Fixed Exchange Rates and Foreign Exchange Intervention
ECON 4550 Study Notes
Chapter 7 - Fixed Exchange Rates and Foreign Exchange Intervention
Learning Objectives
7.1 Understand how a central bank must manage monetary policy to fix its currency's value in the foreign exchange market.
7.2 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.
7.3 Explain how monetary, fiscal, and sterilized intervention policies affect the economy under a fixed exchange rate.
7.4 Discuss causes and effects of balance of payments crises.
7.5 Describe how alternative multilateral systems for pegging exchange rates work.
Preview
Central banks' balance sheets.
Intervention in 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.
Countries with a flexible or "floating" exchange rate often practice a managed floating exchange rate.
Central banks manage the exchange rate by buying and selling currency and assets, especially during periods of exchange rate volatility.
Primary question: How do central banks intervene in the foreign exchange markets?
Central Bank Intervention and the Money Supply
To understand the effects of central bank intervention in foreign exchange markets, it is essential to construct a simplified balance sheet for the central bank.
A balance sheet records the assets and liabilities of a central bank.
Balance sheets apply double-entry bookkeeping: each transaction appears twice.
Central Bank's Balance Sheet
Assets:
Foreign government bonds (official international reserves).
Gold (official international reserves).
Domestic government bonds.
Loans to domestic banks (termed discount loans in the United States).
Liabilities:
Deposits of domestic banks.
Currency in circulation (historically a central bank had to exchange gold for currency).
Central Bank's Balance Sheet Analysis
Formula: Assets = Liabilities + Net Worth.
Assumption: Net worth is constant.
Consequences of Asset Changes:
Increase in assets → equal increase in liabilities.
Decrease in assets → equal decrease in liabilities.
Changes in the central bank's balance sheet lead to currency in circulation changes or changes in bank deposits, affecting the money supply.
When bank deposits at the central bank increase, banks can utilize these additional funds for lending, increasing the amount of money in circulation.
Assets, Liabilities, and the Money Supply
A purchase of an asset by the central bank is made with currency or a check in domestic currency, both increasing the money supply.
The transaction results in equal increases in both assets and liabilities.
Buying Bonds or Assets:
Domestic or foreign bonds purchased increase the domestic money supply.
Assets, Liabilities, and the Money Supply (continued)
A sale of an asset by the central bank is compensated with currency or a check to the central bank, which decreases the money supply.
The currency is either placed into the central bank's vault or the deposits of banks are reduced, leading to equal decreases in assets and liabilities.
Selling Bonds or Assets:
Selling domestic or foreign bonds decreases the domestic money supply.
Effects of Foreign Exchange Intervention: Summary
Table of Effects on Domestic Money Supply and Central Bank's Assets: (Summarizes the effects of various types of foreign exchange interventions.)
Nonsterilized foreign exchange purchase: Domestic Money Supply +$100; Central Bank's Domestic Assets 0; Central Bank's Foreign Assets +$100.
Sterilized foreign exchange purchase: Domestic Money Supply 0; Central Bank's Domestic Assets -$100; Central Bank's Foreign Assets +$100.
Nonsterilized foreign exchange sale: Domestic Money Supply -$100; Central Bank's Domestic Assets 0; Central Bank's Foreign Assets -$100.
Sterilized foreign exchange sale: Domestic Money Supply 0; Central Bank's Domestic Assets +$100; Central Bank's Foreign Assets -$100.
Foreign Exchange Markets
Central banks trade foreign government bonds in foreign exchange markets.
Foreign currency deposits and foreign government bonds are substitutes: both are liquid assets denominated in foreign currency.
The quantities of foreign currency deposits and foreign government bonds bought and sold influence the exchange rate.
Sterilization
Buying and selling foreign bonds affects the domestic money supply. To offset this effect, a central bank may use sterilization.
Example: If a central bank sells foreign bonds in the foreign exchange markets, it can purchase domestic government bonds to keep the money supply constant.
Fixed Exchange Rates
A fixed exchange rate occurs when a central bank influences the currency supply and demand by trading foreign and domestic assets, keeping the exchange rate constant.
Equilibrium in foreign exchange markets can be defined with the relationship where P is the domestic price and P* is the foreign price.
Fixed Exchange Rates (continued)
For the central bank to maintain the fixed exchange rate, it must adjust the monetary assets in the money market until domestic interest rates match foreign interest rates.
Equation: where i is the domestic interest rate, i is the foreign interest rate, Y is real output.
Central Bank Responses to Output Levels
If a central bank has fixed the exchange rate at but the level of output increases, raising the demand for real monetary assets, it may lead to upward pressure on interest rates and values of domestic currency.
The central bank should respond by buying foreign assets in the foreign exchange markets, which increases the domestic money supply and reduces interest rates in the short run.
This action results in higher demand for foreign currency, decreasing the value of domestic currency and increasing the value of foreign currency.
Graphical Representation: Asset Market Equilibrium
Graph Description:
Exchange rate on the y-axis versus real domestic money holdings on the x-axis.
The curve M1 represents the money supply and shifts based on various factors affecting domestic currency returns.
Monetary Policy Impact
The central bank's actions to maintain fixed exchange rates prevent adjustments of domestic interest rates to pursue other economic goals, such as adjusting for output and employment levels.
Fiscal Policy under Fixed Exchange Rates
Short-run Effects:
Temporary changes in fiscal policy can significantly influence output and employment levels.
Expansionary fiscal policy increases aggregate demand and output, resulting in upward pressure on interest rates and domestic currency value.
To prevent domestic currency appreciation, the central bank must buy foreign assets to increase the money supply and decrease interest rates.
Long-run Effects of Fiscal Policy
When an exchange rate is fixed, there is typically no real appreciation in domestic products in the short run.
As aggregate output exceeds potential levels, wages and prices usually tend to rise, leading to higher price levels.
This fosters a real appreciation as decreases.
Devaluation and Revaluation
Definitions:
Depreciation/ Appreciation: Market-driven changes in currency value.
Devaluation/ Revaluation: Changes in a fixed exchange rate made by the central bank.
When a central bank buys foreign assets, it increases domestic money supply and reduces interest rates; thus, domestic products' prices become less expensive relative to foreign products, increasing aggregate demand and output.
Financial Crises and Capital Flight
A balance of payments crisis occurs when a central bank cannot maintain sufficient official international reserve assets to sustain a fixed exchange rate.
Investors anticipating currency devaluation will prefer foreign assets, worsening the balance of payments crisis and leading to capital flight (asset migration from domestic to foreign sources).
Policy Responses to Financial Crises
To counteract capital flight, domestic assets must offer high-interest rates to attract investors. The central bank could increase interest rates by reducing the money supply (selling assets), which leads to significant economic drawbacks like low output and employment.
Expectations in Balance of Payments Crises
Market expectations significantly influence the severity of a balance of payments crisis, prompting self-fulfilling prophecies. Investors' belief in a likely devaluation can trigger that very outcome.
The Monetary Approach to the Balance of Payments
The monetary approach suggests that shifts in the balance of payments occur primarily due to changes in the money market. It links the central bank’s balance of payments to its money supply.
Equilibrium is achieved when the real money supply equals real money demand, expressed as .
Crisis Timing and Monetary Policy
A balance of payments crisis may occur due to inconsistent government monetary policies. Factors like expanding domestic credit against fixed exchange rates create vulnerabilities for potential crises.
Interest Rate Differentials
Differences in expected rates of return on domestic versus foreign investments arise from:
Default Risk: Lenders require higher rates for riskier domestic assets.
Exchange Rate Risk: Domestic borrowers must compensate for potential depreciation of currency.
Models of Foreign Exchange Market
Risk factors lead to segmented perceptions of domestic and foreign currency assets as imperfect substitutes, creating risk premia and affecting expected return.
Summary of Key Points
Changes in the central bank’s balance sheet impact domestic money supply; asset purchases increase, while sales decrease the supply.
Unlike a flexible exchange rate regime, monetary policy tools are generally ineffective under fixed exchange rates for output and employment influences;
However, fiscal policy actions can be effective in the short run.
Balance of payments crises manifest when reserve levels cannot maintain a fixed exchange rate, often precipitated by capital flight induced by investor expectations.
Various systems exist for pegging exchange rates, such as reserve currency systems and gold standards, each with distinct mechanisms for maintaining stability in exchange rates.
Conclusion
This chapter underscores the intricate balance between monetary policy, fiscal interventions, and the dynamics of foreign exchange markets in maintaining fixed exchange rates, highlighting the challenges faced by central banks in managing economic stability amidst global pressures.