Fixed Exchange Rates and Foreign Exchange Intervention

1. Fixed Exchange Rates and Foreign Exchange Intervention Chapter 18 Krugman and Obstfeld 9e ECO41 International Economics Udayan Roy

2. 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

3. Central Bank Interventionand the Money Supply • The Central Bank owns two types of assets: • Foreign assets • Mainly foreign currency bonds owned by the central bank (its official international reserves) • Domestic assets • Central bank holdings of claims to future payments by its own citizens and domestic institutions

4. Central Bank Interventionand the Money Supply • Any central bank purchase of assets automatically results in an increase in the domestic money supply. • Example: If the US central bank (“The Fed”) buys Yen, it must pay for the Yen with newly printed dollars. Therefore, the US money supply (MUS) must increase

5. Central Bank Interventionand the Money Supply • Any central bank sale of assets automatically causes the money supply to decrease. • Example: If the Fed sells its Yen reserves, the dollars paid by the buyer will no longer be in circulation. Therefore, the US money supply (MUS) must decrease • In short, a country’s reserves of foreign currencies moves in the same direction as its money supply

6. How Can Central Banks Keep Exchange Rates Fixed? • Simple! • When the value of the dollar starts to fall against the euro (that is, E starts to increase), a central bank (such as the US Fed) could push it back up • How? The Fed could selleuros from its reserves in exchange for dollars. • This will create an abundance of euros and a shortage of dollars and thereby reverse the fall in the dollar’s value. • Recall from the last slide that this decrease in US reserves of Euros must be accompanied by a decrease in US money supply. Warning: This strategy will not work if the Fed runs out of Euros!

7. How Can Central Banks Keep Exchange Rates Fixed? • On the other hand, when the value of the dollar starts to rise against the euro (that is, E starts to fall), a central bank (such as the US Fed) could pull it back down • How? The Fed could buy euros with freshly printed dollars. • This will create an shortage of euros and a flood of dollars and thereby reverse the rise in the dollar’s value. • Recall from the last slide that this increase in US reserves of Euros must be accompanied by an increase in US money supply.

8. How Can Central Banks Keep Exchange Rates Fixed? • To summarize, a central bank can • raise the value of the domestic currency (E↓) by reducing the money supply (Ms↓) • reduce the value of the domestic currency (E↑) by increasing the money supply (Ms↑) • In this way, the central bank can keep the exchange rate fixed at the desired level, as long as it does not run out of foreign currency

9. Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate • Recall that the foreign exchange market is in equilibrium when: R = R* + (Ee – E)/E • When the central bank fixes E at E0, the expected rate of domestic currency depreciation is zero: (Ee – E)/E = 0. • Therefore, R = R*. • Under fixed exchange rates, the domestic interest rate is tied to the foreign interest rate.

10. Goods Market Equilibrium • Equilibrium is achieved in the goods market when the value of output Y equals aggregate demand D. Y = D(EP*/P, Y – T, I, G) • Note that P* and P are fixed in the short run, that T, I, and G are exogenous and fixed, and that E is fixed: after all, this is a fixed exchange rate system! • So, only Y can vary and only Y can ensure goods market equilibrium • Therefore, this equation determines the equilibrium value of Y.

11. Goods Market Equilibrium • We saw in Chapter 17 that • the goods market’s equilibrium equation gives us the upward rising DD curve, and that • The DD curve shifts right if • G increases • T decreases • I increases • P decreases • P* increases • C increases for some unknown reason • CA increases for some unknown reason

12. Goods Market Equilibrium • In this chapter, the exchange rate is fixed • So, whatever shifts DD right must also increaseY • The DD curve shifts right if • G increases • T decreases • I increases • P decreases • P* increases • C increases for some unknown reason • CA increases for some unknown reason • Moreover, if the fixed level of E↑, then Y↑

13. Goods Market Equilibrium Note that an increase in the (fixed) value of the foreign currency raises output. Such a policy—which could be very useful in a recession—is called a devaluation. Among the “CA (other reasons)” factors would be tariffs or other protectionist policies. The theory suggests that such policies could also help boost output … so long as other countries don’t retaliate.

14. Goods Market Equilibrium

15. Goods Market Equilibrium

16. Goods Market Equilibrium

17. Goods Market Equilibrium Note that, as under flexible exchange rates, contractionary fiscal policies (“fiscal austerity” or “belt tightening”) can raise a country’s current account balance in the short run. So can protectionist policies such as tariffs and quotas.

18. Money Market Equilibrium Under a Fixed Exchange Rate • Equilibrium in the money market requires MS/P = L(R, Y) • But equilibrium in the foreign exchange market determines R (=R*) and equilibrium in the goods market determines Y. • Therefore, L(R, Y) is already determined. • Moreover, P is exogenous and fixed in the short run. • So, this equation determines the equilibrium level of the money supply (Ms)

19. Monetary Policy Is Useless in a Fixed Exchange Rate System • Under a fixed exchange rate, central bank monetary policy tools are powerless to affect the economy’s money supply or its output.

20. The DD and AA curves: recap • Although Chapter 17 was about the flexible exchange rate system, the DD and AA curves introduced there continue to apply to the discussion of fixed exchange rates. • Just remember what we saw a few slides earlier: E can be increased (decreased) by increasing (decreasing) Ms

21. The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason Shifting the DD and AA Curves

22. Fig. 18-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate The economy’s short-run equilibrium as point 1 when the central bank fixes the exchange rate at the level E0. An increase in Ms shifts AA right. This threatens to raise E above E0. The central bank must hastily reverse itself and decreaseMs in order to keep E fixed. Monetary policy cannot work! The result will be equally inconsequential if Ee rises, R* rises, or L falls.

23. Fiscal Policy is Very Effective in a Fixed Exchange Rate System • How does the central bank intervention hold the exchange rate fixed after the fiscal expansion (G↑ and/or T↓)? • The rise in output due to expansionary fiscal policy raises money demand. • To prevent an increase in the home interest rate and an appreciation of the currency, the central bank must buy foreign assets with money (i.e., increasing the money supply).

24. The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason Shifting the DD and AA Curves

25. Fig. 18-3: Fiscal Expansion Under a Fixed Exchange Rate A fiscal expansion shifts the DD curve to the right, threatening to decreaseE. To keep E fixed, the AA curve must be moved to the right, usually by increasing the money supply. As a result the overall effectiveness of fiscal policy is greater than under flexible exchange rates. As under flexible exchange rates, expansionary fiscal policies reduce net exports (CA).

26. It Might Help to Adjust the Fixed Exchange Rate From Time to Time • Devaluation • It occurs when the central bank raises the domestic currency price of the foreign currency, E. • It causes: • A rise in output • A rise in official reserves • An expansion of the money supply • It is chosen by governments to: • Fight domestic unemployment • Improve the current account • Affect the central bank's foreign reserves

27. It Might Help to Adjust the Fixed Exchange Rate From Time to Time • Revaluation • It occurs when the central bank lowers E. • In order to devalue or revalue, the central bank has to announce its willingness to trade domestic against foreign currency, in unlimited amounts, at the new exchange rate.

28. The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason Shifting the DD and AA Curves

29. Fig. 18-4: Effect of a Currency Devaluation If a devaluation from E0 to E1 is to be achieved, the equilibrium value of E must be made to rise to E1. This can be done by increasing the money supply and moving the AA curve to the right. So, devaluation raises GDP and reduces unemployment and is, therefore, a tempting policy option in a recession. This increases net exports (CA).

30. The DD curve shifts right if: G increases T decreases I increases P decreases P* increases C increases for some unknown reason CA increases for some unknown reason The AA curve shifts right if: Ms increases P decreases Ee rises R* rises L decreases for some unknown reason Shifting the DD and AA Curves

31. Fig. 18-4: Effect of the Expectation of a Currency Devaluation If a devaluation (an increase in E) is widely expected, there is an increase in Ee. As a result, the AA curve shifts right. To keep E fixed, the central bank must sell its foreign currency reserves and thereby reduce the domestic money supply and bring the AA curve back to where it was. So, the mere expectation of a devaluation may cause the central bank to lose a lot of its reserves. If its reserves are inadequate, the central bank may be forced to devalue or to simply switch to flexible exchange rates.

32. Balance of Payments Crises and Capital Flight • Balance of payments crisis • It is a sharp fall in official foreign reserves sparked by a change in expectations about the future exchange rate.

33. Balance of Payments Crises and Capital Flight • 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 revaluation causes the opposite effects of an expected devaluation.

34. Balance of Payments Crises and Capital Flight • 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 • It occurs when an economy is vulnerable to speculation. • The government may be responsible for such crises by creating or tolerating domestic economic weaknesses that invite speculators to attack the currency.