Fixed Exchange Rate & Foreign Exchange Intervention

1. Fixed Exchange Rate & Foreign Exchange Intervention Fixed exchange rate: end of World War II-1973 Hybrid system (managed floating): after 1973 feature: central banks routinely intervening Chinese version

2. Fixed exchange rates? • Managed floating • Regional currency arrangements • Developing countries and countries in transition • Lessons of the past for the future

3. Central bank intervention & the money supply • central bank transactions in asset markets • the central bank balance sheet • according to the principles of double-entry bookkeeping

4. double-entry bookkeeping

5. Changes in the central bank’s assets cause changes in the domestic money supply • When the central bank buys an asset from the public, its payment (cash/check) enters the money supply. • the asset purchase →money supply to expand. • the asset sale →receive cash or check →money supply shrinks

6. upshot • Changes in the level of central bank asset holdings cause the money supply to change in the same direction because they require equal changes in the central bank’s liabilities. • Any central bank purchase of assets automatically results in an increase in the domestic money supply, while any central bank sale of assets automatically causes the money supply to decline.

7. Money multiplier Effect • When the central bank buys assets, the accompanying increase in the money supply is larger than the initial asset purchase because of multiple deposit creation within the private banking system.

8. Central Bank Balance Sheet

9. Exchange intervention ① sell $100 for ￥ ② pay $100 in ￥

10. Decline in Money Supply

11. private citizen’s action ②Private bank deposits with the central bank fall by $100 ① buyer of foreign asset pays a $100 check drawn on deposit

12. result of such action

13. Sterilization • Sterilized foreign exchange intervention: Central banks carry out equal foreign and domestic asset transactions in opposite directions to nullify the impact of their foreign exchange operation on domestic money supply.

14. Before Sterilized $ 100 Sale ① sell $100

15. Sterilized Process ① sell $100 ②buy $100 of domestic A

16. After Sterilized $ 100 Sale

17. Table 17-2 Summary 简译

18. Balance of Payments & Money Supply • Different definition: • BOP is the sum of the current account and the non-reserve component of capital account, that is, the international payment gap that central banks must finance through their reserve transaction.

19. BOP & Growth of Money Supply • If central banks are not sterilizing and the home country has balance of payments surplus, any associated increase in the home central bank’s foreign assets implies an increased home money supply. Similarly, any associated decrease in a foreign central bank’s claims on the home country implies a decreased foreign money supply.

20. Burden of BOP adjustment • Macroeconomic goals of the central banks and institutional arrangement governing intervention; • Central banks may be sterilizing to counter the monetary effects of reserve changes; • Some central bank transactions indirectly help to finance a foreign country’s BOP deficit.

21. How the central bank fixes the exchange rate? • Through foreign exchange intervention. • Condition: only if its financial transactions ensure the asset market remain in equilibrium when the exchange rate is at its fixed level. • Foreign exchange market equilibrium • Money market equilibrium

22. Exchange market equilibrium • Interest rate parity must hold Expectation of domestic currency is zero!

23. Money market equilibrium R* equates aggregate real domestic money demand and real money supply. Given P and Y, the above equilibrium condition tells what the money supply must be if a permanently fixed exchange rate is consistent with asset market equilibrium at foreign exchange rate of R*.

24. A rise in output raises the demand for domestic money… • This foreign asset purchase (by the central bank) eliminates the excess demand for domestic money because the central bank issues money to pay for the foreign assets it buys.

25. E 外币储蓄的本币收益 维持固定汇率 ● ● R ②货币供应增加 ● ● 实际货币供给 ● ①产出增加 实际国内货币持有

26. Stabilization Policies Alternatives: • Monetary policy • Fiscal policy • An abrupt change in the exchange rate’s fixed level, E0

27. Two alternatives under the fixed • By fixing the exchange rate, the central bank gives up its ability to influence the economy through monetary policy. Fiscal policy becomes a more potent tool for affecting output and employment.

28. Analysis approaches • DD-AA model • Add the assumption that the expected future exchange rate (Ee) equals the rate E0 at which the central bank is pegging.

29. 1. Monetary Policy • Under a fixed exchange rate, central bank monetary policy tools are powerless to affect the economy’s money supply or its output.

30. 在固定汇率制下货币扩张是无效的 E DD 央行不得不出售外国资产来换回本币 ② E2 维持固定汇率 E0 ① 中央银行通过购买国内资产扩大国内货币供给来增加产出 AA2 AA1 Y Y1 Y2

31. 2. Fiscal Policy • Fiscal policy can be used to affect output under a fixed exchange rate. • In comparison with under a floating rate, fiscal expansion is accompanied by an appreciation of domestic currency and the central bank is forced to expand the money supply through foreign exchange purchases.

32. 为了避免过度的货币需求造成利率上升,引起本币升值,央行购买外国资产,从而增加了本币的供给,这种干预移动了AA曲线为了避免过度的货币需求造成利率上升,引起本币升值,央行购买外国资产,从而增加了本币的供给,这种干预移动了AA曲线 财政扩张政策移动DD E DD1 DD2 ③ ① E0 ② 本币升值压力 E2 AA2 AA1 Y 干预结果产出增加而汇率不变 Y1 Y2 Y3

33. 3. Changes in the exchange rate • Devaluation (or revaluation) is a last resort for the central bank… • Devaluation causes a rise in output, a rise in official reserves, and an expansion of the money supply. A private capital inflow matches the central bank’s reserve gain (an official outflow) in the balance of payments account.

34. E DD ② Both output & money supply expand E1 本币贬值 ① E0 AA2 AA1 Y Y1 Y2

35. Why choose to devaluate? • Devaluation allows the government to fight domestic unemployment despite the lack of effective monetary policy. • Devaluation is the most convenient way of boosting aggregate demand. (government spending and budget deficit unpopular) • Central bank is running low on reserves, devaluation is a kind of tax on holders of government bonds and money.

36. Balance of payments crises & capital flight • The market’s belief in an impending change in the exchange rate gives rise to a balance of payments crisis, a sharp change in official foreign exchange reserves sparked by a change in expectations about the future exchange rate.

37. E 本币贬值预期右移外币储蓄的本币收益曲线 ⑴ ⑵ 外币储蓄的本币收益 ● ● R 央行必须出售外汇储备,紧缩国内货币供给。 ● ② 实际货币供给 ● ① 实际国内货币持有

38. Upshot • The expectation of a future devaluation causes a balance of payment crisis marked by a sharp fall in reserves and a rise in the home interest rate above the world interest rate and vice versa.

39. Capital flight • The reserve loss accompanying a devaluation scare is often labeled capital flight because the associated debt in the balance of payments accounts is a private capital outflow.

40. What causes currency crises? • Central bank is compelled to buy bonds form the domestic government to allow the government to run continuing fiscal deficits. • Central bank’s purchases of domestic assets cause losses of foreign exchange reserves. • Central bank can not support of rise of domestic interest rate.

41. Solution to the currency crises • The central bank should stop bankrolling the government deficit, hopefully forcing the government to live within its means. • Independence of central bank.

42. Self-fulfilling currency crises • An economy can be vulnerable to currency speculation without being in such bad shape that a collapse of its fixed exchange regime is inevitable. • An economy in which domestic commercial banks’ liabilities are mainly short-term deposits. The central bank has to lend money to the commercial banks.

43. Managed floating & sterilized intervention • Under managed floating, monetary policy is influenced by exchange rate changes without being completely subordinate to the requirements of a fixed rate. • The central bank faces a trade-off between domestic objectives (employment or the inflation rate) and exchange rate stability. • Such efforts are usually ended in sterilization or nullification.

44. Intervention=sterilization? • Tools of intervention: money supply & interest rate. • Empirical studies confirm that such intervention are sterilized throughout the 20th century and earlier.

45. Perfect asset substitutability & Ineffectiveness of sterilized intervention • Without change in the domestic money supply, any intervention by the central bank will not affect the domestic interest rate and therefore will not affect the exchange rate.

46. Mexico’s 1994 Balance of Payments Crisis 利率被迫拉升 储备不断减少

47. Sterilization is fruitless under the fixed exchange rate • The ineffectiveness of monetary policy under a fixed exchange rate implies that sterilization is a self-defeating policy.

48. Perfect asset substitutability • All interest-bearing (non-money) assets denominated in the same currency, whether illiquid time deposits or government bonds, are perfect substitutes in portfolios.The single term “bonds” will generally be used to refer to all assets. • Interest Parity Condition holds • Nothing a central bank can do through intervention.

49. Imperfect asset substitutability • Risk in the foreign exchange market. • Risk preference is different to investors.

50. Perfect asset substitutability: expected rate of return that matters • Imperfect asset substitutability: both returns and risk that matters.