Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy International.

Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld

2Copyright © 2003 Pearson Education, Inc. Chapter Organization  Why Study Fixed Exchange Rates?  Central Bank Intervention and the Money Supply  How the Central Bank Fixes the Exchange Rates  Stabilization Policies with a Fixed Exchange Rate  Balance of Payments Crises and Capital Flight  Managed Floating and Sterilized Intervention  Reserve Currencies in the World Monetary System  The Gold Standard

3Copyright © 2003 Pearson Education, Inc. Introduction  In reality, the assumption of complete exchange rate flexibility is rarely accurate. Industrialized countries operate under a hybrid system of managed floating exchange rates. –A system in which governments attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. A number of developing countries have retained some form of government exchange rate fixing.  How do central banks intervene in the foreign exchange market?

4Copyright © 2003 Pearson Education, Inc. Why Study Fixed Exchange Rates?  Four reasons to study fixed exchange rates: Managed floating Regional currency arrangements Developing countries and countries in transition Lessons of the past for the future

12Copyright © 2003 Pearson Education, Inc. Central Bank Intervention and the Money Supply Foreign Assets1,000.00$ Deposits by private1,000.00$ (Foreign Reserves)(Mainly Legal Reserves) Domestic Assets1,500.00$ Currency in Circulation1,500.00$ (Mainly from refinancing private banks) Simplified Central Bank's Balance Sheet The Central Bank Balance Sheet and the Money Supply: After a non-sterilized exchange rate intervention (selling foreign currency for $200) Foreign Assets 800.00$ Deposits by private1,000.00$ (Foreign Reserves)(Legal and Voluntary Reserves) Domestic Assets1,500.00$ Currency in Circulation1,300.00$ (Mainly from refinancing private banks) Simplified Central Bank's Balance Sheet The Central Bank Balance Sheet and the Money Supply: Initially

13Copyright © 2003 Pearson Education, Inc. Central Bank Intervention and the Money Supply Foreign Assets1,000.00$ Deposits by private1,000.00$ (Foreign Reserves)(Mainly Legal Reserves) Domestic Assets1,500.00$ Currency in Circulation1,500.00$ (Mainly from refinancing private banks) Simplified Central Bank's Balance Sheet The Central Bank Balance Sheet and the Money Supply: After the exchange rate intervention (selling foreign currency for $200) Foreign Assets 800.00$ Deposits by private1,000.00$ (Foreign Reserves)(Legal and Voluntary Reserves) Domestic Assets1,700.00$ Currency in Circulation1,500.00$ (Mainly from refinancing private banks) Simplified Central Bank's Balance Sheet The Central Bank Balance Sheet and the Money Supply: Initially Foreign Assets 800.00$ Deposits by private1,000.00$ (Foreign Reserves)(Legal and Voluntary Reserves) Domestic Assets1,500.00$ Currency in Circulation1,300.00$ (Mainly from refinancing private banks) Simplified Central Bank's Balance Sheet The Central Bank Balance Sheet after sterilization

14Copyright © 2003 Pearson Education, Inc. How the Central Bank Fixes the Exchange Rate  Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate The foreign exchange market is in equilibrium when: R = R* + (E e – E)/E –When the central bank fixes E at E 0, the expected rate of domestic currency depreciation is zero. –The interest parity condition implies that E 0 is today’s equilibrium exchange rate only if: R = R*.

15Copyright © 2003 Pearson Education, Inc.  Money Market Equilibrium Under a Fixed Exchange Rate To hold the domestic interest rate at R*, the central bank’s foreign exchange intervention must adjust the money supply so that: M S /P = L(R*, Y) Example: –Suppose the central bank has been fixing E at E 0 and that asset markets are in equilibrium. An increase in output would raise the money demand and thus lead to a higher interest rate and an appreciation pressure on the home currency. How the Central Bank Fixes the Exchange Rate

16Copyright © 2003 Pearson Education, Inc. –The central bank must intervene in the foreign exchange market by buying foreign assets in order to prevent an appreciation. –This increases the money supply (eventually until it is equal to the money demand) and r=r* –If the central bank sterilizes r>r* and the whole process would start over again. This shows: Sterilization works only in the short run! How the Central Bank Fixes the Exchange Rate

18Copyright © 2003 Pearson Education, Inc. 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 Figure 17-1: Asset Market Equilibrium with a Fixed Exchange Rate, E 0 Real domestic money holdings Domestic Interest rate, R Exchange rate, E 0 M 2 P 3 2'2' E0E0 3 R*R* 1 1'1' L(R, Y 2 ) How the Central Bank Fixes the Exchange Rate 2

19Copyright © 2003 Pearson Education, Inc. Stabilization Policies With a Fixed Exchange Rate  Monetary Policy Under a fixed exchange rate, central bank monetary policy tools are powerless to affect the economy’s money supply or its output.

20Copyright © 2003 Pearson Education, Inc. Balance of Payments Crises and Capital Flight  Balance of payments crisis It triggers a sharp change in official foreign reserves sparked by a change in expectations about the future exchange rate.

21Copyright © 2003 Pearson Education, Inc. M 2 P Figure 17-7: Capital Flight, the Money Supply, and the 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' Balance of Payments Crises and Capital Flight

22Copyright © 2003 Pearson Education, Inc.  The expectation of a future devaluation causes: A balance of payments crisis marked by a sharp fall in reserves A rise in the home interest rate above the world interest rate  An expected evaluation causes the opposite effects as an expected devaluation. Balance of Payments Crises and Capital Flight

23Copyright © 2003 Pearson Education, Inc.  Capital flight The reserve loss accompanying a devaluation scare –The associated debit in the balance of payments accounts is a private capital outflow.  Self-fulfilling currency crises Balance of Payments Crises and Capital Flight

24Copyright © 2003 Pearson Education, Inc. Reserve Currencies in the World Monetary System  Two possible systems for fixing the exchange rates: Reserve currency standard –Central banks peg the prices of their currencies in terms of a reserve currency. –The currency central banks hold in their international reserves. Gold standard –Central banks peg the prices of their currencies in terms of gold.

25Copyright © 2003 Pearson Education, Inc. The Gold Standard  Each country fixes the price of its currency in terms of gold.  No single country occupies a privileged position within the system.  The Mechanics of a Gold Standard Exchange rates between any two currencies were fixed. –Example: If the dollar price of gold is pegged at $35 per ounce by the Federal Reserve while the pound price of gold is pegged at £14.58 per ounce by the Bank of England, the dollar/pound exchange rate must be constant at $2.40 per pound.

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-26 Alternatives to Flexible Exchange Rates  Fixed exchange rate system: The value of a nation’s money is defined in terms of a fixed amount of a commodity (e.g., gold) or of another currency (e.g., U.S. dollar); the Gold standard exchange rate system System of fixed exchange rate (EMS I and II) Unilateral Peg Currency Board Dollarization/Euroization Single Currency/Currency Union

Fixed Exchange Rate Intervention When: 10-28 FX D <FX S

10-29 Fixed Exchange Rates and Changes in Demand FX D <FX S (Pressure on the Pound to decrease) Central Bank(s) need to intervene: Buy Pounds (lower Supply) S1 D1 D2 1 2 12

10-30 Fixed Exchange Rates and Changes in Demand S1 D1 D2 1 12 S2 Q2 When Central Bank(s) buy (supply less) Pounds. Supply curve shift to the left, until... FX D =FX S

Fixed Exchange Rate Intervention When: Consequences:  Domestic central bank buys Pounds and sells Dollar Currency Reserves increase  Foreign central bank buys Pound and sells Dollar From its reserves or through a loan from the domestic country  Money (Dollar) in circulation in domestic country increases 10-31 FX D <FX S

Fixed Exchange Rate Intervention When: 10-32 FX D >FX S

10-33 FIGURE 10.8 Fixed Exchange Rates and Changes in Demand FX D >FX S (Pressure on the Pound to increase) Central Bank(s) need to intervene: Sell (supply) Pounds

10-34 Selling Reserves of Pounds to Counter an Increasing Pound (Weakening Dollar) When Central Bank(s) sell (supply) Pounds. Supply curve shift to the right, until... FX D =FX S

Fixed Exchange Rate Intervention When: Consequences:  Domestic central bank sells Pound and buys Dollar Out of its reserves From a loan from the foreign central bank  Foreign central bank sells Pound and buys Dollar  Money (Dollar) in circulation in domestic country decreases Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-35 FX D >FX S

10-36 Monetary Policy is not Available in a System of Fixed Exchange Rates  Uncovered Interest Rate Parity:  If people trust in fixed exchange rates E=R. Thus, E-R=0:  The domestic interest rate must equal foreign rate that leaves no room for monetary policy.

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-37 Single Currency Areas/Fixed Exchange Rates  4 reasons for countries to adopt fixed exchange rates: Reduces currency conversions and transaction costs Eliminates exchange rate risk!!! Eliminates price fluctuations for imports and exports Increases in inter-state trade

10-38 Flixed Exchange Rates  Options for fixed exchange rate systems: the Gold standard exchange rate system System of fixed (pegged) exchange rate (EMS I and II; Bretton Woods (although often compared to Gold Standard) Unilateral Peg Currency Board Dollarization/Euroization Single Currency/Currency Union

Gold Standard  Gold standards are a form of fixed exchange rates. National currency is fixed to gold at a certain price (e.g. $36 per ounce of gold).  If all participating countries fix their currency to gold the currencies in the system will have fixed prices among each other. E.g. ₤18 pound per ounce of gold. => R=2$/ ₤  Under a pure gold standard, nations keep gold as their international reserve.  In a pure gold standard all national currency in circulation is backed by gold. 10-39

10-40 Fixed Exchange Rates and Changes in Demand FX D >FX S (Pressure on the Pound to increase) Central Bank(s) need to intervene: Sell (supply) Pounds

10-41 Selling Reserves of Pounds to Counter an Increasing Pound (Weakening Dollar) When Central Bank(s) sell (supply) Pounds. Supply curve shift to the right, until... FX D =FX S

Fixed Exchange Rate Intervention - Gold Standard - When: Consequences: 1. Domestic central bank sells Pound and buys Dollar 2. Money (Dollar) in circulation in domestic country decreases, which frees gold that was previously used to back Dollar. 3. This gold can be used to buy Pounds from the Bank of England, which is needed for step 1. 4. Prices in England increase prices in US decrease. US Exports increase, US Imports decrease. This helps to solve the initial problem. 10-42 FX D >FX S

Gold Standard: Advantages and Disadvantages  Pro: Participating countries cannot increase money supply without more gold reserves. This protects from inflation.  Pro: Self stabilizing mechanisms.  Con (!!!): In a world of growing economies world money supply must increase. Gold production cannot keep up.  Con (!!!): If world gold reserves increase by accident (e.g., new gold mines found), world money demand increases too.  Con (!!!): To increase world money supply as an emergency measure (2007) is not possible in a gold standard  Con: Gold is a resource for many products. Holding it in the vaults of central banks is inefficient. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-43

 Options for fixed exchange rate systems: the Gold standard exchange rate system System of fixed (pegged) exchange rate (EMS I and II; Bretton Woods (although often compared to Gold Standard) Unilateral Peg Currency Board Dollarization/Euroization Single Currency/Currency Union 10-44 Fixed Exchange Rates

Pegged Exchange Rate Systems  Pegged Exchange Rate System: Currencies in the system are pegged to an anchor (currency or basket of currencies). Bretton woods: Dollar was the anchor, dollar was fixed to Gold (although: not backed by gold and only official institutions could exchange dollar for gold $35 per ounce) 10-45

Pegged Exchange Rate Systems  Bretton Woods exchange rate system: A type of gold standard in 1947–1971: U.S. dollar and British Pound were fixed to each other and to gold; a modified Gold standard exchange rate system  Other currencies were fixed to the US dollar with a band. Participating countries agreed to intervene when a currency would deviate more than the band from the fixed exchange rate. 10-46

10-47 FIGURE 10.8 Fixed Exchange Rates and Changes in Demand FX D >FX S (Pressure on the Pound to increase) Central Bank(s) need to intervene: Sell (supply) Pounds

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-48 Selling Reserves of Pounds to Counter an Increasing Pound (Weakening Dollar) When Central Bank(s) sell (supply) Pounds. Supply curve shift to the right, until... FX D =FX S

Fixed Exchange Rate Intervention - US Situation - When: Consequences:  Domestic central bank sells Pound and buys Dollar Out of its reserves From a loan from the foreign central bank (Bretton Woods included a system of credit lines between countries)  Foreign central bank sells Pound and buys Dollar  Money (Dollar) in circulation in domestic country did not decrease. Foreign CB bought gov. bonds 10-49 FX D >FX S

Problems of Bretton Woods  Dollar was the anchor. Consequently foreign countries bought dollar as international reserves.  This allowed the US to have big trade deficits over the years.  Dollars in the hands of foreign central banks and the foreign private sector accumulated  World dollar amount in circulation was not in sync with US gold reserves.  1971/73 the Bretton Woods system collapsed 10-50

EMS I+II/Lessons Learnt  ECU (European Currency Unit) was the anchor. Consequently foreign countries bought ECU or a mix of European currencies as international reserves.  ECU was an artificial currency consisting of a basket of major European currency.  Thus no single country would be the anchor and could easily run trade deficits.  However, the Italian Lira and the Spanish Peseta were overvalued. These countries ran trade deficits offset by slightly higher interest rates.  1992 EMS I collapsed and was replaced with EMS II. The Lira and Peseta were devaluated and the band was widened. 10-51

Unilateral Peg  One country pegs its country to another country’s exchange rate without a formal agreement.  China and the US-$ or Mexico and the Dollar  Consequently only one county is responsible for intervening. 10-53

Fixed Exchange Rate Intervention - Unilateral Peg - Possible Problem: (e.g. China RMB/$) (note, the following slights are from the view of China not the US! China is the domestic country, the US the foreign country) 10-54 FX D <FX S

10-55 Fixed Exchange Rates and Changes in Demand FX D <FX S (Pressure on the Dollar to decrease) Bank of China needs to intervene: Buy Dollar (lower Supply) S1 D1 D2 1 2 12 RMB/$ US-$

10-56 Fixed Exchange Rates and Changes in Demand S1 D1 D2 1 12 S2 Q2 When Bank of China buys (supply less) Dollar. Supply curve shift to the left, until... FX D =FX S

Fixed Exchange Rate Intervention When: Consequences:  Domestic (Chinese) central bank buys Dollar and sells RMB Currency Reserves increase  Foreign central bank buys Dollar and sells RMB From its reserves or through a loan from the domestic country  Money (RMB) in circulation in domestic country increases  Bank of China sterilizes by selling Chinese governments bonds to lower RMB in circulation but sterilization does not work in the long run 10-57 FX D <FX S

Fixed Exchange Rate Intervention - Unilateral Peg - Possible Problem: (e.g. Mexican Peso/$) (note, the following slights are from the view of Mexico not the US! Mexico is the domestic country, the US the foreign country) 10-58 FX D >FX S

10-59 Fixed Exchange Rates and Changes in Demand FX D >FX S (Pressure on the Dollar to increase) Mexican Central Bank needs to intervene: Sell (supply) Dollar Peso/$ US-$

10-60 Selling Reserves of Pesos to Counter an Increasing Dollar (Weakening Peso) When Mexican Central Bank sells (supply) Dollar. Supply curve shift to the right, until... FX D =FX S Peso/$ Dollar

Fixed Exchange Rate Intervention - Possible Problem with Unilateral Peg - When: Consequences:  Mexican central bank sells Dollar and buys Peso From its international currency reserves From a loan from the foreign central bank  Foreign central bank sells Euro and buys Peso  Money (Peso) in circulation in domestic country decreases 10-61 FX D >FX S

10-62  Uncovered Interest Rate Parity:  If people trust in fixed exchange rates E=R. Thus, E-R=0:  The domestic interest rate equals foreign rate  If currency reserves run low, market participants may lose trust (E>R) Market participants invest abroad (capital flight). Consequently, FX D > FX D  More intervention (or domestic interest increase) needed  When reserves shrink further, more trust might be lost in the ability of the domestic central bank to intervene Fixed Exchange Rate Intervention - Possible Problem with Unilateral Peg – -Trust Problem -

Currency Boards - Why? -  A major problem with pegged exchange rates are credibility problem related to balance of payment. Especially: low currency reserves evaluation expectations of the foreign currency Lost of trust in the ability of the domestic central bank to intervene (sell foreign currency)  These issues are addressed by a currency board! 10-64

Currency Boards A country unilaterally pegs its exchange rate to another country’s exchange rate It guarantees that all domestic money in circulation is backed proportionally to the exchange rate by the anchor currency.* Note, that this would allow the domestic central bank at all times to buy all domestic currency in circulation and pay with the anchor currency. The same requirement applies to private banks. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-65

Currency Boards - How it works - In case of a deficit FX D >FX S : Let’s assume country has only imports. Private agents will exchange domestic currency for foreign currency at the central bank. Consequence: International Reserves are decreased but domestic currency in circulation is decreased by an equivalent amount. Domestic currency in circulation is still fully backed by international reserves. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 10-66

Currency Boards - How it works - In case of a deficit FX D < FX S : Let’s assume country has only exports. Private agents will exchange foreign currency for domestic currency at the central bank. Consequence: Domestic currency in circulation increases, but international reserves increase by an equivalent amount. Domestic currency in circulation is still fully backed by international reserves. 10-67

Dollarization/Euroization  A country fully gives up monetary sovereignty.  It sets a conversion rate (akin to exchange rate) between the domestic and foreign exchange rate  All domestic currency is either exchanged (cash) or converted bank accounts to the foreign currency  Panama (1904), El Salvador(2001), Ecuador (2000)  Dollarized countries have no authority about monetary policy and they don’t collect seigniorage. 10-69

Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy International.

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Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy International.

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Presentation on theme: "Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy International."— Presentation transcript:

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