Money, Banking, and Financial Markets : Econ. 212

1. Money, Banking, and Financial Markets : Econ. 212 Stephen G. Cecchetti: Chapter 19 Exchange-Rate Policy and the Central Bank

2. Linking Exchange-Rate Policy with Domestic Monetary Policy • Inflation and the Long-Run Implications of Purchasing Power Parity • The law of one price says that identical goods should sell for the same price regardless of where they are sold. The concept of purchasing power parity extends the logic of the law of one price to a basket of goods and services. • The implication of this is that when prices change in one country, but not in another, the exchange rate will adjust to reflect the change. In the long run, changes in the exchange rate are tied to differences in inflation. • If a country wants to fix its exchange rate with another country, it must therefore conduct its monetary policy so that the two countries’ inflation rates match.

3. The central bank must choose between a fixed exchange rate and an independent inflation policy; it cannot have both. • Deviations from purchasing power parity occur, and can last for years. • Interest Rates and the Short-Run Implications of Capital Market Arbitrage • In the short run, a country’s exchange rate is determined by supply and demand. The exchange value of a currency depends on the preferences of the country’s citizens for foreign assets and the preferences of foreign investors for the country’s assets. • In the short run, investors can move large quantities of currency across international borders, assuming that governments allow the free movement of funds.

4. International capital mobility results in capital market arbitrage across nations. Two bonds that are equally risky, with the same maturity and same coupon rate will sell for the same price and have the same interest rate; this is true even if the bonds are denominated in different currencies. • If interest rates differ in two countries and their exchange rate is fixed, investors will move back and forth, wiping out the difference.

5. Capital Controls and the Policymakers’ Choice • If capital cannot flow freely between countries, there is no mechanism to equate interest rates in the two countries. • So long as capital can flow freely, monetary policymakers must choose between fixing their exchange rate and fixing their interest rate. A country cannot be open to capital flows, control its domestic interest rate, and fix its exchange rate. Policymakers must choose two of these three. • Different countries make different choices; if a country is willing to forgo participation in international capital markets it can impose capital controls, fix its exchange rate, and still use monetary policy to pursue domestic objectives.

6. Capital controls go against the grain of modern economic thinking. Internationally integrated capital markets ensure that capital goes to its most efficient uses. • The free flow of capital across borders enhances competition, improves opportunities for diversification, and equalizes rates of return (adjusted for risk). • For a developing country, openness comes with the risk of large movements of funds out of the country, driving the interest rate up and the value of the currency down. • It is tempting for governments to try to avoid such crises by restricting the ability to move capital in and out of a country (inflow controls and outflow controls).

7. Mechanics of Exchange Rate Management • The Central Bank’s Balance Sheet • If all policymakers want to do is fix the exchange rate they can offer to buy and sell their country’s currency at a fixed rate. • However, these interventions have an impact on interest rates and on the quantity of money in the economy: buying foreign currency or selling dollars increases reserves, putting downward pressure on interest rates and expanding the quantity of money. • In effect, the decision to control the exchange rate means giving up control of the size of reserves, so that the market determines the interest rate. • A foreign exchange intervention has the same impact on reserves as a domestic open market operation.

8. A foreign exchange intervention affects the value of a country’s currency by changing domestic interest rates. In general any central bank policy that influences the domestic interest rate will affect the exchange rate.

10. Sterilized Intervention • In a sterilized intervention, a change in foreign exchange reserves alters the asset side of the central bank’s balance sheet, but the domestic monetary base remains unaffected. • A sterilized intervention is actually a combination of two transactions, the purchase (or sale) or foreign currency reserves and an open market operation of exactly the same size, designed to offset the impact of the first transaction on the monetary base. • The intervention changes the composition of the asset side of the central bank’s balance sheet but not its size.

12. The Costs, Benefits, and Risks of Fixed Exchange Rates • Assessing the Costs and Benefits • Fixed exchange rates simplify operations for businesses that trade internationally and reduce the risk that investors face when they hold foreign stocks and bonds as well. • A fixed exchange rate ties policymakers’ hands, and in countries that are prone to bouts of high inflation, a fixed exchange rate may be the only way to establish a credible low-inflation policy. Moreover, An exchange rate target enforces low-inflation discipline on both central banks and politicians and enhances transparency and accountability. • There is one serious drawback to a fixed exchange rate; it means importing monetary policy.

13. Fixing our currency to that of another country means adopting the interest rate policy of the other country, which can be a real problem if the two countries have different macroeconomic fluctuations. • In order to fix the rate, the central bank must have ample reserves because it will need to buy (and sell) its currency at the fixed rate; such reserves may be difficult to obtain and expensive to keep. • Fixing the exchange rate also means reducing the domestic economy’s natural ability to respond to macroeconomic shocks. The stabilization mechanism of interest rates is shut down.

14. The Danger of Speculative Attacks • Fixed exchange rates are fragile and are prone to a type of crisis called a speculative attack. • If traders believe that the reserves at the central bank are insufficient they can launch an attack and, in effect, drain those reserves. • Speculative attacks are caused by traders not believing that officials can maintain the exchange rate at its fixed level (perhaps due to expectations of inflation) but can also arise spontaneously (and can be contagious). • Summarizing the Case for a Fixed Exchange Rate • A country will be better off fixing its exchange rate if it has a poor reputation for controlling inflation on its own, an economy that is well integrated with the one to whose currency the rate is fixed, and a high level of foreign exchange reserves.

15. Regardless of how closely a country meets these criteria, fixed exchange rates are still risky to adopt and difficult to maintain. • Fixed Exchange-Rate Regimes • Exchange-Rate Pegs and the Bretton Woods System • The Bretton Woods System, which lasted from 1945 to 1971, was a system of fixed exchange rates that offered more flexibility over the short term than had been possible under the gold standard. • Each country maintained an agreed-upon exchange rate with the U.S. dollar (currencies were pegged to the dollar). Every country held dollar reserves and stood ready to exchange its own currency for the dollar at the fixed rate. • Countries had to intervene regularly to maintain the fixed rates at the peg.

16. The International Monetary Fund (IMF) was created to manage the system by making loans to countries in need of short-term financing to pay for an excess of imports over exports. • As capital markets opened up the system came under increasing strain, because with a fixed exchange rate and the free movements of capital, countries could no longer have independent monetary policies. • When U.S. inflation began to rise in the late 1960s many countries balked; they didn’t want to match the rise in inflation. • By 1971 the system had completely fallen apart, and American officials have allowed the dollar to float freely ever since. Europeans took the different approach of maintaining various fixed exchange rate mechanisms, up to the introduction of the euro.

17. Hard Pegs: Currency Boards and Dollarization • Under a hard-peg system the central bank implements an institutional mechanism that ensures its ability to convert a domestic currency into the foreign currency to which it is pegged. • Only two exchange-rate regimes can be considered hard pegs: a currency board (whereby the central bank commits to holding enough foreign currency assets to back domestic currency liabilities at a fixed rate) and dollarization (whereby the country formally adopts the currency of another country for use in all its financial transactions). • Currency Boards and the Argentinean Experience • Somewhere between 10 and 20 currency boards operate in the world today, the best known of which is the Hong Kong Monetary Authority. • With a currency board, the central bank’s only job is to maintain the exchange rate.

18. While that means that policymakers cannot adjust monetary policy in response to domestic economic shocks, the system does have its advantages. • Prime among the advantages is the control of inflation. But currency boards do have their problems, including the fact that the central bank loses its role as the lender of last resort to the domestic banking system. • Dollarization in Ecuador • In January of 2000, Ecuador officially gave up its currency, and almost immediately interest rates dropped, the banking system reestablished itself, inflation fell dramatically and growth resumed. • A year later El Salvador followed suit. Panama has been dollarized since 1904.

19. A country might choose dollarization because with no exchange rate there is no risk of an exchange-rate crisis, it helps the country become integrated into world markets, and it can reduce their risk premium (associated with inflation risk). • The benefits of dollarization are balanced against the loss of revenue from issuing currency (called seigniorage), the loss of the central bank’s role as lender of last resort, the loss of autonomous monetary or exchange rate policy, and the importing of U.S. monetary policy (like it or not). • Dollarization is not the same as monetary union, because dollarized countries have no “vote” in the monetary policy chosen by the FOMC. A monetary union is shared governance; dollarization is not.

20. Appendix: What You Really Need to Know about the Balance of Payments • To understand the international financial system you need to know three important terms connected with the international balance of payments: (1) current account balance; (2) capital account balance; and (3) the official settlements balance. • The current account tracks the flow of payments across national boundaries; the balance on the account is the difference between a country’s exports and imports of goods and services (also included are transfers and investment income). • The capital account tracks the purchase and sale of assets, and the balance is the difference between a country’s capital inflows and outflows.

21. The official settlements balance is the change in a country’s official reserve holdings; it shows the change in the central bank’s foreign exchange reserves (or gold reserves). • The three must sum to zero. A country running a current account deficit can pay for it by running a capital account surplus or it can draw down its foreign exchange reserves. • Countries with current account deficits would lose reserves and those with surpluses would gain them.

22. Lessons of Chapter 19 • When capital flows freely across a country's borders, fixing the exchange rate means giving up domestic monetary policy. • Purchasing power parity implies that, in the long run, exchange rates are tied to inflation differentials across countries. • Capital market arbitrage means that, in the short run, the exchange rate is tied to differences in interest rates. • Monetary policymakers must choose two of the following three options: open capital markets, control of domestic interest rates, and a fixed exchange rate. • Countries that impose controls on capital flowing in and/or out can fix the exchange rate without giving up their domestic monetary policy. • Central banks can intervene in foreign exchange markets. • When they do, it affects their balance sheet in the same way as an open market operation. • Foreign exchange intervention affects the exchange rate by changing domestic interest rates. This is called unsterilized intervention. • A sterilized intervention is a purchase or sale of foreign exchange reserves that leaves the central bank’s liabilities unchanged. It has no impact on the exchange rate. • The decision to fix the exchange rate has costs, benefits, and risks. • Both corporations and investors benefit from predictable exchange rates. • Fixed exchange rates can reduce domestic inflation by importing the monetary policy of a country with low inflation.

23. Fixed exchange rate regimes are fragile and leave countries open to speculative attacks. • The right conditions for choosing to fix the exchange rate include: • a poor reputation for inflation control. • an economy that is well integrated with the one to whose currency the rate is fixed. • a high level of foreign exchange reserves. • There are a number of examples of exchange-rate systems. • The Bretton Woods System, set up after World War II, pegged exchange rates to the U.S. dollar, but collapsed in 1971 after U.S. inflation began to rise. • Most fixed exchange rate regimes are no longer thought to be viable. • Two that may work are currency boards and dollarization. • With a currency board, the central bank holds enough foreign currency reserves to exchange the entire monetary base at the promised exchange rate. • Argentina's currency board collapsed when the regional governments began printing their own money. • Dollarization is the total conversion of an economy from its own currency to the currency of another country. • Several Latin American countries have adopted the dollar recently, with good results over the short run.

25. Key Terms • Bretton Woods System capital controls • capital inflow controls capital outflow controls • currency board dollarization • foreign exchange intervention gold standard • hard peg reserve currency • speculative attack sterilized intervention • unsterilized intervention