Microsoft PowerPoint – C18_ECON7520_week6
Chapter 18
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Fixed Exchange Rates and
Foreign Exchange Intervention
Instructor:
Learning Objectives
18.1 Understand how a central bank must manage monetary
policy so as to fix its currency’s value in the foreign exchange
18.2 Describe and analyze the relationship among the central
bank’s foreign exchange reserves, its purchases and sales in
the foreign exchange market, and the money supply.
18.3 Explain how monetary, fiscal, and sterilized intervention
policies affect the economy under a fixed exchange rate.
18.4 Discuss causes and effects of balance of payments crises.
18.5 Describe how alternative multilateral systems for pegging
exchange rates work
• Balance sheets of central banks
• Intervention in the foreign exchange markets and the
money supply
• How the central bank fixes the exchange rate
• Monetary and fiscal policies under fixed exchange rates
• Financial market crises and capital flight
• Types of fixed exchange rates: reserve currency and
gold standard systems
Introduction
• Many countries try to fix or “peg” their exchange rate to a
currency or group of currencies by intervening in the foreign
exchange markets.
• Many with a flexible or “floating” exchange rate in fact
practice a managed floating exchange rate.
– The central bank “manages” the exchange rate from time
to time by buying and selling currency and assets,
especially in periods of exchange rate volatility.
• How do central banks intervene in the foreign exchange
Central Bank Intervention and the Money Supply
• To study the effects of central bank intervention in the
foreign exchange markets, first construct a simplified
balance sheet for the central bank.
– This records the assets and liabilities of a central
– Balance sheets use double-entry bookkeeping: each
transaction enters the balance sheet twice.
Central Bank’s Balance Sheet (1 of 2)
– Foreign government bonds (official international reserves)
– Gold (official international reserves)
– Domestic government bonds
– Loans to domestic banks (called discount loans in United
• Liabilities
– Deposits of domestic banks
– Currency in circulation (previously central banks had to
give up gold when citizens brought currency to exchange)
Central Bank’s Balance Sheet (2 of 2)
• Assets = Liabilities + Net Worth
– If assume that net worth is constant, then
▪ An increase in assets leads to an equal increase in
liabilities.
▪ A decrease in assets leads to an equal decrease in
liabilities.
• Changes in the central bank’s balance sheet lead to changes
in currency in circulation or changes in deposits of banks,
which lead to changes in the money supply.
– If their deposits at the central bank increase, banks are
usually able to use these additional funds to lend to
customers, so amount of money in circulation increases.
Assets, Liabilities, and the Money
Supply (1 of 2)
• A purchase of any asset by the central bank will be paid
for with currency or a check written from the central bank,
– both of which are denominated in domestic currency,
– both of which increase the supply of money in
circulation.
– The transaction leads to equal increases of assets and
liabilities.
• When the central bank buys domestic bonds or foreign
bonds, the domestic money supply increases.
Assets, Liabilities, and the Money
Supply (2 of 2)
• A sale of any asset by the central bank will be paid for
with currency or a check written to the central bank,
– both of which are denominated in domestic currency.
– The central bank puts the currency into its vault or
reduces the amount of deposits of banks,
– causing the supply of money in circulation to shrink.
– The transaction leads to equal decreases of assets
and liabilities.
• When the central bank sells domestic bonds or foreign
bonds, the domestic money supply decreases.
Foreign Exchange Markets
• Central banks trade foreign government bonds in the
foreign exchange markets.
– Foreign currency deposits and foreign government
bonds are often substitutes: both are fairly liquid
assets denominated in foreign currency.
– Quantities of both foreign currency deposits and
foreign government bonds that are bought and sold
influence the exchange rate.
Sterilization
• Because buying and selling of foreign bonds in the
foreign exchange markets affects the domestic money
supply, a central bank may want to offset this effect.
• This offsetting effect is called sterilization.
• If the central bank sells foreign bonds in the foreign
exchange markets, it can buy domestic government
bonds in bond markets—hoping to leave the amount of
money in circulation unchanged.
Table 18.1 Effects of a $100 Foreign
Exchange Intervention: Summary
Domestic Central
Bank’s Action
Effect on Domestic
Money Supply
Effect on Central
Bank’s Domestic
Effect on Central
Bank’s Foreign Assets
Nonsterilized foreign
exchange purchase
+$100 0 +$100
Sterilized foreign
exchange purchase
Negative $100
Nonsterilized foreign
exchange sale
Negative $100
Negative $100
Sterilized foreign
exchange sale
Negative $100
$100 $100
Fixed Exchange Rates (1 of 4)
• To fix the exchange rate, a central bank influences the quantities
supplied and demanded of currency by trading domestic and foreign
assets, so that the exchange rate (the price of foreign currency in
terms of domestic currency) stays constant.
• Foreign exchange markets are in equilibrium when
• When the exchange rate is fixed at some level 0E and the
market expects it to stay fixed at that level, then
Fixed Exchange Rates (2 of 4)
• To fix the exchange rate, the central bank must trade foreign
and domestic assets in the foreign exchange market until
• Alternatively, we can say that it adjusts the quantity of
monetary assets in the money market until the domestic
interest rate equals the foreign interest rate, given the level
of average prices and real output:
Fixed Exchange Rates (3 of 4)
• Suppose that the central bank has fixed the exchange
rate at 0E but the level of output rises, raising the
demand of real monetary assets.
• This is predicted to put upward pressure on interest rates
and the value of the domestic currency.
• How should the central bank respond if it wants to fix
exchange rates?
Fixed Exchange Rates (4 of 4)
• The central bank should buy foreign assets in the foreign
exchange markets,
– thereby increasing the domestic money supply,
– thereby reducing interest rates in the short run.
– Alternatively, by demanding (buying) assets
denominated in foreign currency and by supplying
(selling) domestic currency, the price/value of foreign
currency is increased and the price/value of domestic
currency is decreased.
Figure 18.1 Asset Market Equilibrium
With a Fixed Exchange Rate, E sub 0 0E
To hold the exchange rate fixed at 0E when output rises from 1 2 to ,Y Y the central
bank must purchase foreign assets and thereby raise the money supply from 1 2 to .M M
Monetary Policy and Fixed Exchange Rates
• When the central bank buys and sells foreign assets to
keep the exchange rate fixed and to maintain domestic
interest rates equal to foreign interest rates, it is not able
to adjust domestic interest rates to attain other goals.
– In particular, monetary policy is ineffective in
influencing output and employment.
Figure 18.2 Monetary Expansion Is Ineffective
Under a Fixed Exchange Rate
Initial equilibrium is shown at point 1, where the output and asset markets simultaneously
clear at a fixed exchange rate of 0E and an output level of 1.Y Hoping to increase output to
2,Y the central bank decides to increase the money supply by buying domestic assets and
shifting 1 2 to .AA AA Because the central bank must maintain 0,E however, it has to sell
foreign assets for domestic currency, an action that decreases the money supply
immediately and returns 2 1 back to .AA AA The economy’s equilibrium therefore remains at
point 1, with output unchanged at 1.Y
Fiscal Policy and Fixed Exchange Rates in the
• Temporary changes in fiscal policy are more effective in
influencing output and employment in the short run:
– The rise in aggregate demand and output due to
expansionary fiscal policy raises demand for real
monetary assets, putting upward pressure on interest
rates and on the value of the domestic currency.
– To prevent an appreciation of the domestic currency,
the central bank must buy foreign assets, thereby
increasing the money supply and decreasing interest
Figure 18.3 Fiscal Expansion Under a Fixed
Exchange Rate
Fiscal expansion (shown by the shift from 1 2 ) to DD DD and the
intervention that accompanies it (the shift from 1 2 ) to AA AA move the
economy from point 1 to point 3.
Fiscal Policy and Fixed Exchange Rates
in the Long Run (1 of 2)
• When the exchange rate is fixed, there is no real appreciation of the
value of domestic products in the short run.
• But when output is above its potential level, wages and prices tend
to rise in the long run.
• A rising price level makes domestic products more expensive:
a real appreciation falls .
– Aggregate demand and output decrease as prices rise: DD
curve shifts left.
– Prices tend to rise until employment, aggregate demand, and
output fall to their normal (potential or natural) levels.
Fiscal Policy and Fixed Exchange Rates
in the Long Run (2 of 2)
• Prices are predicted to change proportionally to the
change in the money supply when the central bank
intervenes in the foreign exchange markets.
– AA curve shifts down (left) as prices rise.
– Nominal exchange rates will be constant (as long as
the fixed exchange rate is maintained), but the real
exchange rate will be lower (a real appreciation).
Devaluation and Revaluation
• Depreciation and appreciation refer to changes in the
value of a currency due to market changes.
• Devaluation and revaluation refer to changes in a fixed
exchange rate caused by the central bank.
– With devaluation, a unit of domestic currency is made
less valuable, so that more units must be exchanged
for 1 unit of foreign currency.
– With revaluation, a unit of domestic currency is made
more valuable, so that fewer units need to be
exchanged for 1 unit of foreign currency.
Devaluation
• For devaluation to occur, the central bank buys foreign
assets, so that domestic monetary assets increase and
domestic interest rates fall, causing a fall in the rate
return on domestic currency deposits.
– Domestic products become less expensive relative to
foreign products, so aggregate demand and output
– Official international reserve assets (foreign bonds)
Figure 18.4 Effect of a Currency Devaluation
When a currency is devalued from 0 1 to ,E E the economy’s
equilibrium moves from point 1 to point 2 as both output and the money
supply expand.
Financial Crises and Capital Flight (1 of 6)
• When a central bank does not have enough official
international reserve assets to maintain a fixed exchange
rate, a balance of payments crisis results.
– To sustain a fixed exchange rate, the central bank
must have enough foreign assets to sell in order to
satisfy the demand of them at the fixed exchange
Financial Crises and Capital Flight (2 of 6)
• Investors may expect that the domestic currency will be
devalued, causing them to want foreign assets instead of
domestic assets, whose value is expected to fall soon.
1. This expectation or fear only makes the balance of
payments crisis worse:
– Investors rush to change their domestic assets into
foreign assets, depleting the stock of official
international reserve assets more quickly.
Financial Crises and Capital Flight (3 of 6)
2. As a result, financial capital is quickly moved from domestic assets
to foreign assets: capital flight.
– The domestic economy has a shortage of financial capital for
investment and has low aggregate demand.
3. To avoid this outcome, domestic assets must offer high interest
rates to entice investors to hold them.
– The central bank can push interest rates higher by reducing the
money supply (by selling foreign and domestic assets).
4. As a result, the domestic economy may face high interest rates, a
reduced money supply, low aggregate demand, low output, and low
employment.
Figure 18.5 Capital Flight, the Money Supply, and
the Interest Rate
To hold the exchange rate fixed at 0E after the market decides it will be devalued
to 1,E the central bank must use its reserves to finance a private financial
outflow that shrinks the money supply and raises the home interest rate.
Financial Crises and Capital Flight (4 of 6)
• Expectations of a balance of payments crisis only worsen
the crisis and hasten devaluation.
– What causes expectations to change?
▪ Expectations about the central bank’s ability and
willingness to maintain the fixed exchange rate.
▪ Expectations about the economy: shrinking
demand of domestic products relative to foreign
products means that the domestic currency should
become less valuable.
• In fact, expectations of devaluation can cause a
devaluation: a self-fulfilling crisis.
Financial Crises and Capital Flight (5 of 6)
• What happens if the central bank runs out of official
international reserve assets (foreign assets)?
• It must devalue the domestic currency so that it takes more
domestic currency (assets) to exchange for 1 unit of foreign
currency (asset).
– This will allow the central bank to replenish its foreign
assets by buying them back at a devalued rate,
– increasing the money supply,
– reducing interest rates,
– reducing the value of domestic products,
– increasing aggregate demand, output, and employment
over time.
Financial Crises and Capital Flight (6 of 6)
• In a balance of payments crisis,
– the central bank may buy domestic bonds and sell
domestic currency (to increase the money supply) to
prevent high interest rates, but this only depreciates
the domestic currency more.
– the central bank generally cannot satisfy the goals of
low domestic interest rates (relative to foreign interest
rates) and fixed exchange rates simultaneously.
Figure 18.6 The Swiss Franc’s Exchange Rate against the Euro and
Swiss Foreign Exchange Reserves, 2006–2016
The Swiss National Bank intervened heavily to slow the Swiss franc’s appreciation
against the euro, setting a floor under the price of the euro in September 2011 and
abandoning that floor in January 2015.
Source: Swiss National Bank.
Interest Rate Differentials (1 of 3)
• For many countries, the expected rates of return are not
• Default risk:
The risk that the country’s borrowers will default on their loan
repayments. Lenders therefore require a higher interest rate to
compensate for this risk.
• Exchange rate risk:
If there is a risk that a country’s currency will depreciate or be
devalued, then domestic borrowers must pay a higher interest
rate to compensate foreign lenders.
Interest Rate Differentials (2 of 3)
• Because of these risks, domestic assets and foreign assets
are not treated the same.
– Previously, we assumed that foreign and domestic
currency deposits were perfect substitutes: deposits
everywhere were treated as the same type of investment,
because risk and liquidity of the assets were assumed to
be the same.
– In general, foreign and domestic assets may differ in the
amount of risk that they carry: they may be imperfect
substitutes.
– Investors consider these risks, as well as rates of return on
the assets, when deciding whether to invest.
Interest Rate Differentials (3 of 3)
• A difference in the risk of domestic and foreign assets is
one reason why expected rates of return are not equal
across countries:
where is called a risk premium, an additional amount
needed to compensate investors for investing in risky
domestic assets.
• The risk could be caused by default risk or exchange rate
The Rescue Package: Reducing rho
• The United States and IMF set up a $50 billion fund to
guarantee the value of loans made to Mexico’s government,
– reducing default risk,
– and reducing exchange rate risk, since foreign loans could
act as official international reserves to stabilize the
exchange rate if necessary.
• After a recession in 1995, the economy began to recover.
– Mexican goods were relatively inexpensive, allowing
production to increase.
– Increased demand of Mexican products relative to demand
of foreign products stabilized the value of the peso and
reduced exchange rate risk.
Figure 18.7 Effect of a Sterilized Central Bank Purchase of Foreign
Assets Under Imperfect Asset Substitutability
A sterilized purchase of foreign assets leaves the money supply unchanged but raises the
risk-adjusted return that domestic currency deposits must offer in equilibrium. As a result,
the return curve in the upper panel shifts up and to the right. Other things equal,
this depreciates the domestic currency from 1 2 to .E E
Types of Fixed Exchange Rate Systems
1. Reserve currency system: one currency acts as
official international reserves
– The U.S. dollar was the currency that acted as official
international reserves from under the fixed exchange rate
system from 1944 to 1973.
– All countries except the United States held U.S. dollars as
the means to make official international payments.
2. Gold standard: gold acts as official international reserves
that all countries use to make official international payments.
Reserve Currency System
• From 1944 to 1973, central banks throughout the world fixed the value of
their currencies relative to the U.S. dollar by buying or selling domestic
assets in exchange for dollar denominated assets.
• Arbitrage ensured that exchange rates between any two currencies
remained fixed.
– Suppose Bank of Japan fixed the exchange rate at 360 ¥ US$1
and the Bank of France fixed the exchange rate at 5Ffr US$1.
– The yen/franc rate was
– If not, then currency traders could make an easy profit by buying
currency where it was cheap and selling it where it was expensive.
• Bimetallic standard: the value of currency is based on both silver
• The United States used a bimetallic standard from 1837 to 1861.
• Banks coined specified amounts of gold or silver into the national
currency unit.
– 371.25 grains of silver or 23.22 grains of gold could be turned
into a silver or a gold dollar
– So gold was worth 371.25 / 23.22 16 times as much as silver.
– See www.micheloud.com for a fun description of the bimetallic
standard, the gold standard after 1873, and the Wizard of Oz!
Figure 18.8 Growth Rates of International
Annualized growth rates of international reserves did not decline sharply after
the early 1970s. Recently, developing countries have added large sums to their
reserve holdings, but their pace of accumulation has slowed starting with the
crisis years of 2008–2009. The figure shows averages of annual growth rates.
Source: International Monetary Fund.
Figure 18.9 Currency Composition of
Global Reserve Holdings
While the euro’s role as a reserve currency increased during the first decade of its existence,
it has taken a hit after the euro crisis. The dollar remains the overwhelming favorite.
Source: International Monetary Fund, Currency Composition of Foreign Exchange Reserves
(COFER), a
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