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Fixed exchange rates

Fixed exchange rates. Lecture outline. Interventions on the FX market Equilibrium on the FX market in a fixed ER regime Adjustment mechanisms . Why analyze fixed ER?. Managed floating Regional monetary agreements Monetary unions and currency boards ERR in developing countries

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Fixed exchange rates

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  1. Fixed exchange rates International finance 120181-1165

  2. Lecture outline • Interventions on the FX market • Equilibrium on the FX market in a fixed ER regime • Adjustment mechanisms International finance 120181-1165

  3. Why analyze fixed ER? • Managed floating • Regional monetary agreements • Monetary unions and currency boards • ERR in developing countries • Conclusions from the past International finance 120181-1165

  4. Central bank interventions • Money supply management • The influence of CB transations on money supply • The CB balance sheet International finance 120181-1165

  5. The CB balance sheet • CB assets and liabilities • Foreign and national assets • Foreign assets- e.g. bonds denominated in foreign currency • National assets- CB claims concerning future payments from national market participants International finance 120181-1165

  6. Foreign assets • Foreign assets are a part of CB reserves • CB interventions- reserves shifts • Reserves- liabilities of foreign market participants and other commonly accepted monetary values International finance 120181-1165

  7. CB liabilities • Private banks’ deposits • Money in circulation International finance 120181-1165

  8. The CB balance sheet • The CB assets equal the liabilities plus the net value of the balance • The net value e.g reinvested profits from interest from assets- modest share in the balance International finance 120181-1165

  9. The CB balance sheet • Shifts in assets automatically imply shifts in liabilities • Example: • CB buys assets --> money supply increases International finance 120181-1165

  10. CB payments and money supply • Payment in cash • Payment by cheque • CB liabilities increase BC due to the payment for assets  money supply increase • Selling assets cheque or cash withdrawal from the circulation  money supply decreases International finance 120181-1165

  11. Monetary multiplicator effect • Each time the CB buys assets the money supply increases automatically while each time it sells assets it causes it’s decrease International finance 120181-1165

  12. Monetary multiplicator effect • the ratio of commercial bank and central bank money • the impact of raising the money supply on commercial bank money • MM=1/ reserves requirements International finance 120181-1165

  13. CB interventions • CB sells foreign bonds at the FX market  foreign reserves decrease  CB asstes decrease • Payment to the CB decreases it’s liabilities • Payment in national currency  cash withdrawal from the circulation  CB balance changes, both sides of the balance decrease by the value of money in circulation International finance 120181-1165

  14. CB interventions • CB sells foreign bonds at the FX market  foreign reserves increase  CB asstes increase • Payment of the CB increases it’s liabilities • Payment in national currency  cash introduction to the circulation  CB balance changes, both sides of the balance increase by the value of money in circulation International finance 120181-1165

  15. CB interventions- sterilisation • contrary transactions at the foreign at national assets market  neutralising the influence of FX market transactions on national money supply operacji walutowych na krajową podaż pieniądza • Example: • CB sells foreign asstes to a commercial bank and at same time it buys national governement bonds • Influence on the balance- national assets increase, foreign assets decrease, money supply does not change International finance 120181-1165

  16. Sterilized vs. not sterilized interventions Source: Krugman, Obstfeld, 2009. International finance 120181-1165

  17. CB interventions and the balance of payments • Financing a part of the current account balance, which has not been equilibrated by the financial account balance except foreign reserves • Absorbing the part of the surplus of the current account which has not been equilibrated buy the net outflow from the financial account except foreign reserves International finance 120181-1165

  18. CB interventions and the balance of payments • If CB does not conduct sterilized interventions while a country has a BP deficit/surplus than each decrease/increase of foreign assetes related to that situation decreases/increases the national money supply International finance 120181-1165

  19. CB interventions and the balance of payments • The influence of the BP gap on the money supply- hard to predict • BP adjustments born by several CB • Sterilization International finance 120181-1165

  20. The equilibrium on the FX market in a fixed ERR • The mechanism of fixing the ER • The necessity to exchange currencies at a fixed ER • Eliminating demand and supply surpluses at the FX market • CB transactions must insure constant equilibrium on the assets market • Equilibrium on the FX market and on the money market International finance 120181-1165

  21. The equilibrium on the FX market in a fixed ERR • Interest rate parity rUSD=rEUR+ (EReEUR-EeUSD)/EUSD/EUR • Fixed ER expected ER changes=0 • rUSD=rEUR International finance 120181-1165

  22. The equilibrium on the FX market in a fixed ERR • The necessity to keep the interest rateat r  the necessity of CB interventions aiming at stabilizing money supply • r must equalize the real national demand for money and the real national money supply • M/P=L(r, Y) International finance 120181-1165

  23. The equilibrium on the FX market in a fixed ERR • The equilibrium condition defines the money supply by fixed ER, which equilibrates the asset market by a given level of the foreign interest rate International finance 120181-1165

  24. The equilibrium on the FX market in a fixed ERR • CB interventions aimed at maintaining the ER  the necessity to adjust the money supply in order to maintain the equilibrium on the money market International finance 120181-1165

  25. The equilibrium on the FX market in a fixed ERR • Example: • ER fixed at E0 • Assets market in equilibrium • Production increase  pressure on the assets market + expectations that the ER will be maintained at E0 • Endavour to apply monetary policy measures- the necessity to decrease money demand in order to counteract appreciation of the currency  CB buys foreign assets  national money supply increases  the equilibrium reinstated ??? International finance 120181-1165

  26. Adjustment mechanisms in fixed ERR • Monetary policy • Fiscal policy • ER policy International finance 120181-1165

  27. Monetary policy • ER fixed at E0 • Equilibrium on the money market • Endeavour to raise production money supply increase unequilibrium on the assets market  pressure on depreciation  the necessity for the CB to sell foreign assets money supply decrease International finance 120181-1165

  28. Monetary policy Source: Own elaboration based on Krugman, Obstfeld, op. cit. International finance 120181-1165

  29. Monetary policy • In fixed ERR monetary policy does not influence neither the money supply nor the production level International finance 120181-1165

  30. Fiscal policy • Expansionary fiscal policy  increase of demand on the products market production increase  pressure for appreciation  CB interventions • CB buys foreign assets  ER maintained at E0 • Effect: • Production growth, • Maintained ER • Foreign reserves increase and money supply increase International finance 120181-1165

  31. Fiscal policy Source: Own elaboration based on Krugman, Obstfeld, op. cit. International finance 120181-1165

  32. ER policy • Excessive deficit of the current account balance  decrease of foreign reserves  necessity to devalue the ER • Currency exchange at a new ER International finance 120181-1165

  33. ER policy • devaluation  decrease of relative national prices  production increase  excessive money demand  CB buys foreign assets in order to increase money supply • Effect: • Production increase • Foreign reserves increase • Money supply increase International finance 120181-1165

  34. ER policy Source: Own elaboration based on Krugman, Obstfeld, op. cit International finance 120181-1165

  35. Adjustment mechanisms in the long term • Full employment • Expansionary fiscal policy  production increase  price increase  real appreciation  the necessity of CB interventions in order to increase money supply International finance 120181-1165

  36. Adjustment mechanisms in the long term • Devaluation does not increase neither the demand nor the supply on the product market • The only effect is the increase of prices and money supply International finance 120181-1165

  37. Adjustment mechanisms in the long term • devaluation may trigger demand shifts within countries characterized by different economic cycles • the wages-prices interdependence  potential inflationary pressures • Balance of payments reactions to devaluation/ revaluation International finance 120181-1165

  38. Fixed ER and expectations • Changing economic conditions  speculation on ER changes • The balance of payment crisis • Immediate capital outflow • Foreign reserves decrease • Monetary crisis International finance 120181-1165

  39. Intermediate ER regimes • Aimed at mainataining the internal and external eqilibrium at the same time • Contradictory economic policy measures • Example: • Money supply increase in order to fight unemployment and selling foreign assets at the same time in order to counteract depreciation  counteracting the monetary expansion International finance 120181-1165

  40. Intermediate ER regimes • Sterilisation by intermediate ERR is inefficient • The role of expectations • Vanishing of intermediate ERR • Example: • Crawling peg- inflationary pressures International finance 120181-1165

  41. Summing up • The CB balance sheet construction • CB interventions • Sterilization International finance 120181-1165

  42. Summing up • Monetary policy tools are inefficient by fixed ERR • Fiscal policy tools are efficient by fixed ERR • ER policy may be efficient in the short term, but it does not work in the long term International finance 120181-1165

  43. References • P. Krugman, M.Obstfeld, International economics: theory and policy. Part II, Pearson, Addison Wesley, Boston2009 • F. Mishkin, The economics of money banking and financial markets, Addison-Wesley, Longman, Boston 2001 • P. De Grauwe, Economics of monetary union, Oxford University Press, 2007. • L. Sarno, M. Taylor, Official intervention in the foreign exchange market: is it effective and if so, how does it work?, Journal of Economic Literature, 2001 International finance 120181-1165

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