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Fixed Exchange Rates and Foreign Exchange Intervention

Fixed Exchange Rates and Foreign Exchange Intervention

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Fixed Exchange Rates and Foreign Exchange Intervention

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  1. Fixed Exchange Rates and Foreign Exchange Intervention Chapter 18 Krugman and Obstfeld 9e ECO41 International Economics Udayan Roy

  2. Why Study Fixed Exchange Rates? • Four reasons to study fixed exchange rates: • Managed floating • Regional currency arrangements • Developing countries and countries in transition • Lessons of the past for the future • In this chapter, we will stick to short-run analysis

  3. Central Bank Interventionand the Money Supply • The Central Bank owns two types of assets: • Foreign assets • Mainly foreign currency bonds owned by the central bank (its official international reserves) • Domestic assets • Central bank holdings of claims to future payments by its own citizens and domestic institutions

  4. Central Bank Interventionand the Money Supply • Any central bank purchase of assets automatically results in an increase in the domestic money supply. • Example: If the US central bank (“The Fed”) buys Yen, it must pay for the Yen with newly printed dollars. Therefore, the US money supply (MUS) must increase

  5. Central Bank Interventionand the Money Supply • Any central bank sale of assets automatically causes the money supply to decrease. • Example: If the Fed sells its Yen reserves, the dollars paid by the buyer will no longer be in circulation. Therefore, the US money supply (MUS) must decrease • In short, a country’s reserves of foreign currencies moves in the same direction as its money supply

  6. How Can Central Banks Keep Exchange Rates Fixed? • Simple! • When the value of the dollar starts to fall against the euro (that is, E starts to increase), the US central bank (the ‘Fed’) could push it back up • How? The Fed could selleuros from its reserves in exchange for dollars. • This will create an abundance of euros and a shortage of dollars and thereby reverse the fall in the dollar’s value. • Recall from the last slide that this decrease in US reserves of Euros must be accompanied by a decrease in US money supply. Warning: This strategy will not work if the Fed runs out of Euros!

  7. How Can Central Banks Keep Exchange Rates Fixed? • On the other hand, when the value of the dollar starts to rise against the euro (that is, E starts to fall), the Fed could pull it back down • How? The Fed could buy euros with freshly printed dollars. • This will create an shortage of euros and a flood of dollars and thereby reverse the rise in the dollar’s value. • Recall from the last slide that this increase in US reserves of Euros must be accompanied by an increase in US money supply.

  8. How Can Central Banks Keep Exchange Rates Fixed? • To summarize, a central bank can • raise the value of the domestic currency (E↓) by reducing the money supply (Ms↓) • reduce the value of the domestic currency (E↑) by increasing the money supply (Ms↑) • In this way, the central bank can keep the exchange rate fixed at the desired level, as long as it does not run out of foreign currency

  9. What is Monetary Policy Under Fixed Exchange Rates? • As the central bank in a fixed exchange rate system must keep the money supply at the precise level necessary to keep the exchange rate fixed at the target rate, it becomes unable to use the money supply to pursue any other objective (such as fighting a recession)

  10. What is Monetary Policy Under Fixed Exchange Rates? • We saw in Chapters 16 and 17 that in an economy with flexible exchange rates, monetary policy consists of changes in the money supply (Ms) • Ms↑ is expansionary monetary policy • Ms↓is contractionary monetary policy • But in a fixed exchange rate system, the money supply is no longer controlled by the central bank

  11. What is Monetary Policy Under Fixed Exchange Rates? • The central bank does, however, control the rate E0 at which the exchange rate is kept fixed • E0 ↑ (devaluation) is expansionary monetary policy • E0 ↓ (revaluation) is contractionary monetary policy

  12. Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate • Recall that the foreign exchange market is in equilibrium when: R= R* + (Ee – E)/E • When the central bank fixes the exchange rate at E= E0, people will expect Ee = E0. • Therefore, (Ee – E)/E= (E0– E0)/E0= 0. • Therefore, R= R*. • Under fixed exchange rates, the domestic interest rate is tied to the foreign interest rate.

  13. Goods Market Equilibrium • Recall that equilibrium is achieved in the goods market when aggregate output Y equals aggregate demand D. • P* and P are assumed fixed in the short run, • T, I, and G are exogenous and fixed, and • Eis fixed: after all, this is a fixed exchange rate system! • So, only Y can vary and only Y can ensure goods market equilibrium • Therefore, this equation alone determines the equilibrium value of Y.

  14. Goods Market Equilibrium • We saw in Chapter 17 that • the goods market’s equilibrium equation gives us the upward rising DD curve, and that • The DD curve shifts right if • G increases • T decreases • I increases • P decreases • P* increases • C increases for some unknown reason • CA increases for some unknown reason

  15. Goods Market Equilibrium • In this chapter, the exchange rate is fixed • So, whatever shifts DD right must also increaseY • The DD curve shifts right if • G increases • T decreases • I increases • P decreases • P* increases • C increases for some unknown reason • CA increases for some unknown reason • Moreover, if the fixed level of E↑, then Y↑

  16. Goods Market Equilibrium Note that an increase in the (fixed) value of the foreign currency raises output. Such a policy—which could be very useful in a recession—is called a devaluation. Among the “CA (other reasons)” factors would be tariffs or other protectionist policies. The theory suggests that such policies could also help boost output … so long as other countries don’t retaliate.

  17. Fig. 18-3: Fiscal Expansion Under a Fixed Exchange Rate A fiscal expansion shifts the DD curve to the right, threatening to decreaseE. To keep E fixed, the AA curve must be moved to the right, usually by increasing the money supply. As a result the overall effectiveness of fiscal policy is greater than under flexible exchange rates. As under flexible exchange rates, expansionary fiscal policies reduce net exports (CA).

  18. The Current Account • Recall from Chapter 17, that there are two ways to express a country’s current account • Method 1: • Method 2:

  19. The Current Account • Assumption: When Y changes and T is unchanged, C changes in the same direction but by less. • Therefore, when Ychanges and T is unchanged, Y−Cchanges in the same direction • It then follows from that all the exogenous factors other than I, G, and T that affect Y must affect CA in the same way

  20. The Current Account • We have seen that T↓, I↑ and/or G↑ causes Y↑ • Therefore, Y − T ↑ • Therefore, must ↓

  21. Goods Market Equilibrium Note that, as under flexible exchange rates, contractionary fiscal policies (“fiscal austerity” or “belt tightening”) can raise a country’s current account balance in the short run. So can protectionist policies such as tariffs and quotas.

  22. Money Market Equilibrium Under a Fixed Exchange Rate • Equilibrium in the money market requires MS/P = L(R, Y) • But equilibrium in the foreign exchange market determines R (=R*) and equilibrium in the goods market determines Y. • Therefore, L(R, Y) is already determined. • Moreover, P is exogenous and fixed in the short run. • So, this equation alone determines the equilibrium level of the money supply (Ms)

  23. The Money Supply is no longer a policy tool • Under a fixed exchange rate, the money supply is an endogenous variable • It is no longer a policy tool • The monetary policy tool is now E0, the rate at which the exchange rate is pegged

  24. It Might Help to Adjust the Fixed Exchange Rate From Time to Time • Devaluation • It occurs when the central bank raises the domestic currency price of the foreign currency, E. • 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 • Affect the central bank's foreign reserves

  25. It Might Help to Adjust the Fixed Exchange Rate From Time to Time • Revaluation • It occurs when the central bank lowers E. • In order to devalue or revalue, the central bank has to announce its willingness to trade domestic against foreign currency, in unlimited amounts, at the new exchange rate.

  26. The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason Shifting the DD and AA Curves

  27. Fig. 18-4: Effect of a Currency Devaluation If a devaluation from E0 to E1 is to be achieved, the equilibrium value of E must be made to rise to E1. This can be done by increasing the money supply and moving the AA curve to the right. So, devaluation raises GDP and reduces unemployment and is, therefore, a tempting policy option in a recession. This increases net exports (CA).

  28. The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason Shifting the DD and AA Curves

  29. Fig. 18-4: Effect of the Expectation of a Currency Devaluation If a devaluation (an increase in E) is widely expected, there is an increase in Ee. As a result, the AA curve shifts right. To keep E fixed, the central bank must sell its foreign currency reserves and thereby reduce the domestic money supply and bring the AA curve back to where it was. So, the mere expectation of a devaluation may cause the central bank to lose a lot of its reserves. If its reserves are inadequate, the central bank may be forced to devalue or to simply switch to flexible exchange rates.

  30. Balance of Payments Crises and Capital Flight • Balance of payments crisis • It is a sharp fall in official foreign reserves sparked by a change in expectations about the future exchange rate.

  31. Balance of Payments Crises and Capital Flight • 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 • An expected revaluation causes the opposite effects of an expected devaluation.

  32. Balance of Payments Crises and Capital Flight • Capital flight • The reserve loss accompanying a devaluation scare • The associated debit in the balance of payments accounts is a private capital outflow. • 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.

  33. The long run under fixed exchange rates

  34. Summary: Long-Run, Flexible Exchange Rates • q = 1, absolute PPP • Y = Yp This is a recap of Chapter 16, which discussed flexible exchange rates. How will these results change under fixed exchange rates? The first two are real variables. Under the principle of monetary neutrality, they will not change. We saw earlier that R = R*. Also, it is obvious that E = E0 and Eg = 0. Only P and π remain to be determined.

  35. Inflation • As we saw in Chapter 16, under either absolute purchasing power parity or relative purchasing power parity we get • But under fixed exchange rates, the rate at which the exchange rate appreciates must be zero: • Therefore,

  36. The Price Level • Absolute PPP: • Therefore, • Relative PPP: , a constant • Therefore,

  37. Summary: Long-Run, Fixed Exchange Rates • q = 1, absolute PPP • q=q0, relative PPP • Y = Yp • , absolute PPP • , relative PPP One major weakness of a fixed exchange rate system is that the country adopting such a system loses control of its inflation and interest rates.