Fixed Exchange Rate and
Foreign Exchange Intervention
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Objective
This chapter studies the short-run determination of
the exchange rate and output and the working of
macroeconomic policies under a managed floating
exchange rate systems.
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• Central Bank intervention and the supply of money
• Foreign exchange intervention under a fixed exchange rate
regime
• Stabilization policies under a fixed exchange rate regime
• Balance of payment crisis
• Managed floating regime and sterilized intervention
• Reserve currencies in the world monetary system
The Central Bank balance sheets
The balance sheet of the central bank records all
assets and liabilities.
The balance sheet consists of the asset side and
liability side.
• The acquisition of an asset is recorded on the asset
side.
• The increase in the liability is recorded on the
liability side.
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The central bank balance sheet:
The asset side
The asset side of the central bank consists of domestic assets
and foreign assets.
The foreign assets consist of
foreign exchange,
foreign bonds and
other universally acceptable means of making international
payments.
The central bank’s foreign assets constitute the international
reserve.
Domestic assets consist of the central bank holdings of claims
to future payment by its own citizens and domestic institutions.
The most common domestic assets are government bonds and
loans to domestic commercial banks
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The central bank balance sheet:
The liability side
The central bank’s liabilities consist of
i) Currency in circulation and
ii) Required and other reserves by commercial banks.
The central bank’ assets must be equal to its liability
plus its net worth. Since the net worth is low, we
assume it is zero.
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The central bank’s intervention
The central bank’s intervention consists of open
market intervention and foreign exchange
intervention.
Since the net worth is zero, any change in the asset
side must be associated with a corresponding change
in the liability side.
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Open market intervention and the money supply
When the central bank sells or purchases domestic
assets, it will affect the supply of money.
When the central bank purchases government bonds,
it makes payment in cash or check, and thereby raising
the supply of money.
When the central bank sells government bonds, it is
paid in cash or check, thus lowering the supply of
money.
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Foreign exchange intervention
and the money supply
The central bank’s intervention in the foreign
exchange market is conducted through its purchase or
sale of foreign assets
When the central bank sells foreign asset, the foreign
reserves fall and the supply of money falls.
When the central bank purchases foreign assets, the
foreign reserves rise, and the supply of money also
rises.
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Sterilized intervention
The central bank’s intervention in the foreign
exchange and money markets may have undesired
effects on the supply of money.
The central bank can nullify the impacts of foreign
exchange intervention on the supply of money using a
mix of the intervention in the foreign exchange and
money market.
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Sterilized intervention
The sterilized intervention is the combination of a
foreign exchange market intervention and an open
market intervention of the opposite direction.
• When the central bank sells foreign assets, the supply
of money falls. The effect on the supply of money can be
nullified by purchasing back government bonds.
• When the central bank purchases foreign assets, the
supply of money rises. The effect on the supply of money
can be nullified by selling government bonds.
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The balance of payments
and the money supply
The change in the balance of payment has effects on
foreign reserves and the supply of money.
If the central bank’s intervention is not sterilized, a
deficit in the balance of payment would lead to a
monetary contraction, while a surplus in the BOP
would lead to monetary expansion.
The effect of the change in the BOP on the supply of
money depends on how the BOP is financed and the
degree of sterilized intervention adopted by the central
bank.
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• Central Bank intervention and the supply of money
• Foreign exchange intervention under a fixed exchange rate
regime
• Stabilization policies under a fixed exchange rate regime
• Balance of payment crisis
• Managed floating regime and sterilized intervention
• Reserve currencies in the world monetary system
Foreign exchange intervention
The foreign exchange intervention are used to
maintain the fixed exchange rate
• The central bank sells foreign exchange to the market
when there is a shortage of foreign exchange
• The central bank purchases foreign exchange from
the market when there is a surplus of foreign
exchange.
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Equilibrium in the foreign exchange market
under a fixed exchange rate
The foreign exchange market is in equilibrium
when the interest parity condition holds.
R = (Ee-E)/E + R*
Since the exchange rate is fixed by the central
bank, the interest parity condition implies the
equality between domestic interest rate and
foreign interest rate.
R = R*
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Equilibrium in the foreign exchange market
under a fixed exchange rate
Given a price level and an exchange rate, the
equilibrium condition in the money market
determines the volume of the money supply.
Ms/P = L(Y,R) = L(Y,R*)
When the central bank intervenes in the foreign
exchange market, the supply of money is
automatically adjusted to maintain the
equilibrium in the money market.
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Equilibrium in the foreign exchange market under
a fixed exchange rate: An increase in income
Exchange rate, E
To hold the exchange rate fix at E0 when output raises from
Y1 to Y2, the central bank must purchase the foreign assets
thereby raise the money supply from M1 to M2
1'
E0 3' Rate of Return on FCD
Rate of return, R
0
R* L(R, Y1)
M1
P 1 3 Real Money Supply
M2
P 2
Real money
holdings
• Central Bank intervention and the supply of money
• Foreign exchange intervention under a fixed exchange rate
regime
• Stabilization policies under a fixed exchange rate regime
• Balance of payment crisis
• Managed floating regime and sterilized intervention
• Reserve currencies in the world monetary system
Monetary policies
under the fixed exchange rate regime
Under a fixed exchange rate regime, monetary policies
have no effects on output and the exchange rate.
Any increase in the supply of money puts a downward
pressure on domestic currency and the central bank needs
to intervene to maintain the fixed exchange rate.
The initial increase in the supply of money is eventually
offset by the fall in foreign reserves.
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Monetary policies
under the fixed exchange rate regime
Exchange rate, E
DD
2
E2
1
E0
AA2
AA1
Y1 Y2 Output, Y
Fiscal policies
under the fixed exchange rate regime
In the short-run, fiscal policies have effects on output and
employment.
The rise in output due to expansionary fiscal policy raises
money demand.
To prevent an increase in the home interest rate and an
appreciation of the currency, the central bank must buy
foreign assets with money (i.e., increasing the money supply).
An increase in government spending will lead to the output
expansion and increase in foreign reserves and money supply.
In the long-run, the fiscal policies would have no effect on
output. Higher government spending is totally offset by the
increase in prices.
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Fiscal policies
under the fixed exchange rate regime
Exchange rate, E
DD1
DD2
1 3
E0
2
E2
AA2
AA1
Y1 Y2 Y3 Output, Y
Exchange rate policies
In the short-run, devaluation has effects on output and
employment.
Devaluation will lead to the output expansion and
increase in foreign reserves and money supply.
In the long-run, devaluation would have no long-run
effect on the output as the effect of devaluation is offset
by the increase in prices
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Exchange rate policies
Effects of Currency Devaluation
Exchange
rate, E
DD
2
E1
1
E0
AA2
AA1
Y1 Y2 Output, Y
• Central Bank intervention and the supply of money
• Foreign exchange intervention under a fixed exchange rate
regime
• Stabilization policies under a fixed exchange rate regime
• Balance of payment crisis
• Managed floating regime and sterilized intervention
• Reserve currencies in the world monetary system
The balance of payment crises
The balance of payment crisis refers to a sharp change in
foreign reserves caused the sudden change in the market
belief and the expected exchange rate.
• In the previous section, we assume that market participants
don’t change their expectation on the exchange rate under the
fixed exchange rate regime.
• Under the fixed exchange rate regime, market participants
may change their expectation on the exchange rate when
unemployment rises or foreign reserves run out.
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BOP crises under the fixed exchange rate regime
Suppose there is serious deterioration in the current
account, causing an expectation on the devaluation of
domestic currency and a downward pressure on domestic
currency.
An expected devaluation can lead to a BOP crisis, and the
resulting fall in foreign reserves and rise in the interest
rate.
• The sale of foreign assets by central banks to fix the exchange rate
leads to a decline in the supply of money and an increase in the
interest rate
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BOP crises under the fixed exchange rate
regime
Exchange
rate, E
1' 2'
E0
R* + (E1– E)/E
R* + (E0 – E)/E Rate of return R
0 R* R* + (E1 – E0)/E0
M2
P 2
M1 Real Money Supply
P 1
Real money
holdings
Capital flight and currency crisis
Capital flight is the loss of foreign reserves caused by an
expected devaluation of domestic currency
Capital flight may cause a currency crisis especially in the
case foreign reserves are low and the expected devaluation
is large.
There are several causes for a currency crisis:
i) the inconsistency of macroeconomic policies with the fixed
exchange rate regime;
ii) The volatility of capital inflows or
iii) The speculative attacks
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• Central Bank intervention and the supply of money
• Foreign exchange intervention under a fixed exchange rate
regime
• Stabilization policies under a fixed exchange rate regime
• Balance of payment crisis
• Managed floating regime and sterilized intervention
• Reserve currencies in the world monetary system
Perfect Asset Substitutability
In the previous section, we assume domestic and foreign
assets are perfect substitutes.
Under the assumption of perfect asset substitutability
investors don’t care how their portfolio is divided between
domestic assets and foreign assets provided both yield the
same expected rate of return.
Under the assumption of perfect asset substitutability, the
equilibrium in the foreign exchange market requires the
equality between domestic and foreign asset or the interest
parity condition must hold.
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Equilibrium in the foreign exchange market with
imperfect asset substitutability
Domestic and foreign assets are imperfect
substitutes since they have different degrees of risk
and liquidity, and other characteristics.
Under the imperfect asset substitutability, the
interest parity condition must be modified as
follows:
R = R* + (Ee-E)/E + ρ
here p is risk premium
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Risk premium
Risk premium depends on the stock of domestic
government debt and domestic assets held by the
central bank
ρ = ρ(B-A)
here B is the stocks of government bonds, and A is
domestic assets of the central bank.
When the stock of government bond rises, this
risk of holding domestic currency rises.
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The effect of sterilized intervention under the
imperfect asset substitutability
When domestic and foreign assets are imperfect
substitutes, sterilized intervention can influence
the exchange rate.
Assume the central bank purchases foreign assets and
sells domestic assets. This sterilized intervention raises
the risk premium, causing the depreciation of domestic
currency.
When the central bank sells foreign assets and
purchases domestic assets, the risk premium would fall,
causing an appreciation of domestic currency.
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The effect of sterilized intervention under the
imperfect asset substitutability
Exchange rate, E
Sterilized purchase
2' of foreign assets
E2 Risk adjusted domestics
currency rate of return on
1' FCD R* + (Ee– E)/E + (B –A2)
E1
R* + (Ee – E)/E + (B –A1)
Rate of return, R
0
R1
Ms
Real Money Supply
P 1
Real money
holdings
• Central Bank intervention and the supply of money
• Foreign exchange intervention under a fixed exchange rate
regime
• Stabilization policies under a fixed exchange rate regime
• Balance of payment crisis
• Managed floating regime and sterilized intervention
• Reserve currencies in the world monetary system
Fixed exchange rate systems
There are several fixed exchange rate systems in reality
i) Reserves currency standard: one currency is singled
out as a reserve currency and is held as international
reserves;
ii) Gold standard: prices of all currencies are pegged in
terms of gold, and gold is held as international reserves
iii) Bimetallic standard
iv) Gold exchange standard
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(i) Reserve currency standard
Mechanism
Under the reserve currency system, every central banks fix
the exchange rate of its own currency to the reserve
currency.
Exchange rates between other currencies rather than the
reserve currency are automatically fixed by the market.
The reserve currency is used as international reserves, and
central banks intervened in the foreign exchange market to
maintain the fixed exchange rate.
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(i) Reserve currency standard
The asymmetric position of the reserve center
In the reserve currency system, the reserve-issuing country
has a privileged/special position
The reserve-issuing country don’t need to intervene in the
foreign exchange market to maintain the fixed exchange rate
The reserve-issuing country can maintain the autonomy of
monetary policies under the fixed exchange rate regime.
Basic asymmetry: reserve country has a power to affect its
own economy and foreign economies using monetary
policies.
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(ii) Gold standard
Prices of all currencies are fixed in terms of gold.
Under the gold standard:
i) Gold is used as international reserve; and gold
is exported or imported across borders without
restrictions.
ii) No country issues reserve currency, and no
country has a privileged position.
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(ii) Gold standard
Symmetric adjustments under a gold standard
Under a gold standard, countries share equally the burden
of the balance of payment adjustment.
The expansion of the domestic supply of money puts a
downward pressure on the interest rate and a portfolio shift
toward foreign assets. The home reserves of gold fall and the
domestic supply of money shrinks. This causes the domestic
interest rate back up.
The foreign reserves of gold rise, causing a monetary
expansion in the foreign country and a decline in foreign
interest rate.
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(ii) Gold standard
The gold standard has several potential benefit:
i) International monetary adjustments are
symmetric, and no country has a special
position;
ii) The fixed exchange rate under the gold
standard places automatic limits on monetary
policies.
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(ii) Gold standard
The gold standard also has some drawbacks:
i) The supply of money is tied to the reserve of gold and
the supply of gold;
ii) The gold standard places undesirable constraints on
the use of monetary policies to fight unemployment;
iii) The stability of domestic prices requires the stable
price of gold;
iv) Large gold production countries have ability to
influence macroeconomic conditions in other countries.
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(iii)Bimetallic standard
Under a bimetallic standard, the value of currency is based on
both silver and gold.
The US used a bimetallic standard from 1837–1861.
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.
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(iv) Gold Exchange Standard
The central banks’ international reserves consist of gold
and the currencies with fixed prices with gold. The
exchange rates are fixed to the currency with a fixed gold
price.
The gold exchange standard operates like a gold standard,
but it allows more flexibility in the growth of international
reserves.
The Bretton-Woods system established after the Second
World War was a gold exchange system.
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THANK YOU!
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