Chapter 7 Fixed Exchange Rates and

Foreign Exchange Intervention

Why Study Fixed Exchange Rates?
Four reasons to 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
Learning Objectives
1 Understand how a central bank must manage monetary policy
to fix its currency's value in the foreign exchange market.
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.
3 Explain how monetary, fiscal, and sterilized intervention
policies affect the economy under a fixed exchange rate.
4 Discuss causes and effects of balance of payments crises.
5 Describe how alternative multilateral systems for pegging
exchange rates work
Preview
• 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
markets?
Central Bank Intervention
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
bank.
– Balance sheets use double-entry bookkeeping:
each transaction enters the balance sheet twice.
Central Bank’s Balance Sheet
• Assets
– Foreign government bonds (official international
reserves)
– Gold (official international reserves)
– Domestic government bonds
– Loans to domestic banks (called discount loans in US)
• Liabilities
– Deposits of domestic banks
– Currency in circulation (previously central banks had to
give up gold when citizens brought currency to
exchange)
Assets, Liabilities, and the Money
Supply
• 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,
and
– 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
• 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.
Effects of a $100 Foreign Exchange
Intervention: Summary
Effect on Effect on Central Effect on Central
Domestic Central
Domestic Money Bank’s Domestic Bank’s Foreign
Bank’s Action
Supply Assets Assets
Nonsterilized foreign +$100 0 +$100
exchange purchase

Sterilized foreign 0 −$100 +$100

exchange purchase

Nonsterilized foreign −$100 0 −$100

exchange sale

Sterilized foreign 0 +$100 −$100

exchange sale
Fixed Exchange Rates
Fixed Exchange Rates
• So how do central banks keep exchange rates fixed?
• First, recall that foreign exchange markets are in
equilibrium when

= R
R ∗
+
( Ee −E )
E

• So when the exchange rate is fixed at some level E0 and

the market expects it to stay fixed at that level, then

R = R∗
Fixed Exchange Rates
• To fix the exchange rate, the central bank must trade
foreign and domestic assets in the foreign exchange
market until R = R ∗ .
• In other words, it adjusts the money supply until the
domestic interest rate equals the foreign interest rate,
given the level of average prices and real output:

MS
P
(
= L R ∗ ,Y )

• We will assume central bank changes money supply by

buying/selling foreign assets (bonds)
Fixed Exchange Rates
• Let’s consider an example
• Suppose that the central bank has fixed the exchange
rate at E0 but the level of output rises, raising the real
money demand.
• This is predicted to put upward pressure on interest rates
and downward pressure on the exchange rate.
• How should the central bank respond if it wants to keep
exchange rates fixed?
Output and the Exchange Rate in Asset
Market Equilibrium

E0

3’

3
Fixed Exchange Rates
• 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.

• Let’s see this example in a graph…

Asset Market Equilibrium with a Fixed
0
Exchange Rate, E

Increase in
domestic
money supply
keeps Increase in output
exchange rate shifts money
fixed at E0 demand curve
Monetary Policy and Fixed Exchange
Rates
• When the central bank is committed to a fixed exchange
rate, it is not able to adjust domestic interest rates to
attain other goals.
– In particular, monetary policy can’t be used to
influence output and employment.
– For example, we have seen monetary expansion can
be used to combat a recession, but this policy tool is
not available when the central bank is committed to
using money supply to maintain a fixed exchange
rate
Fiscal Policy and Fixed Exchange Rates
in the Short Run
• With a fixed exchange rate, temporary fiscal policy is still
effective in influencing output in the short run:
– The rise in output due to expansionary fiscal policy
raises real money demand, putting upward pressure on
interest rates and on the value of the domestic
currency.
– To prevent an appreciation, the central bank must buy
foreign assets, thereby increasing the money supply
and decreasing interest rates, further increasing output.
– So fiscal policy is actually more effective under a fixed
exchange rate than under a floating rate
• Let’s look at this example with the DD-AA model…
Fiscal Expansion under a Fixed Exchange
Rate, E0
(1) Expansionary
fiscal policy shifts
DD curve right

(2) To prevent the

domestic currency from
appreciating, the central
bank increases the
money supply and shifts
the AA curve right.
Output increases to Y3
Fiscal Policy and Fixed Exchange Rates
in the Long Run
• When the exchange rate is fixed, there is no real appreciation of
the value of domestic products in the short run (because prices
are also fixed).
• But when output is above its long-run level, wages and prices
𝐸𝐸𝑃𝑃∗
tend to rise over time and there is real appreciation falls .
𝑃𝑃

• A rising price level makes domestic products more expensive,

aggregate demand and output decrease, the DD curve shifts
left.
• AA curve shifts left to maintain fixed exchange rate
• Prices tend to rise until employment, aggregate demand, and
output fall back to their long-run levels.
Devaluation, Revaluation, and
Financial Crisis
Devaluation and Revaluation
• Depreciation and appreciation refer to changes in the
value of a currency due to market changes (i.e. a floating
exchange rate).
• Devaluation and revaluation refer to changes in a fixed
exchange rate chosen by the central bank.
– Devaluation of a fixed exchange rate is analogous to
depreciation – the nominal exchange rate becomes
higher
– Revaluation of a fixed exchange rate is analogous to
appreciation – the nominal exchange rate becomes
lower
Devaluation
• For devaluation to occur,
– the central bank buys foreign assets (official
international reserve assets increase)
– the domestic money supply increases
– domestic interest rate falls
– nominal exchange rate increases
– AA curve shifts right
– domestic products become less expensive relative to
foreign products, CA goes up, aggregate demand
and output increase (move along the DD curve)
• Or in a graph…
Effect of a Currency Devaluation

If the central bank

devalues the
domestic currency
so that the new
fixed exchange rate
is E1, it buys foreign
assets, increasing
the money supply,
decreasing the
interest rate and
increasing output
Devaluation
• So why might a country choose to devalue their
currency?
1. Stimulate aggregate demand and increase
output
2. Improve their current account balance (i.e.
increase exports and decrease imports)
3. Increase their official international reserves
Fixed Exchange Rates and Changing
Expectations
• If a country is running low on international reserves, has
high unemployment, or has growing concern over their
trade balance, they may be forced to devalue their
currency
• But investors may see this coming and expect that the
domestic currency will be devalued (Ee > E0), which
increases the expected return on foreign assets above R:
𝑒𝑒 0
𝐸𝐸 − 𝐸𝐸
𝑅𝑅 = 𝑅𝑅∗ +
𝐸𝐸 0
• How would the country respond to keep the current
exchange rate fixed?
– increase domestic return R
Fixed Exchange Rates and Changing
Expectations
Expected devaluation
makes the expected return
on foreign assets higher

To attract investors to hold domestic

assets (currency) at the original
exchange rate, the interest rate must
rise through a sale of foreign assets
(a decrease in money supply).
Financial Crises and Capital Flight
• The sale of foreign assets by the central bank to lower the
money supply and maintain the fixed exchange rate
causes a decrease in official foreign reserves
• A balance of payments crisis is a sharp fall in official
foreign reserves sparked by a change in expectations
about the future exchange rate.
– Also marked by a rise in the domestic interest rate above the world
interest rate: R > R*
– Capital flight is the reserve loss accompanying a devaluation
scare – investors sell off domestic currency for foreign currency

• The central bank is forced to deplete their reserves quickly

(if they have them) or else devalue their currency
immediately
Financial Crises and Capital Flight
• In fact, expectations of future devaluation (for whatever
reason) can cause a current devaluation and capital flight:
a self-fulfilling crisis.
• What causes expectations to change and can cause a
balance of payment crisis?
– Expectations about the central bank’s ability and willingness
to maintain the fixed exchange rate.
 e.g. can’t support fiscal deficits by depleting international
reserves forever
– Expectations about the economy: shrinking demand of
domestic products relative to foreign products means that
the domestic currency should become less valuable.
Risk Premium
Interest Rate Differentials
• For many countries, the expected rates of return are not
the same:
R>R + ∗ ( E e
−E)
. Why?
E
• 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 unexpectedly
depreciate or be devalued, then domestic borrowers must
pay a higher interest rate to compensate foreign lenders.
Interest Rate Differentials
• 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
• A difference in the risk of domestic and foreign assets is
one reason why expected rates of return are not equal
across countries:
R= ∗
R +
( E e
−E)
+ρ
E
where ρ is called a risk premium, an additional amount
needed to compensate investors for investing in risky
domestic assets.

• Side note: by changing the risk premium, sterilized

interventions could (in theory) have an impact on
exchange rates without changing the money supply
– We won’t cover sterilized interventions in detail, but
see text for more on this if you are interested
 17-
38

Interest Rate Differentials

Exchange R1 R2 An increase in the perceived
rate, E risk of investing in domestic
assets makes foreign assets
E2 more attractive and leads to a
depreciation of the domestic
currency.
E1
R* + (Ee – E)/E + ρ
R* + (Ee – E)/E
Domestic
interest rates, R

M2/P MS2/P Or at fixed exchange

rates, the central bank will
M1/P MS1/P need to sell foreign assets,
increasing the domestic
interest rates and
Quantity of decreasing the domestic
money supply.
real monetary L(R, Y)
assets
Case Study: Reducing ρ in Mexico
• In 1994, a currency crisis led to devaluation of the Mexican
peso by 35% in a matter of weeks
• Capital flight was $5.5 billion and official reserves plummeted
Case Study: Reducing ρ in Mexico
• The U.S. & 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.
Types of Global Fixed Exchange Rate
Systems
(much more on this next chapter too)
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 under the fixed exchange rate system from 1944 to 1973.
– All countries except the U.S. 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.
– Prevalent from 1870-1914
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 the Bank of Japan fixed the exchange rate at 360¥/US$1
and the Bank of France fixed the exchange rate at 5₣/US$1.
360¥
US$1 72¥
– The yen/franc rate was = .
5₣ 1₣
US$1

– If not, then currency traders could make an easy profit by buying

currency where it was cheap and selling it where it was expensive.
Reserve Currency System
• Because most countries maintained fixed exchange rates
by trading dollar denominated (foreign) assets, they had
ineffective monetary policies.
• The Federal Reserve, however, did not have to intervene
in foreign exchange markets, so it could conduct monetary
policy to influence aggregate demand, output and
employment.
– The U.S. was in a special position because it was able
to use monetary policy as it wished.
Reserve Currency System
• In fact, the monetary policy of the U.S. influenced the
economies of other countries.
• Suppose that the U.S. increased its money supply.
– This would lower U.S. interest rates, putting downward
pressure on the value of the U.S. dollar.
– If other central banks maintained their fixed exchange rates,
they would have needed to buy dollar denominated (foreign)
assets, increasing their money supplies.
– In effect, the monetary policies of other countries had to
follow that of the U.S., which was not always optimal for
their levels of output and employment.
• Perhaps not too surprising this system didn’t last (much more on
this next chapter)
Gold Standard
• Under the gold standard from 1870–1914 and after 1918
for some countries, each central bank fixed the value of its
currency relative to a quantity of gold (in ounces or grams)
by trading domestic assets in exchange for gold.
– For example, if the price of gold was fixed at $35 per
ounce by the Federal Reserve while the price of gold
was fixed at £14.58 per ounce by the Bank of England,
then the $/£ exchange rate must have been fixed at
$2.40 per pound.
– Why?
Gold Standard: Benefits
• The pure gold standard in theory did not give the monetary
policy of the U.S. or any other country a privileged role.
• If one country lost official international reserves (gold) so
that its money supply decreased, then another country
gained them so that its money supply increased.
• The gold standard also acted as an automatic restraint on
increasing money supplies too quickly, preventing
inflationary monetary policies.
Gold Standard: Drawbacks
1. But restraints on monetary policy restrained central
banks from increasing the money supply to increase
aggregate demand, output, and employment.
2. And the price of gold relative to other goods and services
varied, depending on the supply and demand of gold.
– A new supply of gold made gold abundant (cheap), and
prices of other goods and services rose because the
currency price of gold was fixed.
– Strong demand for gold jewelry made gold scarce
(expensive), and prices of other goods and services fell
because the currency price of gold was fixed.
Gold Standard: Drawbacks
3. A reinstated gold standard would require new discoveries
of gold to increase the money supply as economies and
populations grow.
4. A reinstated gold standard may give Russia, South Africa,
the U.S. or other gold producers inordinate influence on
international financial and macroeconomic conditions.
Gold Exchange Standard
• The gold exchange standard: a system of official
international reserves in both a group of currencies (with
fixed prices of gold) and gold itself.
– allows more flexibility in the growth of international
reserves, depending on macroeconomic conditions,
because the amount of currencies held as reserves
could change.
– does not constrain economies as much to the supply
and demand of gold
– The fixed exchange rate system from 1944–1973 used
gold (maintained at US$35 an ounce), and so operated
more like a gold exchange standard than a pure
currency reserve system.
Gold and Silver Standard
• Bimetallic standard: the value of currency is based on both
silver and gold.
• The U.S. 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 [Link] for a fun description of the
bimetallic standard, the gold standard after 1873, and the
Wizard of Oz!
Summary
1. Changes in a central bank's balance sheet leads to
changes in the domestic money supply.
– Buying domestic or foreign assets increases the
domestic money supply.
– Selling domestic or foreign assets decreases the
domestic money supply.
2. When markets expect exchange rates to be fixed,
domestic and foreign assets have equal expected
returns if they are treated as perfect substitutes.
Summary
3. Monetary policy is ineffective in influencing output or
employment under fixed exchange rates.
4. Temporary fiscal policy is more effective in influencing
output and employment under fixed exchange rates,
compared to under flexible exchange rates.
Summary
5. A balance of payments crisis occurs when a central bank
does not have enough official international reserves to
maintain a fixed exchange rate.
6. Capital flight can occur if investors expect a devaluation,
which may occur if they expect that a central bank can no
longer maintain a fixed exchange rate: self-fulfilling crises
can occur.
7. Domestic and foreign assets may not be perfect
substitutes due to differences in default risk or due to
exchange rate risk.
Summary
8. Under a reserve currency system, all central banks but
the one that controls the supply of the reserve currency
trade the reserve currency to maintain fixed exchange
rates.
9. Under a gold standard, all central banks trade gold to
maintain fixed exchange rates.