Essay about Fixed Exchange Rates

Submitted By Hilary T Quynhanh-Ho
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Pages: 5
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Fixed Exchange Rates and Exchange Market
Intervention

Chapter 18

1. Central bank intervention in the foreign exchange market

2. Stabilization under …xed exchange rates

3. Exchange rate crises

4. Sterilized intervention

5. Historical …xed exchange rate systems

1

Central Bank Intervention in the Foreign Exchange Market

1.1

Central Bank Balance Sheet

Assets domestic government securities foreign exchange reserves gold Liabilities currency private bank deposits (bank reserves)

Base money = high-powered money = currency + deposits at the Fed

= Currency held by the public + vault cash + bank reserves at the Fed
= Liabilities of Fed

1.2

Central Bank Activities and the Money Supply
Open market purchase: Fed buys government bonds with currency ( or by increasing bank reserves)

Fed buys foreign currency paying for it with domestic currency

Sterilized foreign exchange market intervention
– buy $1,000 worth of foreign currency
– simultaneously sell $1,000 worth of domestic govenment securities
– monetary base unchanged

2

2.1

Fixing the Exchange Rate

Principle:

adjust the money supply to make the equilibrium value for the exchange rate equal to the …xed rate

2.2

Interest Rate Parity

R=R +

Ee

E
E

R=R

Ee = E

if the …xed rate (peg) is credible

…xing the exchange rate requires pegging the interest rate to the foreign interest rate

2.3

Example: Transitory increase in G, raising Y

3

3.1

Stabilization policy under …xed exchange rates

Monetary expansion
An open market operation is ultimately an exchange of foreign-currency assets for domestic assets with no change in the money supply

AA never actually shifts

A country which pegs its exchange rate loses monetary policy

3.2

Fiscal expansion (transitory)
Requires an increase in the money supply to keep exchange rate from appreciating Very e¤ective compared to ‡exible rates because accompanied by monetary expansion and no currency appreciation

3.3

O¢ cially devalue currency
Raise the exchange rate

Requires increasing the money supply, shifting AA right

In the short-run, output expands

Devaluation is a way to use monetary expansion under a …xed exchange rate regime

3.4

Peg exchange rate at a higher value to escape a liquidity trap
Interest rate parity in a liquidity trap
R=R +

Ee

E
E

=0

If R > 0; implies domestic currency is appreciating (E is falling)

Upper bound on E implied by interest rate parity, no matter what the quantity of money
Ee
E=
1 R

If credibly announce a higher peg, E e rises, and if peg is high enough R rises above 0.

4

4.1

Exchange Rate Crises
Increase in E e
Agents expect a devaluation next period
Interest rate parity
R=R +

Ee

E
E

– Either let E rise today
– Or increase R today by selling foreign exchange reserves in exchange for domestic currency

Once run out of foreign exchange reserves, forced to let E rise

Or might not want contractionary e¤ect of R up on economy

4.2

Reasons for E e up
Government is …nancing an ongoing de…cit by selling bonds to the central bank – Central bank buys bonds with currency and is forced to sell foreign exchange reserves in exchange for currency to keep exchange rate …xed
– Reserves are falling
– Once reserves are gone, the increase in the money supply to …nance government spending will depreciate the currency

Country is in recession and devaluation would stimulate demand

Country is experiencing a banking crisis and lending foreign exchange reserves to banks

5

5.1

Sterilized Intervention

Sterilized intervention has no e¤ect
Buy foreign currency and sell money

Sell domestic bonds and buy money

No e¤ect on money and no e¤ect on E

5.2

Sterilized intervention has a signaling e¤ect
Buy foreign currency and sell domestic bonds so no e¤ect on money

However, agents think central bank is buying foreign currency because it wants E to increase

Therefore E e increases, raising E

Government must follow through in the future and increase the money supply validating the
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