. - The reason is that if the N-1 nonreserve
- currency countries fix their exchange
rates, - there is no exchange rate left for the
reserve - currency country to fix. The reserve
country - has the power to affect its own economy by
54Chapter 17
- using monetary policy. Other central banks
are - forced to relinquish monetary policy as a
- stabilization tool, and instead must
passively - import the monetary policy of the
reserve - center because of their commitment to peg
- their currencies to the reserve currency.
- 3.The Gold Standard
- (1)DefinitionUnder a gold standard, central
- banks peg the prices of their currencies
in
55Chapter 17
- terms of gold, and hold gold as official
- international reserves.
- (2)The heyday of the gold standard was
- between 1870 and 1914.
- (3)A countrys international reserves takes the
- form of gold.
- (4)Gold standard rules require each country to
- allow unhindered imports and exports of
- gold across its borders.
56Chapter 17
- (5)symmetric monetary adjustment under a gold
- standard
- Because of the inherent symmetry of a gold
- standard, no country in the system
occupies - a privileged position by being relieved of
the - commitment to intervene.
- (6)benefits and drawbacks of the gold standard
- benefitsymmetry and stability
- drawback(a)powerless of monetary policy
57Chapter 17
- (b)the relative price of gold and
other - goods and serves is fluctuated
largely - (c)the problem of the shortage of
gold - (d)the dominated position of the gold
- production country
- (7)the gold exchange standard
- Under a gold exchange standard central
- banks reserves consist of gold and
currencies - whose prices in terms of gold are fixed.
58Chapter 17
- Appendix I to Chapter 17
- Equilibrium in the Foreign Exchange Market with
Imperfect Asset Substitutability - 1.Demand of Private Sector
- (1)individual demand for domestic bonds
-
59Chapter 17
- (2)aggregate demand for domestic bonds
- 2.Supply of Private Sector
- SupplyB-A
- 3.Equilibrium
- Equilibrium occurs where the private sectors
- net demand for domestic currency bonds
- equals the net supply.
60Chapter 17
- Figure 17AI-1 shows the effect of a central
- bank sale of domestic assets that lowers
its - domestic asset holdings to A² lt A¹. The new
- equilibrium occurs at point 2, at a risk
- premium of ?² gt ?¹.
61Figure 17AI-1 The Demand Bond Supply and the
Foreign Exchange Risk premium Under Imperfect
asset Substitutability
Chapter 17