Fixed Exchange Rates & FX Intervention – Quick Review

Learning Objectives

• Manage monetary policy to maintain a fixed exchange rate.

• Link among FX reserves, central‐bank trades, and domestic money supply.

• Effects of monetary, fiscal, and sterilized interventions under pegs.

• Causes/effects of balance-of-payments crises & capital flight.

• Alternative multilateral peg systems (reserve-currency, gold, etc.).

Central-Bank Balance Sheet & Money Supply

• Assets: foreign bonds (reserves), gold, domestic bonds, bank loans.

• Liabilities: bank deposits, currency in circulation.

• Accounting identity: $\text{Assets}=\text{Liabilities}+\text{Net Worth}$ (net worth ≈ constant).

• Asset purchase ⇒ equal rise in assets & liabilities ⇒ $\uparrow M^{s}$.

• Asset sale ⇒ equal fall ⇒ $\downarrow M^{s}$.

• Table 18.1: Non-sterilized FX purchase raises $M^{s}$; sterilized offsets via opposite domestic-bond trade (neutral $M^{s}$).

FX Intervention & Sterilization

• FX trades change $M^{s}$ unless sterilized with opposite domestic-bond trade.

• Sterilization keeps $M^{s}$ constant; can still move exchange rate if assets are imperfect substitutes.

Mechanism of a Fixed Exchange Rate

• Goal: keep $E$ at target $E_{0}$.

• With perfect asset substitutability & stable expectations: $R = R^{*}$ (interest parity) and $E^{e}=E_{0}$.

• Central bank adjusts $M^{s}$ via FX trades so money-market equilibrium $\frac{M^{s}}{P}=L(R,Y)$ delivers $R=R^{*}$.

• Output ↑ ⇒ $\uparrow L(R,Y)$ ⇒ upward pressure on $R$ & $\downarrow E$; central bank buys foreign assets ⇒ $\uparrow M^{s}$ to restore $R=R^{*},E=E_{0}$.

Policy Effectiveness Under Pegs

• Monetary policy: ineffective. Any autonomous $\uparrow M^{s}$ triggers FX sales that drain $M^{s}$ back; output unchanged.

• Fiscal policy (temporary): effective short-run. Expansion shifts $DD$ right, raises $Y$; central bank buys FX to prevent appreciation, reinforcing $\uparrow M^{s}$.

• Long run: price level rises proportionally to accumulated $\uparrow M^{s}$ ⇒ real appreciation, $Y$ returns to potential.

Devaluation & Revaluation

• Devaluation: official rise in $E$. Central bank buys foreign assets ⇒ $\uparrow M^{s}, \downarrow R$ ⇒ domestic goods cheaper, $\uparrow AD, Y$.

• Revaluation: opposite (central bank sells FX, $\downarrow M^{s}$).

Balance-of-Payments (BoP) Crises & Capital Flight

• Crisis when reserves insufficient to defend peg.

• Expectation of devaluation ⇒ investors demand FX ⇒ reserve drain ⇒ self-fulfilling.

• Capital flight shrinks $M^{s}$, forces $\uparrow R$; macro effects: $\downarrow AD, Y,\,$ employment.

• Eventually peg breaks; devaluation restores reserves & $M^{s}$.

Interest Rate Differentials & Imperfect Substitutability

• With risk: $R = R^{*} + \rho - \frac{E^{e}-E}{E}$.

• $\rho$ (risk premium) reflects default & exchange-rate risk.

• Sterilized FX purchase can still move $E$ if it alters perceived risk/asset mix.

Types of Fixed-Rate Systems

• Reserve-currency: one country supplies reserve asset (e.g., \text{US}$ 1944–73); others trade that currency to keep pegs.

• Gold standard: currencies convertible into fixed gold amount; gold used for settlements.

• Bimetallic (historical): both gold & silver define currency value.

Key Takeaways

• Central-bank asset trades directly affect M^{s}$$; sterilization can offset.

• Under credible pegs with perfect substitutes: monetary policy powerless, fiscal policy potent short-run.

• Peg viability hinges on adequate reserves & credible commitment; loss of confidence induces BoP crises.

• Risk and imperfect asset substitutability create interest-rate differentials and give sterilized intervention some bite.