1 section 6 exchange rate regimes. 2 content exchange rate regimes central bank intervention fixing...

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Section 6Exchange Rate Regimes

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Content

• Exchange Rate Regimes

• Central Bank Intervention

• Fixing Exchange Rates

• BOP Crises and Capital Flight

• Sterilized Intervention

• The World Monetary System

• Summary

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Objectives

• To know how central banks manage exchange rate regimes.

• To know the impact of macroeconomic policies under fixed exchange rates.

• To know the effects of sterilization under imperfect asset substitutability.

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Exchange Rate Regimes

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Central Bank Intervention

• The Central Bank Balance Sheet – It records the assets and liabilities of the central

bank.• It is organized according to the principles of double-

entry bookkeeping.– Any acquisition of an asset by the central bank results in a

+ change on the assets side of the balance sheet.

– Any increase in the bank’s liabilities results in a + change on the balance sheet’s liabilities side.

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Assets LiabilitiesForeign Assets (FA)

Domestic Assets (DCB)

Monetary Base or Currency in Circulation (H)

Deposits from private banks (Db)

FA + DCB H + Db

Central Bank

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Assets LiabilitiesDeposits at Central Bank (Db)

Domestic Assets and loans to private individuals (DCB)

Deposits from private individuals (D)

Db + DCB D

Private banks

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Assets LiabilitiesForeign Assets (FA)

Net Domestic Assets

(DC= DCB + Db)

Currency in Circulation (H)

Deposits from private individuals (D)

FA + DC H + D

Consolidated Banking Sector

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• The money supply is M– M = FA + DC = H + D

• Example: Assume that the Central Bank has– FA=USD 1000

– DC=USD 1500

– H=USD 2000

– D=USD 500

– M = USD 2500

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Assets LiabilitiesFA: USD 1000

DC: USD 1500

H: USD 2000

D: USD 500

M = FA +DC = USD 2500 M = H + D = USD 2500

Example:


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• The money supply is M– M = FA + DC = H + D

• How does the central bank raises the money supply?

1. Open Market operations

2. Rediscount operations

3. Foreign exchange operations

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• Open Market Operations– The central banks purchases domestic assets (t-bills)

from private individuals.

– So, increase in DC= DCB + Db (from rise in DCB) raises M. Must be matched by a rise in either H or D.

– Example: The central bank buys USD 100 of US t-bills on the open market with newly printed money. This raises money in circulation by USD 100. Total money supply is raised by USD 100.

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DC: USD 1600

H: USD 2100

D: USD 500

M = FA + DC = USD 2600 M = H + D = USD 2600

An open market operation:


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• Rediscount Operations– The central bank lends to commercial (private) banks at the

“discount rate.” A reduction in the discount rate should raise the amount of loans to private banks.

– So, increase in DC= DCB + Db (from rise in DCB) raises M, since M = FA + DC = H + D. Must be matched by a rise in either H or D.

– Example: The central bank reduces the discount rate. This raises loans from private banks by USD 50 (issued in newly printed money). This raises money in circulation by USD 50. Total money supply is raised by USD 50.

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DC: USD 1550

H: USD 2050

D: USD 500

M = FA + DC = USD 2550 M = H + D = USD 2550

A rediscount operation


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• Foreign Exchange Operations– The central banks purchases foreign assets.

– So, increase in FA raises M, since M = FA + DC = H + D.

– Must be matched by a rise in either H or D.

– Example 1: The central bank purchases USD 60 worth of foreign assets (from foreigners) with newly issued money. This raises money in circulation and money supply by USD 60.

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DC: USD 1500

H: USD 2060

D: USD 500

M = FA +DC = USD 2560 M = H + D = USD 2560

Example 1:


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• Foreign Exchange Operations– Example 2: The central bank purchases USD 60 worth

of foreign assets from domestic (depositors at) private banks. This raises deposits by USD 60. Overall, money supply is raised by USD 60.

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DC: USD 1500

H: USD 2000

D: USD 560

M = FA +DC = USD 2560 M = H + D = USD 2560

Example 2:


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• Sterilized Intervention– A sterilized intervention is an intervention in

which the central banks either purchases or sells foreign reserves with net domestic assets.

DCFAM

0 MDCFA

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• Sterilized Intervention– Example 3: The central bank purchases USD 60 worth

of foreign assets from foreigners. The bank pays using domestic assets. This raises foreign assets but lowers domestic credit. There is no effect on money supply.

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DC: USD 1440

H: USD 2000

D: USD 500

M=FA +DC = USD 2500 M=H + D = USD 2500

Example 3:


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• The Balance of Payments and Money Supply– Earlier, we defined changes in official reserves (RFX)

only briefly. Formally, the balance of payments (CA + KA) is the international payment gap that central banks must finance through their reserve transactions.

– It is the net purchases of foreign assets by the home central bank less net purchases of domestic assets by foreign central banks.

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• If a country has a balance of payments surplus: – CA + KA > 0

– If the central bank does not sterilize, the resulting increase in the central bank’s foreign assets implies a rise in the money supply.

– If the central bank sterilizes, the resulting in the central bank’s foreign assets is matched by a reduction in the central bank’s domestic assets, and the money supply does not change.

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Fixing Exchange Rates

• Preliminaries– Who fixes the exchange rate?

• One-sided peg versus two-sided peg.

– It is a single target or a target zone?– It is a credible policy?

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• Foreign Exchange Market Equilibrium– The foreign exchange market is in equilibrium

when:

i = i* + (Se – S)/S• As long as the fixed rate policy is credible, Se = S.

That is, investors expect no appreciation or depreciation of their currency. The expected future exchange rate must equal the current exchange rate.

• This implies that i = i*.

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• Money Market Equilibrium– The money market equilibrium requires that

• M/P = L( i, Y) at home

• M/P = L( i*, Y*) abroad

– In a two-sided peg, both central banks work together to ensure that i = i*.

– In a one-sided peg, the home central bank alone works to ensure that i = i*.

• That is, the central bank takes the foreign interest rate i* as given.

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• One-Sided Peg– To hold the domestic interest rate at i*, the central

bank’s foreign exchange intervention must adjust the money supply so that i=i* and

M/P = L( i*, Y)

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– Example: Suppose the central bank has been fixing S at S0.

• An increase in output would raise the money demand and thus lead to a higher interest rate and an appreciation of the home currency.

• The central bank must intervene in the foreign exchange market by buying foreign assets to prevent this appreciation.

• If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, it cannot keep the exchange rate fixed at S0.

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M/P

USD Rates of Return

S

0

i* + (S0 – S)/S

M1

P

L(i, Y1)i*

1

2

3

1'3'

L(i, Y2)

S0

M2

P

One-Sided Peg: A rise in output

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• Monetary Policy– Under a fixed exchange rate regime, monetary policy

tools are ineffective to affect output and the interest rate.

– With sticky prices, a rise in M would otherwise change the interest rate, and thus the exchange rate.

– Monetary policy must ensure that i = i*.

– Thus, a rise in M must lead to an immediate reduction in M to prevent any short-run or long-run changes in the exchange rate.

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Y

S

S0

Y1

1

S2

Y2

2

AA1

AA2

DD

Policy Ineffectiveness: A rise in M

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• Monetary Policy– Under a fixed exchange rate regime, the country

imports foreign inflation.

– The real interest rate is given by:

– So, for a constant real interest rate, i = i* implies that

eir

*

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• Fiscal Policy– Under a fixed exchange rate regime, fiscal policy is

more effective.

– The rise in government expenditures stimulates output. • This raises money demand and puts pressure to raise the

interest rate and change the exchange rate.

• To prevent the rise in the interest rate and exchange rate, the central banks must raise money supply. That is, the central bank must buy foreign assets with money (i.e., increasing the money supply).

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Y

S

S2

Y2

2S0

Y1

1

AA1

DD2

DD1

AA2

3

Y3

Policy Effectiveness: A rise in G

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• Devaluation– It occurs when the central bank lowers the value of its

currency on the foreign exchange market. It is an increase in the target value of S.

– It causes:• A rise in output• A rise in official reserves • An expansion of the money supply

– It is chosen by governments to:• Fight domestic unemployment• Improve the current account• Raise the central bank's foreign reserves

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• Revaluation– It occurs when the central bank lowers E.

• To devalue or revalue, the central bank must announce its willingness to stand and trade, in unlimited amounts, at the new exchange rate.

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• Devaluation– A devaluation can be studied like a rise in money

supply.

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Y

S

S0

Y1

1

S1

Y2

2

DD

AA1

AA2

A Currency Devaluation

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BOP Crises and Capital Flight

• Balance of payments crisis– A rapid change in official foreign reserves. – Generally sparked by a change in expectations

about the future exchange rate. That is, a belief of a large future devaluation.

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• The belief in a large future devaluation might result from:

– A large balance of payment imbalance.• To resolve the imbalance, a devaluation would promote

exports and reduce imports.

– A high domestic unemployment.• An expansionary monetary policy (a devaluation) could

stimulate output and lower unemployment.

– Low foreign reserves.• If the central bank sells foreign reserves to fix the exchange

rate, low reserves signal that the regime is about to stop.

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• The expectation of a future devaluation causes:– A balance of payments crisis marked by a sharp fall in

reserves

– A rise in the home interest rate above the world interest rate

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M/P

Home currency rates of return

S

0 i*

1M1

P

M2

P

L(i, Y)

2

i* + (S1 – S0)/S0

i* + (S0 – S)/S

i* + (S1– S)/S

2'S0

1'

A rise in Se

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• Capital flight:

– A rapid transfer of currencies and assets out of a country.

• Mechanisms to transfer currencies and assets:

– Transfers via the international payments mechanisms. These are just regular bank transfers.

– Transfer of physical currency by the bearer. This cash smuggling activity is usually illegal.

– Transfer of cash into collectibles or precious metals.

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– Cross-border purchase of foreign assets that are managed to hide movement of money and ownership (Money Laundering).

– False invoicing of international trade transactions. Capital is moved via the under-invoicing (over-invoicing) of exports (imports), where the difference between the invoiced amount and the actually agreed-upon payment is deposited in banking institutions in another country. The most typically associated with capital flight.

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• Self-fulfilling currency crises– It occurs when an economy is vulnerable to

speculation.

– The government may be responsible for such crises by creating or tolerating domestic economic weaknesses that invite speculators to attack the currency.

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Sterilized Intervention

• A sterilized intervention is a change in the composition of assets at the central bank that leaves the money supply unchanged.– Example: A sale of foreign reserves against a purchase

of domestic assets.

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• In our current framework, a sterilized intervention does not affect the exchange rate.– Under our current framework, a sterilized intervention

does not affect money supply M.• It does not affect the interest rate.

• It does not affect inflation.

– A sterilized intervention does not affect the exchange rate in either short or long run.

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• Imperfect Asset Substitutability– The ineffectiveness of sterilized intervention is linked

to the assumption of perfect asset substitutability embedded in our version of uncovered interest parity:

– A departure from this version is required for sterilized intervention to matter.

SSSii e /)(*

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• Imperfect asset substitutability– We need to take seriously the idea of a risk premium.

– Risk is the main factor that may lead to imperfect asset substitutability in foreign exchange markets.

– Knowledge of the risk premium may allow central banks to control both the money supply and the exchange rate separately through sterilized intervention.

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• Imperfect asset substitutability– Investors may be willing to earn lower expected returns

on less risky assets.

– Investors require higher expected returns to accept holding on to riskier assets.

– This trade-off between expected returns and risk can be exploited by central banks.

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• Imperfect asset substitutability– The risk premium version of the uncovered interest

parity or foreign exchange market equilibrium is

i = i* + (Se – S)/S +

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• Imperfect asset substitutability is a risk premium that reflects the difference between

the riskiness of domestic and foreign bonds. – The risk premium is a positive function of the stock of

domestic government debt:

= (B – A) where:

B is the stock of domestic government debt

A is domestic assets of the central bank

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• A model of the risk premium– In a risky world where assets are imperfect substitutes,

investors prefer holding on to a diversified portfolio of assets.

– Starting from a well diversified portfolio, investors may be willing to hold more domestic assets if expected returns on domestic currency assets are higher.

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• A model of the risk premium– The demand for domestic currency assets (i.e. domestic

government debt) by investors is an increasing function of B-A: The higher the return, the higher the quantity demanded:

Bd = F( )

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• A model of the risk premium– The supply of domestic currency assets to

investors is equal to the value of domestic currency government debt B less what is held by the central bank A:

Bs = B – A– The equilibrium is Bs = Bd:

B – A = F( )

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domestic bonds

B – A

Bd

A model of the risk premium

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• The Effects of a Sterilized Intervention– The central bank purchases foreign assets sterilized by

a sale of domestic assets.– The supply of money does not change. Abstracting

from changes in output, the domestic interest rate does not change.

– The rise in the amount of domestic asset that investors must hold: A drops from A1 to A2.

– This raises the amount of domestic currency assets that investors must bear. They will do so, only if expected returns are higher (through a higher risk premium).

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domestic bonds

B – A1

Bd

1

1

2

(A2 < A1)B – A2

Sterilized intervention and the risk premium

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– Effectively, the rise in the risk premium engineers a depreciation of the domestic currency.

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M/P

DomesticInterest rate

S

0

Ms

P

L(i, Y)

1

1' i* + (Se– S)/S + (B –A2)

i* + (Se – S)/S + (B –A1)

S2

S1

Sterilized intervention and the risk premium

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– Empirical evidence provides little support for the idea that sterilized intervention has a significant direct effect on exchange rates.

• Signaling effect of foreign exchange intervention

– Sterilized intervention may give an indication of where the central bank expects (or desires) the exchange rate to move.

– This signal can change market views of future policies even when domestic and foreign bonds are perfect substitutes.

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The World Monetary System

• Two Systems for Fixing Exchange Rates:– Reserve currency standard

• Central banks peg the prices of their currencies in terms of a reserve currency.

– Gold standard• Central banks peg the prices of their currencies in

terms of gold.

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• Reserve Currency Standard– A reserve currency standard system is similar to the

system based on the U.S. dollar set up at the end of World War II

– Every central bank fixed the U.S. dollar exchange rate of its currency through foreign exchange interventions.

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• Asymmetric Position of the Reserve Currency– The reserve-issuing country has a big advantage

• It is not pegging its currency.

• It can use its monetary policy for domestic stabilization.

– The purchase of domestic assets by the central bank of the reverse currency country leads to:

• Higher demand for foreign currencies: an upward pressure on the exchange rate.

• Expansionary monetary policies by all other central banks

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• Gold Standard– Each country fixes its currency in terms of gold.

– No single country occupies a privileged position within the system.

– Exchange rates between any two currencies are fixed.• Example: If the dollar price of gold is pegged at USD 35 per

ounce while the pound price of gold is pegged at GBP 14.58, the USD/GBP exchange rate is constant at USD 2.40/GBP.

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• Symmetric Adjustment with a Gold Standard– If a country is losing reserves and its money

supply decreases, foreign countries are gaining reserves and their money supplies increases.

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• Benefits of the Gold Standard– It avoids the asymmetry inherent in a reserve

currency standard.– It places constraints on the growth of countries’

money supplies.

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• Drawbacks of the Gold Standard– Undesirable constraints on the use of monetary policy

to fight unemployment.

– Ensures a stable overall price level only if the relative price of gold and other goods is stable.

– Makes central banks compete for reserves and bring about world unemployment.

– Gives gold producing countries (like Russia and South Africa) a lot of power.

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• Bimetallic standard– The currency is based on both silver and gold.– The U.S. was bimetallic from 1837 until the Civil War.– In a bimetallic system, a country’s mint coins specified

amounts of gold or silver into the national currency unit.

• Example: 371.25 grains of silver or 23.22 grains of gold yield a silver or a gold dollar. Thus, gold is worth 371.25/23.22 = 16 times as much as silver.

– It might reduce price-level instability resulting from the use of one of the metals alone.

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• The Gold Exchange Standard– Central banks’ reserves consist of gold and currencies

whose prices are fixed in terms of gold.• For example, each central bank fixes its exchange rate to the

USD, and the USD is a fixed to gold.

– It can operate like a gold standard in restraining excessive monetary growth throughout the world, but it allows more flexibility in the growth of international reserves.

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Summary

• The central bank balance sheet shows a direct link between foreign exchange intervention and the money supply.

• A central bank’s purchase of foreign assets raises the country's money supply.

• The central bank can negate the money supply effect of intervention through sterilization.

• A central bank can fix the exchange rate of its currency against foreign currency if it trades unlimited amounts of domestic money against foreign assets at the target rate.

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Summary

• A commitment to fix the exchange rate forces the central bank to sacrifice its ability to use monetary policy for stabilization.

• Fiscal policy is more effective on output under fixed exchange rates than under floating rates.

• Balance of payments crises occur when market participants believe the central bank will change the exchange rate from its current level.

• Self-fulfilling currency crises can occur when an economy is vulnerable to speculation.

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Summary

• A system of managed floating allows the central bank to retain some ability to control the domestic money supply.

• A world system of fixed exchange rates based on a reserve currency gives an asymmetric higher power to the reserve currency country.

• A gold standard avoids the asymmetry inherent in a reserve currency standard.

• A related arrangement was the bimetallic standard based on both silver and gold.

1 section 6 exchange rate regimes. 2 content exchange rate regimes central bank intervention fixing...

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