EXCHANGE RATES

Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Supplementary Notes

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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?

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Central Bank’s Balance Sheet • Assets – Domestic government bonds – Loans to domestic banks (cal ed 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.

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Assets, Liabilities and the Money Supply • A purchase of any asset wil 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 or foreign bonds, the domestic money supply increases.

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Assets, Liabilities and the Money Supply (cont.) • A sale of any asset wil 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 sel s domestic bonds or foreign bonds, the domestic money supply decreases.

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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.

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Sterilization • Because buying and sel ing 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 cal ed sterilization.

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Examples • The central bank attempts to support the DC with a sterilized intervention. – It sel s 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?

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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 E and the market 0 expects it to stay fixed at that level, then R = R*

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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 smal country under a fixed exchange rate wil 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)

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Fixed Exchange Rates (cont.) • Suppose that the central bank has fixed the exchange rate at E but the level of output rises, raising the demand 0 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?

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Fixed Exchange Rates (cont.) • The central bank must buy foreign assets in the foreign exchange market, – thereby increasing the money supply, – thereby reducing interest rates. – Alternatively, by demanding (buying) assets denominated in foreign currency and by supplying (sel ing) domestic currency, the price/value of foreign currency is increased and the price/value of domestic currency is decreased.

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Fixed Exchang e Rates

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Monetary Policy and Fixed Exchange Rates • Because the central bank must buy and sel foreign assets to keep the exchange rate fixed, monetary policy is ineffective in influencing output and employment.

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Monetary Policy and Fixed Exchange Rates (cont.)

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Fiscal Policy and Fixed Exchange Rates in the Short Run • Because the central bank must buy and sel foreign assets to keep the exchange rate fixed, temporary fiscal policy is more effective in influencing output and employment in the short run. – The rise in output due to expansionary fiscal policy raises money demand, putting upward pressure on interest rates and upward pressure on the value of the domestic currency. – To prevent an appreciation of the domestic currency, the central bank must buy foreign assets, thereby increasing the money supply.

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Fiscal Policy and Fixed Exchange Rates in the Short Run (cont.) A fiscal expansion increases aggregate demand To prevent the domestic currency from appreciating, the central bank buys foreign assets, increasing the money supply and decreasing interest rates.

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Fiscal Policy and Fixed Exchange Rates in the Long Run • When the exchange rate is fixed, there is no real appreciation of the value of domestic products in the short run. • But when output is above its normal (long run) level, wages and prices tend to rise. • A rising price level makes domestic products more expensive: a real appreciation (EP*/P fal s). – Aggregate demand and output decrease as prices rise: DD curve shifts left. – Prices tend to rise until employment, aggregate demand and output fall to their normal levels.

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Fiscal Policy and Fixed Exchange Rates in the Long Run (cont.) • In the long run prices increase proportional y to the increase in the money supply caused by central bank intervention in the foreign exchange market. – AA curve shifts down (left) as prices rise. – Nominal exchange rates wil be constant (as long as the fixed exchange rate is maintained), but the real exchange rate will be lower (a real appreciation). – The economy is back to point 1 in the long run.

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Devaluation and Revaluation • Depreciation and appreciation refer to changes in the value of a currency due to market changes. • Devaluation refers to a change in a fixed exchange rate caused by the central bank. – a unit of domestic currency is made less valuable, so that more units must be exchanged for 1 unit of foreign currency. • Revaluation is the opposite of devaluation.

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Devaluation • For devaluation to occur, the central bank buys foreign assets, so that the domestic money supply increases. – A devaluation of the DC from E0 to E1– Domestic goods become relatively cheaper, so aggregate demand and output increase. – Money demand rises, pushing the interest rate higher.– To maintain E1, the central bank buys foreign assets.– Official international reserve assets increase.– Money supply increases.

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Devaluation (cont.) If the central bankdevalues the domestic currency so that the new fixed exchange rate is E , it buys foreign 1 assets, increasing the money supply, decreasing the interest rate andincreasing output

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Financial Crises and Capital Flight • When a central bank does not have enough official international reserve assets to maintain a fixed exchange rate, a balance of payments crisis results. – To sustain a fixed exchange rate, the central bank must have enough foreign assets to sell in order to satisfy the demand for them at the fixed exchange rate.

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Financial Crises and Capital Flight (cont.) • Investors may expect that the domestic currency wil be devalued, causing them to want foreign assets instead of domestic assets, whose value is expected to fal soon. 1. This expectation or fear only makes the balance of payments crisis worse: – investors rush to change their domestic assets into foreign assets, depleting the stock of official international reserve assets more quickly.

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Financial Crises and Capital Flight (cont.) 2. As a result, financial capital is quickly moved from domestic assets to foreign assets: capital flight. – The domestic economy has a shortage of financial capital for investment and has low aggregate demand. 2. To avoid this outcome, domestic assets must offer a high interest rates to entice investors to hold them. – The central bank can push interest rates higher by reducing the money supply (by selling foreign assets). 2. As a result, the domestic economy may face high interest rates, reduced money supply, low aggregate demand, low output and low employment.

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Financial Crises and Capital Flight (cont.) Expected devaluation makesthe expected return on foreignassets higher To attract investorsto hold domestic assets (currency) atthe original exchangerate, the interest ratemust rise through asale of foreign assets.

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Financial Crises and Capital Flight (cont.) • Expectations of a balance of payments crisis only worsen the crisis and hasten devaluation. • What causes expectations to change? – Expectations about the central bank’s ability and wil ingness to maintain the fixed exchange rate. – Expectations about the economy: shrinking demand for domestic products relative to foreign products means that the domestic currency should become less valuable. • In fact, expectations of devaluation can cause a devaluation: self-fulfilling crisis.

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Financial Crises and Capital Flight (cont.) • What happens if the central bank runs out of official international reserves (foreign assets)? • It must devalue the domestic currency. – This will allow the central bank to replenish its foreign assets by buying them back at a devalued rate, – increasing the money supply, – reducing interest rates, – reducing the value of domestic products, – increasing aggregate demand, output, employment over time.

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Financial Crises and Capital Flight (cont.) • In a balance of payments crisis, – the central bank may buy domestic bonds and sel domestic currency (to increase the money supply) to prevent high interest rates, but this only depreciates the domestic currency more. – the central bank general y can not satisfy the goals of low interest rates and fixed exchange rates simultaneously.

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Interest Rate Differentials • For many countries, the expected rates of return are not the same: R > R*+(Ee –E)/E . Why? • Default risk: The risk that the country’s borrowers will default on their loan repayments. Lenders require a higher interest rate to compensate for this risk. • Exchange rate risk: If there is a risk that a country’s currency wil depreciate or be devalued, then domestic borrowers must pay a higher interest rate to compensate foreign lenders.

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Interest Rate Differentials (cont.) • Because of these risks, domestic assets and foreign assets are not treated the same. – Previously, we assumed that foreign and domestic currency deposits were perfect substitutes: deposits everywhere were treated as the same type of investment, because risk and liquidity of the assets were assumed to be the same. – In general, foreign and domestic assets may differ in the amount of risk that they carry: they may be imperfect substitutes. – Investors consider this risk, as well as rates of return on the assets, when deciding whether to invest.

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Interest Rate Differentials (cont.) • A difference in the risk of domestic and foreign assets is one reason why expected returns are not equal across countries: R = R*+(Ee –E)/E + ρ where ρ is called a risk premium, an additional amount needed to compensate investors for investing in risky domestic assets. • The risk could be caused by default risk or exchange rate risk.∀ ρ= ρ(B-A); ρ’ >0. – B: total value of outstanding domestic bonds– A: value of domestic bonds held by the central bank– B-A: net supply of domestic bonds to the private sector

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Interest Rate Differentials (cont.) Or at fixed exchange rates, the return on Increase in the perceived risk of domestic assets investing in domestic assets needs to be higher makes foreign assets more in equilibrium attractive and leads to a depreciation of the domestic currency.

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CASE STUDY: The Mexican Peso Crisis, 1994–1995 • In late 1994, the Mexican central bank devalued the value of the peso relative to the US dol ar. • This action was accompanied by high interest rates, capital flight, low investment, low production and high unemployment. • What happened?

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CASE STUDY: The Mexican Peso Crisis, 1994–1995 (cont.) 8 .5 7 .5 6 .5 S dolar 5 .5 4 .5 3 .5 exican pesos per U M 2 .5 1 -J u l- 1 -A u g- 1 -Sep – 1 -O ct – 1 -N o v – 1 -D ec- 1 -J an – 1 -F eb – 1 -M ar- 1 -A p r- 1 -M ay – 1 9 9 4 1 9 9 4 1 9 9 4 1 9 9 4 1 9 9 4 1 9 9 4 1 9 9 5 1 9 9 5 1 9 9 5 1 9 9 5 1 9 9 5 Source: Saint Louis Federal Reserve

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Understanding the Crisis • In the early 1990s, Mexico was an attractive place for foreign investment, especial y from NAFTA partners. • During 1994, political developments caused an increase in Mexico’s risk premium (ρ) due to increases in default risk and exchange rate risk: – peasant uprising in Chiapas – assassination of leading presidential candidate from PRI • Also, the Federal Reserve raised US interest rates during 1994 to prevent US inflation. (So, R* ! )

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Understanding the Crisis (cont.) • These events put downward pressure on the value of the peso. • Mexico’s central bank had promised to maintain the fixed exchange rate. • To do so, it sold dol ar denominated assets, decreasing the money supply and increasing interest rates. • To do so, it needed to have adequate reserves of dol ar denominated assets. Did it?

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US Dol ar Denominated International Reserves of the Mexican Central Bank Ja Ja n n u u a arry y 1 1 9 9 9 9 4 4 …… …… ……… ……… … … $ $ 2 2 7 7 b bi illlliio o n n O O ct ct o o b b e err 1 1 9 9 9 9 4 4 ……… …… …… ……… ……$ ……$ 1 1 7 7 b b il il li li o o n n N N o o v v e e m m b b e err 1 1 9 9 9 9 4 4 ……… ………….…… …… $ $ 1 1 3 3 b bi illlliio o n n D D e e c c e e m m b b e err 1 1 9 9 9 9 4 4 …… …… …. ……… … … … $ $ 6 6 b b il il li li o o n n During 1994, Mexico’s central bank hid the fact that its reserves were being depleted. Why? Source: Banco de México, http://www.banxico.org.mx

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Understanding the Crisis • 20 Dec 1994: Mexico devalues the peso by 13%. It fixes E at 4.0 pesos/dol ar instead of 3.4 pesos/dol ar. • Investors expect that the central bank has depleted its reserves. ∀ ρ ! further due to exchange rate risk: investors expect that the central bank to devalue again and they sel Mexican assets, putting more downward pressure on the value of the peso. • 22 Dec 1994: with reserves nearly gone, the central bank abandons the fixed rate. • In a week, the peso fal s another 30% to about 5.7 pesos/dollar.

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The Rescue Package: Reducing ρ • The US & IMF set up a $50 bil ion fund to guarantee the value of loans made to Mexico’s government, – reducing default risk, – and reducing exchange rate risk, since foreign loans could act as official international reserves to stabilize the exchange rate if necessary. • After a recession in 1995, Mexico began a recovery from the crisis. – Mexican goods were relatively cheap. – Stronger demand for Mexican products reduced negative effects of exchange rate risk.

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Types of Fixed Exchange Rate Systems 1. Reserve currency system: one currency acts as official international reserves. – The US dollar was the currency that acted as official international reserves from under the fixed exchange rate system from 1944–1973. – All countries but the US held US dol ars as the means to make official international payments. 1. Gold standard: gold acts as official international reserves that al countries use to make official international payments.

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Reserve Currency System • From 1944–1973, each central bank fixed the value of its currency relative to the US dollar by buying or sel ing domestic assets in exchange for dol ar assets. • Arbitrage ensured that exchange rates between any two currencies remained fixed. – Suppose Bank of Japan fixed the exchange rate at 360¥/US$1 and the Bank of France fixed the exchange rate at 5 Ffr/US$1 – The yen/franc rate would be 360¥/US$1 / 5Ffr/US$1 = 72¥/1Ffr– If not, then currency traders could make an easy profit by buying currency where it is cheap and selling it where it is expensive.

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Reserve Currency System (cont.) • Because most countries maintained fixed exchange rates by trading dol ar denominated (foreign) assets, they had ineffective monetary policies. • The Federal Reserve, however, did not have to intervene in foreign exchange markets, so it could conduct monetary policy to influence aggregate demand, output and employment. – The US was in a special position because it was able to use monetary policy as it wished.

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Reserve Currency System (cont.) • In fact, the monetary policy of the US influenced the economies of other countries. • Suppose the US increased its money supply. – This would lower US interest rates, putting downward pressure on the value of the US dollar. – If other central banks maintained their fixed exchange rates, they would have needed to buy dollar denominated (foreign) assets, increasing their money supplies. – In effect, the monetary policies of other countries had to follow that of the US, which was not always optimal for their levels of output and employment.

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Gold Standard • Under the gold standard from 1870–1914 and after 1918 for some countries, each central bank fixed the value of its currency relative to a quantity of gold (in ounces or grams) by trading domestic assets in exchange for gold. – For example, if the price of gold was fixed at $35 per ounce by the Federal Reserve while the price of gold was fixed at £14.58 per ounce by the Bank of England, then the $/£ exchange rate must have been fixed at $2.40 per pound. – Why?

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Gold Standard (cont.) • The gold standard did not give the monetary policy of the US or any other country a privileged role. • If one country lost official international reserves (gold) and thereby decreased its money supply, then another country gained them and thereby increased its money supply. • The gold standard also acted as an automatic restraint on increasing money supplies too quickly, preventing inflationary monetary policies.

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Gold Standard (cont.) • But restraints on monetary policy restrained central banks from increasing the money supply to encourage aggregate demand, increasing output and employment. • And the price of gold relative to other goods and services varied, depending on the supply and demand of gold. – A new supply of gold made gold abundant (cheap), and prices of other goods and services rose because the currency price of gold was fixed. – Strong demand for gold jewelry made gold scarce (expensive), and prices of other goods and services fell because the currency price of gold was fixed.

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Gold Standard (cont.) • A reinstated gold standard would require new discoveries of gold to increase the money supply as economies and populations grow. • A reinstated gold standard may give Russia, South Africa, the US or other gold producers inordinate influence in international financial and macroeconomic conditions.

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Gold Exchange Standard • The gold exchange standard: a system of official international reserves in both a group of currencies (with fixed prices of gold) and gold itself. – allows more flexibility in the growth of international reserves, depending on macroeconomic conditions, because the amount of currencies held as reserves could change. – does not constrain economies as much to the supply and demand of gold – The fixed exchange rate system from 1944–1973 used gold, and so operated more like a gold exchange standard than a currency reserve system.

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Gold and Silver Standard • Bimetallic standard: the value of currency is based on both silver and gold. • The US used a bimetallic standard from 1837–1861.• Banks coined specified amounts of gold or silver into the national currency unit. – 371.25 grains of silver or 23.22 grains of gold could be turned into a silver or a gold dollar. – So gold was worth 371.25/23.22 = 16 times as much as silver. – See http://www.micheloud.com/FXM/MH/index.htm for a fun description of the bimetallic standard, the gold standard after 1873 (“Crime of 1873”) and the Wizard of Oz!

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