International Economics – Chapter 18: Fixed Exchange Rates and Foreign Exchange Intervention

Vocabulary flashcards covering key terms and concepts from Chapter 18 on fixed exchange rates, central-bank intervention, balance-of-payments crises, and fixed-rate systems.

Central Bank Balance Sheet

A double-entry record listing a central bank’s assets (foreign bonds, gold, domestic bonds, loans) and liabilities (bank deposits, currency in circulation).

Foreign Exchange Intervention

Central-bank purchase or sale of foreign assets to influence the exchange rate and money supply.

Non-sterilized Intervention

Forex intervention that is NOT offset by opposing domestic bond transactions; it changes the money supply.

Sterilization

Central-bank sale or purchase of domestic bonds to offset the money-supply impact of a foreign-asset transaction.

Fixed (Pegged) Exchange Rate

A policy in which the central bank commits to keep the domestic currency’s price against a foreign currency constant by trading assets.

Managed Float

A ‘flexible’ exchange-rate regime in which the central bank occasionally intervenes to dampen volatility.

Official International Reserves

Foreign government bonds, gold, and other reserve assets held by a central bank for intervention purposes.

Domestic Assets (Central Bank)

Primarily domestic government bonds and loans to banks held by the central bank.

Money-Supply Effect of Asset Purchase

Buying any asset (domestic or foreign) creates new central-bank liabilities, increasing the money supply.

Money-Supply Effect of Asset Sale

Selling any asset withdraws central-bank liabilities, shrinking the money supply.

Sterilized Forex Purchase

Buy foreign bonds (↑ foreign assets) + sell domestic bonds (↓ domestic assets) → no net change in money supply.

Sterilized Forex Sale

Sell foreign bonds + buy domestic bonds → money supply unchanged.

Asset Market Equilibrium Condition

Under a credible peg, expected domestic and foreign returns are equal: R = R* when E is fixed.

Interest-Rate Parity with Risk Premium

R = R* + ρ when domestic assets carry extra default or exchange-rate risk (ρ).

Risk Premium (ρ)

Additional return investors demand to hold riskier domestic assets; reflects default and exchange-rate risk.

Default Risk

Possibility that borrowers in a country will fail to make loan payments, raising required interest rates.

Exchange-Rate Risk

Uncertainty that the domestic currency will be devalued or depreciate, raising required interest on domestic assets.

Perfect Substitutes

Condition where domestic and foreign deposits are viewed as identical in risk and liquidity; R = R*.

Imperfect Asset Substitutability

Situation where differences in risk/liquidity make investors require a risk premium; domestic and foreign assets are not perfect substitutes.

Monetary Policy under a Peg

Ineffective for output/employment; any attempt to change M is offset by intervention to keep the exchange rate fixed.

Fiscal Policy under a Peg (Short Run)

Expansionary fiscal policy raises output; the central bank buys foreign assets to prevent appreciation, reinforcing the stimulus.

Fiscal Policy under a Peg (Long Run)

Price level rises, real appreciation occurs, DD shifts left, and output returns to potential despite the initial fiscal boost.

Devaluation

Official lowering of the fixed exchange rate; more domestic currency units per unit of foreign currency.

Revaluation

Official increase in the fixed exchange rate; fewer domestic currency units per unit of foreign currency.

Depreciation vs. Devaluation

Depreciation is a market-driven fall in currency value; devaluation is a policy-driven fall under a peg.

Appreciation vs. Revaluation

Appreciation is a market-driven rise in currency value; revaluation is a policy-driven rise under a peg.

Effects of Devaluation

Central bank buys foreign assets → ↑ money supply, ↓ interest rate, currency cheaper, exports more competitive, output rises.

Balance of Payments Crisis

Occurs when a central bank lacks reserves to defend the peg; often ends in devaluation.

Capital Flight

Rapid shift of investors from domestic to foreign assets due to fears of devaluation, shrinking reserves and money supply.

Self-fulfilling Crisis

Expectations of devaluation cause reserve losses and high rates, forcing the very devaluation that investors feared.

Reserve Currency System

Fixed-rate arrangement where one currency (e.g., US dollar 1944-1973) serves as the main reserve asset for other central banks.

Gold Standard

System in which currencies are convertible into gold at fixed prices; gold serves as the ultimate reserve asset.

Bimetallic Standard

Historical regime where both gold and silver defined the currency’s value (e.g., U.S. 1837-1861).

Official Intervention Constraint

Central bank must have sufficient reserves to meet market demand at the peg; otherwise, the peg collapses.

Figure 18.1 Insight

When output rises, the central bank must buy foreign assets, expanding M to keep E fixed and R = R*.

Sterilized Purchase under Imperfect Substitutability

With risk premiums, sterilized buying of foreign assets can still depreciate the currency by altering perceived risk and asset mix.

Interest-Rate Differential

Gap R – R* driven by risk premium when assets are not perfect substitutes.

Managed Peg Tools

Central bank uses foreign-asset trades, sterilization, and sometimes capital controls to maintain the target rate.

Official Reserve Adequacy

Level of foreign reserves sufficient to intervene credibly; inadequate reserves trigger speculative attacks.

International Reserve Growth Trend

IMF data show reserve holdings continued to grow after the 1970s, especially in developing economies.

Currency Composition of Reserves

Share of global reserves held in each major currency; USD dominant, euro substantial, others minor.

Gold Standard – Pros

Provides exchange-rate stability and limits money-supply expansion, disciplining monetary authorities.

Gold Standard – Cons

Restricts monetary policy during recessions, ties money supply to gold discoveries, benefits gold-rich countries.

Devaluation vs. Monetary Expansion under Peg

Devaluation raises output by changing E, whereas pure monetary expansion is neutral because E is fixed.

Central Bank Intervention Channels

Trades of domestic bonds, foreign bonds, gold, and changes in discount loans affect reserves, rates, and money supply.