1. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 19 Exchange Rate Policy and the Central Bank

2. 19-2 Linking Exchange Rate Policy with Domestic Monetary Policy When capital flows freely across a country's borders, a fixed exchange rate means giving up domestic monetary policy.

3. 19-3 Linking Exchange Rate Policy with Domestic Monetary Policy Purchasing Power Parity In the long run, changes in the exchange rate are tied to differences in inflation. The central bank must choose between a fixed exchange rate and an independent inflation policy; it cannot have both.

4. 19-4 Linking Exchange Rate Policy with Domestic Monetary Policy Percentage Change in the Number of Pesos per Dollar= U.S. Inflation – Mexican Inflation

5. 19-5 Linking Exchange Rate Policy with Domestic Monetary Policy With Fixed Exchange Rates: i f = i

6. 19-6 Linking Exchange Rate Policy with Domestic Monetary Policy Capital Controls and the Policymakers’ Choice A country cannot Be open to international capital flows, Control its domestic interest rate, and Fix its exchange rate. Policymakers must choose two of these three options.

7. 19-7 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.

8. 19-8 The Mechanics of Exchange Rate Management

9. 19-9 The Mechanics of Exchange Rate Management A foreign exchange intervention has the same impact on reserves as a domestic open market operation.

10. 19-10 The Mechanics of Exchange Rate Management

11. 19-11 The Mechanics of Exchange Rate Management 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

12. 19-12 The Mechanics of Exchange Rate Management An intervention is unsterilized if it changes the monetary base and sterilized if it does not change the monetary base.

13. 19-13 The Mechanics of Exchange Rate Management

14. 19-14 The Costs, Benefits, and Risks of Fixed Exchange Rates A country will be better off fixing its exchange rate if it has: A poor reputation for controlling inflation on its own; An economy that is well integrated with the one to whose currency the rate is fixed, trading significantly with it and sharing similar macroeconomic characteristics; and A high level of foreign exchange reserves.

15. 19-15 The Costs, Benefits, and Risks of Fixed Exchange Rates

16. 19-16 Fixed Exchange Rate Regimes Exchange Rate Pegs and the Bretton Woods System International Monetary Fund (IMF). Hard Pegs: Currency Boards and Dollarization

17. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 19 End of Chapter