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Title: Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention ?????????


1
Chapter 17 Fixed Exchange Rates and Foreign
Exchange Intervention ?????????
2
Chapter 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

3
Chapter 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

4
Chapter 17
  • Balance Payments
  • Appendix IIIThe Timing of Balance of
  • Payments Crises

5
Chapter 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

6
Chapter 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.

7
Chapter 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 ????

8
Chapter 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 ????

9
Chapter 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

10
Chapter 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

11
Chapter 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

12
Chapter 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
13
Chapter 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.

14
Chapter 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.

15
Chapter 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
16
Chapter 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

17
Chapter 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
18
Chapter 17
Central Bank Intervention and the Money Supply
19
Chapter 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.

20
Chapter 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.

21
Chapter 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

22
Chapter 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

23
Chapter 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

24
Chapter 17
Figure 17-1 Asset Market Equilibrium with a
Fixed Exchange Rate, EO
25
Chapter 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

26
Chapter 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 .

27
Chapter 17
Figure 17-2 Monetary Expansion Is Ineffective
Under a Fixed Exchange Rate
28
Chapter 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

29
Chapter 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

30
Chapter 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

31
Chapter 17
Figure 17-3 Fiscal Expansion Under a Fixed
Exchange Rate
32
Chapter 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 .

33
Chapter 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

34
Chapter 17
Figure 17-4 Effect of a Currency Devaluation
35
Chapter 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

36
Chapter 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.

37
Chapter 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

38
Chapter 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

39
Chapter 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

40
Chapter 17
Figure 17-5 Capital Flight, the Money Supply,
and the Interest Rate
41
Chapter 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.

42
Chapter 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

43
Chapter 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.

44
Chapter 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

45
Chapter 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

46
Chapter 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

47
Chapter 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

48
Chapter 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.

49
Chapter 17
Figure 17-6 Effect of a Sterilized Central Bank
Purchase of Foreign Assets under Imperfect Asset
Substitutability
50
Chapter 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.

51
Chapter 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.

52
Chapter 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.

53
Chapter 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

54
Chapter 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

55
Chapter 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.

56
Chapter 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

57
Chapter 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.

58
Chapter 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

59
Chapter 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.

60
Chapter 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.

61
Figure 17AI-1 The Demand Bond Supply and the
Foreign Exchange Risk premium Under Imperfect
asset Substitutability
Chapter 17
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