© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 19 Exchange Rate Policy and the Central Bank

19-2 Exchange Rate Policy: The Big Questions How are exchange-rate policy and interest-rate policy connected? Are there times when exchange-rate stabilization becomes a primary policy objective? Should a country give up its own currency?

19-3 Exchange Rate Policy: Roadmap Linking Exchange Rate-Rate Policy and Domestic Monetary Policy Mechanics of Exchange-Rate Management The Costs, Benefits, and Risks of Fixed Exchange Rates Fixed Exchange-Rate Regimes

19-4 Exchange Rate Policy and Monetary Policy When Capital flows freely across a country’s borders, fixing the exchange rate means giving up domestic monetary policy

19-5 Long-run Implications of PPP Remember Purchasing power parity: One unit of domestic currency will buy the same basket of goods anywhere in the world Implication: %  Exchange rate = inflation differential Central bank must choose between controlling inflation or fixing the exchange rate

19-6 Short-run Implications of Capital Market Arbitrage At what interest rates are investors indifferent between bonds in two different currencies? If the exchange rate is fixed, then the interest rate must be the same. If interest rates differ, funds will move to equate them.

19-7 Diversification reduces risk Investing overseas is diversification: You should hold equity from emerging markets Should you worry about crises? Since these countries are small, the answer is almost surely no.

19-8 Capital Controls and the Policymaker’s Choice A country cannot 1.Be Open to international capital flows 2.Control its domestic interest rate 3.Fix its exchange rate A country must choose 2 of the 3.

19-9 Capital Controls Common through much of 20 th century. Benefits of open capital markets clear for large industrialized countries. For emerging markets countries it’s very tempting to try to put these into place

19-10 Capital Controls Inflow Controls: Restrict the ability of foreigners to invest in the country Outflow Controls: Keep foreigners from removing funds that are there.

investors want out of emerging markets Drove the value of Malaysian ringitt down and interest rates up. Malaysian banks and corporations were short of funds to repay their loans. Normal response is to borrow from the IMF Malaysia fixed the value of their currency and instituted capital controls.

19-12 Mechanics of Foreign Exchange Management Simple way to fix the exchange rate: Buy & sell your currency at a fixed rate What happens to the central bank’s balance sheet when they do this? Lose control of balance sheet size

19-13 The Mechanics of Exchange Rate Management The decision to control the exchange rate means giving up control of the size of reserves, so that the market determines the interest rate.

19-14 The Mechanics of Exchange Rate Management: Intervention

19-15 The Mechanics of Exchange Rate Management: Intervention A foreign exchange intervention has the same impact on reserves as a domestic open market operation.

19-16 The Mechanics of Exchange Rate Management: Intervention

19-17 The Mechanics of Exchange Rate Management: Intervention What happens next? –Does this move the exchange rate? –The intervention increases reserves, causing interest rates to fall. –This increases investors’ desire to move funds out of the U.S.

19-18 The Mechanics of Exchange Rate Management: Intervention Affects value of the dollar by changing domestic interest rates. Any policy that changes interest rates changes the exchange rate. The Central Bank must choose between interest rate and exchange rate policy.

19-19 The Mechanics of Exchange Rate Management: Intervention A foreign exchange intervention affects the value of a country's currency by changing domestic interest rates Any central bank policy that influences the domestic interest rate will affect the exchange rate

19-20 The Mechanics of Exchange Rate Management: Sterilized Intervention Fed intervention in foreign exchange does not come with a change in the federal funds rate target. Open market desk sterilizes the intervention: Changes the quantity of securities so that quantity of reserves is unaffected

19-21 The Mechanics of Exchange Rate Management: Intervention

19-22 Fixed Exchange Rates: Benefits Eliminates exchange rate risk, making international trade easier Reduce risk of investing abroad Tie policymakers’ hands

19-23 Fixed Exchange Rates: Costs Eliminates stabilization effects of exchange rate changes. Requires a high level of foreign exchange reserves

19-24 Fixed Exchange Rates: Speculative Attacks Fixed exchange rate regimes are fragile Thailand 1997 –Fixed rate of 26 baht per $ –Bank of Thailand maintained the rate by offering by buy whatever quantity of baht dealers wanted to sell. –What if the dealers start to question the ability of the Bank to maintain the fixed exchange rate peg?

19-25 Speculative Attack: Thailand 1997 Borrow baht, take it to the central bank to get dollars at 26 to one, invest proceeds at short-term $ interest rates. Drains reserves from the Bank of Thailand The lower reserves go, the less likely the Central Bank can maintain the peg. More and more speculators borrow baht and exchange them for dollars. When reserves run out, the baht depreciates and the speculators convert dollars to baht at more than 26 to 1, making a profit.

19-26 Speculative Attack: Causes Unsustainable fiscal policy that looks destine to create inflation. A group of speculator decide that the exchange rate cannot be maintained.

19-27 Idea is for dollars to be convertible into gold. Instead of stabilizing the price of goods, we stabilize the price of gold Why should monetary policy be determined by the rate at which gold comes out of the ground? It is also a fixed exchange rate policy Blamed for the international transmission of the Great Depression of the 1930s

19-28 Amount of money issued by the central bank depended on the gold you had Current account deficit countries lost gold. Losing gold forced contraction of money. Monetary contraction drove prices down. U.S. was running a current account surplus and a deflation at the same time!

19-29 Some financial advisors advocate holding gold as an investment They argue that it reduces inflation risk If you are worried about inflation risk, aren’t you better off with short-term bonds?

19-30 Fixed Exchange Rate Regimes: Bretton Woods 1944 to 1971 Dollars held as reserve currency Dollar convertible into gold at $35/oz Forced countries to adopt U.S. monetary policy Eventually refused, system fell apart

19-31 Fixed Exchange Rate Regimes: Currency Board Central bank guarantees convertibility of domestic currency into a foreign currency like the dollar, euro or yen. Ties monetary policy to that of the country issuing the backing currency. Argentina used it to reduce inflation from 100+% to close to zero.

19-32 Fixed Exchange Rate Regimes: Problems with Currency Boards Give up monetary policy Give up lender of last resort If the currency is overvalued, destroys domestic industry Doesn’t contain fiscal policy

19-33 Fixed Exchange Rate Regimes: Dollarization Adopt currency of another country Eliminates exchange rate risk and helps integrate country into the world trading system Lose revenue from money printing Eliminates monetary policy and lender of last resort. This is not shared governance.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Chapter 19 End of Chapter