1. Why Study Fixed Exchange Rates? –Managed floats/dirty floats –Regionally fixed currencies: euro, cfa –Developing countries –Transition economies –Lessons of the past for the future

2. De facto exchange rate regimes and monetary policy frameworks as of April 2008 http://www.imf.org/external/np/mfd/er/2008/eng/0408.htm

3. Foreign Exchange Market Equilibrium Under Fixed Exchange Rate: R = R* + (E e – E)/E = R* + 0 = R* Money Market Equilibrium Under Fixed Rate –Central Bank must adjust the money supply so: M S /P = L(R*, Y) –Intervention in foreign exchange market assures that R = R* and M S /P = L(R*, Y)

4. Central Bank Balance Sheet Assets Liabilities Foreign Assets Currency in circulation Gold Foreign Govt Bonds Domestic Assets Commercial bank deposits Bank IOU’s Gov’t Bonds Net Worth = 0 by assumption

5. Balance of Payments and M s B of P = CA + Nonofficial Financial Account If BoP > 0 –Excess supply of foreign exchange Domestic currency threatens to appreciate Foreign currency threatens to depreciate –CB BUYS foreign exchange … props it up –CB assets increase  M s increases If B of P < 0 … the reverse … M s decreases Sterilized intervention BofP>0 … Buy foreign & Sell domestic assets … easy BofP<0 … Sell foreign & buy domestic assets … limited

6. Real money supply M 1 P Real money demand, L(R, Y 1 ) Domestic-currency return on foreign-currency deposits, R* + (E 0 – E)/E Real domestic money holdings Domestic Interest rate, R Exchange rate, E 0 M 2 P 3 3'3' E0E0 2 R*R* 1 1'1' L(R, Y 2 ) Asset Market Equilibrium with Fixed Exchange Rate, E 0 : Response to increase in output

7. DD Monetary Expansion Is Ineffective Under a Fixed Exchange Rate M s up  R threatens to fall  Currency Threatens to Depreciate CB props up its currency (sells reserves) on fe mkt  M s down Output, Y Exchange rate, E E2E2 Y2Y2 2 E0E0 Y1Y1 1 AA 2 AA 1

8. DD 1 Fiscal Expansion Is Effective Under Fixed Exchange Rate (at least in short-run) G up  Y up  R threatens to rise  Currency Threatens to Appreciate CB props up foreign currency (buys reserves) on fe mkt  Ms up  Y stays up Output, Y Exchange rate, E E0E0 Y1Y1 1 AA 2 AA 1 DD 2 E2E2 Y2Y2 2 3 Y3Y3

9. DD Effects of a Currency Devaluation Output, Y Exchange rate, E E1E1 Y2Y2 2 E0E0 Y1Y1 1 AA 2 AA 1

10. –Fiscal expansion causes P to rise in long-run. No real appreciation in the short-run (P unchanged) There is real appreciation in the long-run »P rises while E is unchanged Real appreciation shifts DD in; Higher Price shifts AA in …Y back to where it started in long-run –Devaluation is neutral in the long-run. CA surplus  Central Bank Buys Reserves  M s up Excess demand and increased money supply raise P –In proportion to devaluation –In proportion to money supply increase Stabilization Policies With a Fixed Exchange Rate

11. M 2 P Capital Flight, Money Supply, and Interest Rate Real money supply M 1 P R*R* 1 Real domestic money holdings Domestic Interest rate, R Exchange rate, E 0 R* + (E 0 – E)/E R* + (E 1 – E)/E 2 R* + (E 1 – E 0 )/E 0 L(R, Y) 2'2' E0E0 1'1'

12. Managed Floating and Sterilized Intervention Perfect Asset Substitutability –(their bonds are as good as ours)  Ineffectiveness of Sterilized Intervention –Sterilized intervention leaves M s unchanged. –Central banks cannot control M s and E at same time –The Impossible Trilogy: Fixed Exchange Rate Independent Monetary Policy Capital Mobility

13. Imperfect asset substitutability Assets in different countries have different risks Their expected returns can then differ and central banks may be able to control both M s and E through sterilized foreign exchange intervention. Managed Floating and Sterilized Intervention Foreign exchange market equilibrium requires: R = R* + (E e – E)/E +  where:  is a risk premium on domestic bonds –  depends positively on amount of government debt held outside CB:  =  (B – A) where: B is the stock of domestic government debt A is domestic assets of the central bank B – A = govt debt held outside of central bank

14. Sterilized Intervention: Imperfect Substitutability Keeping Your Currency from Appreciating …Or Getting Your Currency to Depreciate –Sterilized purchase of foreign assets  M s constant –Buy foreign assets (foreign currency) and sell domestic assets (gov’t bonds) More government debt now held by the public Riskiness of government debt  (B – A) UP. Interest rate parity equilibrium now requires a higher domestic interest rate: R = R* + (E e – E)/E +  (B – A) But R is unchanged since M/P is unchanged Pressure to depreciate offsets pressure to appreciate Managing Expectations: Signaling Effect of Sterilized Intervention

15. Effect of a Sterilized Central Bank Purchase of Foreign Assets Under Imperfect Asset Substitutability M s P Real money supply Real domestic money holdings Domestic Interest rate, R Exchange rate, E 0 R* + (E e – E)/E +  (B –A 1 ) Risk-adjusted domestic- currency return on foreign currency deposits, R* + (E e – E)/E +  (B –A 2 ) L(R, Y) 2'2' E2E2 E1E1 1'1' R1R1 1 Sterilized purchase of foreign assets

16. Reserve Currencies in Int’l Monetary System Possible systems for fixing the exchange rates: –Reserve currency standard Central banks peg their currencies in terms of a reserve currency ($). –Central banks hold $ as reserve  Asymmetric adjustment –Gold standard Central banks peg the prices of their currencies in terms of gold... or some other commodity … or commodity basket  Symmetry Straitjacket … M – policy constrained  Docile labor

17. Europe Before the War: The Double Bluff Thus this remarkable system depended for its growth on a double bluff or deception. On the one hand the labouring classes accepted from ignorance or powerlessness, or were compelled, persuaded, or cajoled by custom, convention, authority, and the well- established order of society into accepting, a situation in which they could call their own very little of the cake that they and nature and the capitalists were co- operating to produce. And on the other hand the capitalist classes were allowed to call the best part of the cake theirs and were theoretically free to consume it, on the tacit underlying condition that they consumed very little of it in practice.

18. The Gold Standard Each country fixes the price of its currency in terms of gold  no country has a privileged position –Exchange rates between any two currencies fixed by arbitrage. If the $ price of gold is pegged at $35/oz by the Fed while the £ price is pegged at £14.58/oz by the BoE, the par $/ £ exchange rate must be $2.40/ £. E = ($35/oz)/(£14.58/oz ) = $2.40/ £.

19. Symmetric Adjustment Under Gold Standard A country loses reserves  money supply shrinks  price level falls  q depreciates  CA improves Foreign countries gain reserves  money supplies expand  prices rise  q appreciates  CA down –Benefits: Avoids asymmetry of a reserve currency standard. –Surplus country also adjusts Places constraints on the growth of money supplies. –Drawbacks: Constrains use of monetary policy to fight unemployment Stable price level only if relative price of gold stable. Makes central banks compete for reserves and bring about world unemployment  1930s beggar-thy-neighbor.

20. WW I: Capital flight  breakdown of gold standard Interwar turbulence Legacies of WW I –Redrawn borders  disrupted trade patterns –Old debts/reparations – Labor empowered: The eight hour day Excessive claims  hyperinflation The Lenin Dictum: Lenin is said to have declared … Gold Standard Nostalgia

21. The Lenin Dictum Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. … they not only confiscate, but they confiscate arbitrarily… As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.Lenin

22. ‘20s Halting return to gold  Prelude to depression The Economic Consequences of Mr. Churchill  General Strike US monetary expansion – help to Britain  Roaring ’20s Capital flow reversal  European downturn B u b b l e and c o l l a p s e ‘30s World in Depression: UK couldn’t …US wouldn’t lead Protection – beggar thy neighbor British leave gold – US defends gold standard Golden fetters Halting recovery: monetary expansion/fiscal measures/rearmament The Bretton Woods System: IMF a bank/World Bank a fund $ pegged to gold … N – 1 currencies pegged to elastic $ IMF: Int’l lender of last resort  support pegs/allow devaluation when fundamental disequilibrium Impossible Trilogy : Fixed rates/Independent M-Policy/Free capital flows… Pick two Problems/breakdown: Speculative attacks/$ Shortage/$ Glut Nixon Economic Program: Close gold window/surcharge/controls

23. Bretton Woods: $ Standard…more flexible than gold Each central bank fixed the dollar exchange rate of its currency through foreign exchange market trades for $s (dollar assets). Exchange rates between any two currencies fixed by arbitrage. –The reserve-issuing country (USA) can use monetary policy for macroeconomic stabilization even though it has fixed exchange rates. –The purchase of domestic assets by the central bank of the reserve currency country leads to: Excess demand for foreign currencies in the foreign exchange market Expansionary monetary policies by all other central banks Higher world output … and/or INFLATION Reserve Currencies in Int’l Monetary System

24. Achieving Internal and External Balance Pegged rates Fiscal policy effective Exchange rate can be changed Devaluation/revaluation Tools: –Expenditure changing: fiscal policy –Expenditure switching: exchange rate setting Need as many tools as you have objectives For external balance, XX G up  Y up  CA down … unless E up (devaluation) For internal balance, II E down (revaluation)  CA down  Y down … unless G up