Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention

Don't hesitate to comment below if you have any questions or additional phrases Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Supplementary Notes ,Introduction Many countries try to fix or “peg” their exchange rate to a currency or group of currencies by intervening in the foreign exchange market. Many with a flexible or “floating” exchange rate in fact practice a managed floating exchange rate. How do central banks intervene in the foreign exchange market? ,Central Bank’s Balance Sheet Assets Domestic government bonds Loans to domestic banks (called discount loans in US) Foreign government bonds (official international reserves) Gold (official international reserves) Liabilities Deposits of domestic banks Currency in circulation Assets = Liabilities + Net Worth Assume Net Worth = 0. Assets and liabilities move together in the same direction. Changes in the central bank’s balance sheet lead to changes in currency in circulation or changes in bank deposits. In either case, the money supply changes. ,Assets, Liabilities and the Money Supply A purchase of any asset will be paid for with currency or a check from the central bank, both of which increase the supply of money in circulation. The transaction leads to equal increases of assets and liabilities. When the central bank buys domestic bonds orforeign bonds, the domestic money supply increases. ,Assets, Liabilities and the Money Supply (cont.) A sale of any asset will be paid for with currency or a check given to the central bank, the central bank puts the currency into its vault or reduces the amount of bank deposits, causing the supply of money in circulation to shrink. The transaction leads to equal decreases of assets and liabilities. When the central bank sells domestic bonds orforeign bonds, the domestic money supply decreases. ,Central Bank Intervention in Foreign Exchange Markets Central banks trade foreign government bonds in the foreign exchange markets. Foreign currency deposits and foreign government bonds are often substitutes: both are fairly liquid assets denominated in foreign currency. Quantities of both foreign currency deposits and foreign government bonds that are bought and sold influence the exchange rate. ,Sterilization Because buying and selling of foreign bonds in the foreign exchange market affects the domestic money supply, a central bank may want to offset this effect. This offsetting effect is called sterilization. ,Examples The central bank attempts to support the DC with a sterilized intervention. It sells foreign bonds; money supply shrinks. It buys domestic bonds; money supply rises back to the initial level. Construct a sterilized intervention when the DC is considered too strong. Will these sterilized intervention effective? ,Fixed Exchange Rates To fix the exchange rate, a central bank influences the quantities supplied and demanded of currency by trading domestic and foreign assets, so that the exchange rate stays constant. The foreign exchange market is in equilibrium when R = R* + (Ee – E)/E When the exchange rate is fixed at some level E0 and the market expects it to stay fixed at that level, then R = R* ,Fixed Exchange Rates (cont.) To fix the exchange rate, the central bank must trade foreign and domestic assets until R = R*. [The above shows that a small country under a fixed exchange rate will have no independent power to adjust its own interest rate.] In other words, it has to adjust the money supply until the domestic interest rate equals the foreign interest rate. It means Ms is determined endogenously given the price level and real output: Ms = P  L(R*,Y) ,Fixed Exchange Rates (cont.) Suppose that the central bank has fixed the exchange rate at E0but the level of output rises, raising the demand for real money. This leads to higher interest rates and upward pressure on the value of the domestic currency. How should the central bank respond if it wants to fix exchange rates? ,Fixed Exchange Rates (cont.) The central bank must buy foreign assets in