1. The Monetary Approach to Balance-of-Payments and Exchange-Rate Determination

2. Daniels and VanHooseMonetary Approach2 Managed Exchange Rates: Foreign Exchange Interventions Central banks have various objectives and functions. In many countries the central bank acts as the government’s agent, conducting transactions in the foreign exchange markets at the government’s request. Now we should consider how foreign exchange market interventions alter the nation’s monetary base and its money stock.

3. Daniels and VanHooseMonetary Approach3 How to intervene? If central banks seek to attain international objectives, then they typically do so in part through foreign exchange interventions, buying or selling financial assets denominated in foreign currencies in an effort to influence exchange rates.

4. Daniels and VanHooseMonetary Approach4 Leaning With or Against the Wind Leaning with the wind: If a central bank intervenes to support or speed along the current trend in the value of its nation’s currency in the foreign exchange market, then economists say that its interventions are leaning with the wind. Leaning against the wind: economists say that a central bank’s interventions intended to halt or reverse a recent trend in the value of its nation’s currency are leaning against the wind.

5. Daniels and VanHooseMonetary Approach5 Foreign Exchange Interventions and the Money Stock Foreign exchange interventions are purchases or sales of foreign-currency-denominated assets. We consider only the purchase or sale of foreign-currency- denominated bank deposits. These deposits are assets of domestic individuals, firms, brokers, and banks, which they hold on deposit at foreign banks. Hence, foreign exchange transactions of central bank affect the balance sheets of domestic private banks and the balance sheets of foreign private banks. Indirectly, therefore, foreign exchange interventions influence the domestic money stock and potentially the foreign nation’s money stock.

6. Daniels and VanHooseMonetary Approach6 Sterilization of Intervention Sterilization: A central bank policy of altering domestic credit in an equal and opposite direction relative to any variation in foreign exchange reserves so as to prevent the monetary base from changing. A central bank sterilizes foreign exchange interventions when it buys or sells domestic assets in sufficient quantities to prevent the interventions from influencing the domestic money stock.

7. Daniels and VanHooseMonetary Approach7 Monetary Base Monetary base is the sum of domestic credit plus foreign exchange reserves or as the sum of domestic currency and bank reserves. Sterilization of the sale of foreign exchange reserves requires an equal-sized expansion of domestic credit, perhaps via a central bank open- market purchase, that would maintain an unchanged monetary base.(See example in Page220)

8. Daniels and VanHooseMonetary Approach8 Introduction The Monetary Approach focuses on the supply and demand of money and the money supply process. The monetary approach hypothesizes that BOP and exchange-rate movements result from changes in money supply and demand.

9. Daniels and VanHooseMonetary Approach9 Small Country Example A small country is modeled as: (1)M d = kPy (2)M = m(DC + FER) (3)P = SP * and, in equilibrium, (4)M d = M.

10. Daniels and VanHooseMonetary Approach10 Small Country Model The balance of payments is defined as: (5)CA + KA = FER. For example, if FER< 0, then CA + KA < 0, and the nation is running a balance of payments deficit.

11. Daniels and VanHooseMonetary Approach11 Small Country Model (4) and (3) into (1) yields, M = kP * Sy. Sub in (2), (6)m(DC + FER) = kP * Sy.

12. Daniels and VanHooseMonetary Approach12 Small Country Model Fixed Exchange Rate Regime Under fixed exchange rates, the spot rate, S, is not allowed to vary. FER must vary to maintain the parity value of the spot rate. Hence, the BOP must adjust to any monetary disequilibrium.

13. Daniels and VanHooseMonetary Approach13 A Change in the Quantity of Money Supplied Consider what happens if the central bank raises DC. Money supply exceeds money demand. m(DC  + FER) > kP * Sy There is pressure for the domestic currency to depreciate. The central bank must sell FER until M = M d. m(DC  + FER  ) = KP * Sy

14. Daniels and VanHooseMonetary Approach14 A Change in the Quantity of Money Supplied There has been no net impact on the monetary base and money supply as the change in FER offset the change in DC. There results, however, a balance of payments deficit as  FER < 0.

15. Daniels and VanHooseMonetary Approach15 A Change in the Quantity of Money Supplied Flexible exchange rate regime: Under a flexible exchange rate regime, the FER component of the monetary base does not change. The spot exchange rate, S, will adjust to eliminate any monetary disequilibrium.

16. Daniels and VanHooseMonetary Approach16 A Change in the Quantity of Money Supplied Consider the impact of an increase in DC. Again money supply will exceed money demand m(DC  + FER) > kP * Sy. Now the domestic currency must depreciate to balance money supply and money demand m(DC  + FER) = kP * S  y.

17. Daniels and VanHooseMonetary Approach17 A Change in the Quantity of Money Demanded Suppose there is an increase in either the foreign price level or real income, an increase in either of these two variables causes an increase in the quantity of money demanded. As a result, the quantity of money demanded exceeds the quantity of money supplied. m(DC+FER)<kS(P*y)

18. Daniels and VanHooseMonetary Approach18 A Change in the Quantity of Money Demanded In this situation, households find that their current money holdings fall short of the quantity desired. Households increase their money holdings by reducing their expenditures on domestic and foreign goods and services. The decrease in demand for foreign goods and services causes the domestic currency to appreciate. This appreciation continues until the quantity of money supplied once again equals the quantity of money demanded.

19. Daniels and VanHooseMonetary Approach19 Small Country Model The monetary approach postulates that changes in a nation’s balance of payments or exchange rate are a monetary phenomenon. The small country illustrates the impact of changes in domestic credit, foreign price shocks, and changes in domestic real income.

20. Daniels and VanHooseMonetary Approach20 Applying the Monetary Approach: A Two-Country Setting Two-country setting researches how changes in the quantity of money supplied and demanded in another nation might affect the spot exchange rate.

21. Daniels and VanHooseMonetary Approach21 A Two-Country Monetary Model We specify a Cambridge equation of money demand for each nation. We denote the individual nations with subscripts A and B. The Cambridge equations, equilibrium conditions, and absolute purchasing power parity condition for the two nations are:

22. Daniels and VanHooseMonetary Approach22 A Two-Country Monetary Model Divide Country A’s equilibrium condition by Country B’s equilibrium condition:

23. Daniels and VanHooseMonetary Approach23 A Two-Country Monetary Model This expression illustrates the monetary approach to exchange-rate determination in a two-country setting. That is, the spot exchange rate is determined by the relative quantities of money supplied and the relative quantities of money demanded.

24. Daniels and VanHooseMonetary Approach24 Explain with This Two-Country Setting If there is an increase in the money stock of Country A, all other things unchanged, then the spot exchange rate rises. That is, Nation A’s currency depreciates relative to Nation B’s currency. If there is an increase in the real income of Country A, then the relative quantity of money demanded declines and the spot exchange rate falls, or Nation A’s currency appreciates relative to Nation B’s currency.

25. The Portfolio Approach to Exchange-Rate Determination

26. Daniels and VanHooseMonetary Approach26 The Portfolio Approach The portfolio approach expands the monetary approach by including other financial assets. The portfolio approach postulates that the exchange value is determined by the quantities of domestic money and domestic and foreign financial securities demanded and the quantities supplied.

27. Daniels and VanHooseMonetary Approach27 Households’ Allocation of Wealth Households allocate their wealth in three types of financial instruments: domestic money, domestic bonds, and foreign bonds. 1. Individuals earn interest for holding bonds but receive no interest for holding money, so households have no incentive to hold the foreign currency, which they can obtain in the spot exchange market if they wish to conduct a foreign transaction. 2. The domestic and foreign bonds have elements of risk that money does not. To balance the risk and returns on these instruments, households desire to distribute their wealth over all three types of instruments.

28. Daniels and VanHooseMonetary Approach28 The Portfolio Approach Assumes that individuals earn interest on the securities they hold, but not on money. Assumes that households have no incentive to hold the foreign currency. Hence, wealth (W), is distributed across money (M) holdings, domestic bonds (B), and foreign bonds (B*).

29. Daniels and VanHooseMonetary Approach29 The Portfolio Approach A domestic household’s stock of wealth is valued in the domestic currency. Given a spot exchange rate, S, expressed as domestic currency units relative to foreign currency units, a wealth identity can be expressed as: W  M + B + SB*.

30. Daniels and VanHooseMonetary Approach30 The Portfolio Approach The portfolio approach postulates that the value of a nation’s currency is determined by quantities of these assets supplied and the quantities demanded. In contrast to the monetary approach, other financial assets are as important as domestic money.

31. Daniels and VanHooseMonetary Approach31 An Example 1. Suppose the domestic monetary authorities increase the monetary base through an open market purchase of domestic securities. 2. As the domestic money supply increases, the domestic interest rate falls. 3. With a lower interest, households are no longer satisfied with their portfolio allocation. 4. The demand for domestic bonds falls relative to other financial assets.

32. Daniels and VanHooseMonetary Approach32 Example - Continued Households shift out of domestic bonds. They substitute into domestic money and foreign bonds. Because of the increase in demand for foreign bonds, the demand for foreign currency rises. All other things constant, the increased demand for foreign currency causes the domestic currency to depreciate.

33. Daniels and VanHooseMonetary Approach33 Spot Exchange Rate Domestic currency units/foreign currency units Quantity of foreign currency. S FC D FC D FC ’ S1S1 S2S2 Q1Q1 Q2Q2

34. Daniels and VanHooseMonetary Approach34 Commons and Differences Between monetary and portfolio approach Commons: The monetary approach and portfolio approach both predict that an open-market purchase of securities leads to a domestic currency depreciation. Differences: The monetary approach attributes a currency depreciation to changes in the quantity of money demanded and supplied. The portfolio approach attributes a currency depreciation to changes in the quantities demanded and supplied of all the instruments that constitute households’ stock of wealth.

35. Daniels and VanHooseMonetary Approach35 Example2-- A Change in the Foreign Interest Rate Because of the rise in the foreign interest rate, households desire to hold larger quantities of foreign bonds and smaller quantities of domestic money and domestic bonds. The portfolio approach indicates that an increase in the foreign interest rate causes a depreciation of the domestic currency, and that a decline in the foreign interest rate causes an appreciation of the domestic currency.

36. Daniels and VanHooseMonetary Approach36 Spot Exchange Rate Domestic currency units/foreign currency units Quantity of foreign currency. S FC D FC (R 1 * ) D FC ’ (R 2 * ) S1S1 S2S2 Q1Q1 Q2Q2

37. Daniels and VanHooseMonetary Approach37 To Sterilize or Not to Sterilize? Many nations fully sterilize their foreign exchange market interventions as a matter of routine. Should nations routinely sterilize their interventions? The answer to this question depends on whether sterilized foreign exchange interventions affect the exchange value of the domestic currency.

38. Daniels and VanHooseMonetary Approach38 Sterilized foreign exchange Interventions and the Monetary Approach In the monetary approach, foreign exchange interventions affect the spot exchange value of the domestic currency by increasing or decreasing the domestic monetary base, thereby increasing or decreasing the domestic money stock.

39. Daniels and VanHooseMonetary Approach39 Sterilized foreign exchange Interventions and the Monetary Approach 1. A foreign exchange market intervention that increases foreign exchange reserves leads to a multiple increase in the money stock. 2. Complete sterilization of this intervention entails an open-market sale of securities that reduces domestic credit by an amount equivalent to the increase in foreign exchange reserves.

40. Daniels and VanHooseMonetary Approach40 Sterilized foreign exchange Interventions and the Monetary Approach As a result of the open-market transaction, the domestic monetary base remains unchanged, and so does the domestic money stock. According to the monetary approach, fully sterilized foreign intervention is ineffective, because it leaves the exchange value of the domestic currency unchanged.

41. Daniels and VanHooseMonetary Approach41 Sterilized Foreign Exchange Interventions and the Portfolio Approach 1. The purchase of foreign exchange reserves results in an increase in the domestic monetary base and an increase in the domestic money stock. 2. The central bank sterilizes the intervention through an open-market sale of domestic bonds, reducing domestic credit, and leaving the domestic monetary base and money stock unchanged.

42. Daniels and VanHooseMonetary Approach42 Sterilized Foreign Exchange Interventions and the Portfolio Approach Sterilized foreign exchange interventions is an exchange of domestic bonds for foreign bonds. According to the portfolio approach, the exchange of domestic for foreign bonds results in a depreciation of the domestic currency. Thus, sterilized intervention can be effective.

43. Daniels and VanHooseMonetary Approach43 Do Interventions Accomplish Anything? If sterilized interventions have no effects, then the implication would be that interventions would be redundant policies. An important issue for international monetary economists is whether foreign exchange interventions can and do have independent short- and long-term effects on market exchange rates.

44. Daniels and VanHooseMonetary Approach44 Two Types of Effects Most economists believe that sterilized foreign exchange interventions can, at least in theory, have at most two types of immediate effects on exchange rates. Portfolio balance effect Announcement effect (signalling effect)

45. Daniels and VanHooseMonetary Approach45 The Portfolio Balance Effect An exchange rate adjustment resulting from changes in government or central bank holdings of foreign-currency-denominated financial instruments that influences the equilibrium prices of the instruments.

46. Daniels and VanHooseMonetary Approach46 Example If an intervention reduces the supply of domestic assets relative to foreign assets held by individuals and firms, then the expected return on domestic assets must fall to induce individuals and firms to readjust their portfolios. A reduction in the anticipated rate of return on domestic assets, in turn, requires an depreciation of the domestic currency. Hence, a finance ministry or central bank purchase of domestic currency can, through the portfolio balance effect, cause the value of the domestic currency to rise.

47. Daniels and VanHooseMonetary Approach47 The Announcement Effect The other possible effect is an intervention announcement effect or signalling effect, in which foreign exchange interventions may provide traders with previously unknown information that alters their willingness to demand or supply currencies in the foreign exchange markets. The announcement effect can exist, therefore, only if a government or central bank intervention clearly reveals some kind of “inside information” that traders did not have prior to the intervention.

48. Daniels and VanHooseMonetary Approach48 Example A central bank that plans to conduct a future anti- inflation policy by contracting its money stock may reveal this intention by leaning against the wind in the face of a recent downward trend in the value of its nation’s currency. If currency traders believe this message provided by the central bank’s intervention, then they will expect a future appreciation and will increase their holdings of the currency. This concerted action by currency traders then causes an actual currency appreciation.