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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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Contents
 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 sterlized intervention
 Reserve currencies in the world monetary system

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1. The central bank’s intervention and the supply of money
The Central Bank balance sheets and the money supply

 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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1. The central bank’s intervention and the supply of money
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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1. The central bank’s intervention and the supply of money
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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1. The central bank’s intervention and the supply of money
The central bank balance sheet

Assets Liabilities
Foreign Asets 1000 Curency in cỉculation 2500
Deposits held by private
Domestic asets 2000 banks 500
Net worth 0
Total asets 3000 Total liabilities 3000

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1. The central bank’s intervention and the supply of money
The central bank’s intervention and the supply of
money

 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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1. The central bank’s intervention and the supply of money
Open market intervention and the supply of money

 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 by cash or check, and thereby raising
the supply of money.
➢ When the central bank sells government bonds, it is
paid by cash or check, thus lowering the supply of
money.

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1. The central bank’s intervention and the supply of money
Open market intervention and the supply of money
A. The Central Bank purchases domestic assets worth 500
Assets Liabilities
Foreign Asets 1000 Curency in cỉculation 3000
Domestic asets 2500 Deposits held by private banks 500
Total asets 3500 Total liabilities 3500
B. The Central Bank sells domestic assets worth 500
Assets Liabilities
Foreign Asets 1000 Curency in cỉculation 2000
Domestic asets 1500 Deposits held by private banks 500
Total asets 2500 Total liabilities 2500

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1. The central bank’s intervention and the supply of money
Foreign exchange intervention and the supply of
money

 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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1. The central bank’s intervention and the supply of money
Foreign exchange intervention and the supply of money
A. The Central Bank purchases foreign assets worth 500
Assets Liabilities
Foreign Asets 1500 Curency in cỉculation 3000
Domestic asets 2000 Deposits held by private banks 500
Total asets 3500 Total liabilities 3500
B. The Central Bank sells foreign assets worth 500
Assets Liabilities
Foreign Asets 500 Curency in cỉculation 2000
Domestic asets 2000 Deposits held by private banks 500
Total asets 2500 Total liabilities 2500

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1. The central bank’s intervention and the supply of money
Sterlized intervention I

 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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1. The central bank’s intervention and the supply of money
Sterlized intervention II

 The sterlized 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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1. The central bank’s intervention and the supply of money
Sterlized intervention II
A. The Central Bank purchases foreign assets worth 500,
sterilized intervention
Assets Liabilities
Foreign Asets 1500 Curency in cỉculation 2500
Domestic asets 1500 Deposits held by private banks 500
Total asets 3000 Total liabilities 3000
B. The Central Bank sells foreign assets worth 500, sterilized
intervention
Assets Liabilities
Foreign Asets 500 Curency in cỉculation 2500
Domestic asets 2500 Deposits held by private banks 500
Total asets 3000 Total liabilities 3000

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1. The central bank’s intervention and the supply of money
The balance of payments and supply of money
 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 sterlized, 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 sterlized intervention adopted by the central
bank.

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2. Foreign exchange intervention in a fixed exchange rate regime
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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2. Foreign exchange intervention in a fixed exchange rate regime
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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2. Foreign exchange intervention in a fixed exchange rate regime
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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2. Foreign exchange intervention in a fixed exchange rate regime
Equilibrium in the foreign exchange market under a
fixed exchange rate: An increase in income

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3. Stabilization policies under a fixed exchange rate regime
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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3. Stabilization policies under a fixed exchange rate regime
Monetary policies under the fixed exchange rate
regime

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3. Stabilization policies under a fixed exchange rate regime
Fiscal policies under the fixed exchange rate regime

 In the short-run, fiscal policies have effects on output and

employment. 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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3. Stabilization policies under a fixed exchange rate regime
Fiscal policies under the fixed exchange rate regime

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3. Stabilization policies under a fixed exchange rate regime
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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3. Stabilization policies under a fixed exchange rate regime
Exchange rate policies

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4. Balance of Payment Crisis and Capital Flight
The balance of payment crises
 The balance of payment crisis refers to a sharp change in
foreign reserves caused by the sudden change in the
market belief and the expected exchange rate.
➢ In the previous section, we assume that market agents don’t
change their expectation on the exchange rate under the fixed
exchange rate regime.
➢ Under the fixed exchange rate regime, market agents may
change their expectation on the exchange rate when
unemployment rises or foreign reserves run out.

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4. Balance of Payment Crisis and Capital Flight
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 leads to a decline in the
supply of money and an increase in the interest rate

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4. Balance of Payment Crisis and Capital Flight
BOP crises under the fixed exchange rate regime

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5. Managed floating regime and sterlized intervention
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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4. Balance of Payment Crisis and Capital Flight
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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5. Managed floating regime and sterlized intervention
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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5. Managed floating regime and sterlized intervention
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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5. Managed floating regime and sterlized intervention
The effect of sterlized intervention under the
imperfect asset substitutability

 When domestic and foreign assets are imperfect

substitutes, sterlized intervention can influence
the exchange rate.
➢ Assume the central bank purchases foreign assets and
sells domestic assets. This sterlized 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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5. Managed floating regime and sterlized intervention
The effect of sterlized intervention under the
imperfect asset substitutability

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6. Reserve currency 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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6. Reserve currency in the world monetary system
Mechanism of a reserve currency standard
 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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6. Reserve currency in the world monetary system
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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6. Reserve currency in the world monetary system
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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6. Reserve currency in the world monetary system
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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6. Reserve currency in the world monetary system
Benefits and drawbacks of the 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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6. Reserve currency in the world monetary system
Benefits and drawbacks of the 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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6. Reserve currency in the world monetary system
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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6. Reserve currency in the world monetary system
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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