Section 6 Exchange Rate Regimes

1. Section 6Exchange Rate Regimes

2. Content • Exchange Rate Regimes • Central Bank Intervention • Fixing Exchange Rates • BOP Crises and Capital Flight • Sterilized Intervention • The World Monetary System • Summary

3. Objectives • To know how central banks manage exchange rate regimes. • To know the impact of macroeconomic policies under fixed exchange rates. • To know the effects of sterilization under imperfect asset substitutability.

4. Exchange Rate Regimes

5. Exchange Rate Regimes

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11. Central Bank Intervention • The Central Bank Balance Sheet • It records the assets and liabilities of the central bank. • It is organized according to the principles of double-entry bookkeeping. • Any acquisition of an asset by the central bank results in a + change on the assets side of the balance sheet. • Any increase in the bank’s liabilities results in a + change on the balance sheet’s liabilities side.

12. Central Bank Intervention

13. Central Bank Intervention

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15. Central Bank Intervention • The money supply is M • M = FA + DC = H + D • Example: Assume that the Central Bank has • FA=USD 1000 • DC=USD 1500 • H=USD 2000 • D=USD 500 • M = USD 2500

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17. Central Bank Intervention • The money supply is M • M = FA + DC = H + D • How does the central bank raises the money supply? • Open Market operations • Rediscount operations • Foreign exchange operations

18. Central Bank Intervention • Open Market Operations • The central banks purchases domestic assets (t-bills) from private individuals. • So, increase in DC=DCB + Db(from rise in DCB) raises M. Must be matched by a rise in either H or D. • Example: The central bank buys USD 100 of US t-bills on the open market with newly printed money. This raises money in circulation by USD 100. Total money supply is raised by USD 100.

19. Central Bank Intervention

20. Central Bank Intervention • Rediscount Operations • The central bank lends to commercial (private) banks at the “discount rate.” A reduction in the discount rate should raise the amount of loans to private banks. • So, increase in DC=DCB + Db(from rise in DCB) raises M, since M = FA + DC = H + D. Must be matched by a rise in either H or D. • Example: The central bank reduces the discount rate. This raises loans from private banks by USD 50 (issued in newly printed money). This raises money in circulation by USD 50. Total money supply is raised by USD 50.

21. Central Bank Intervention

22. Central Bank Intervention • Foreign Exchange Operations • The central banks purchases foreign assets. • So, increase in FA raises M, since M = FA + DC = H + D. • Must be matched by a rise in either H or D. • Example 1: The central bank purchases USD 60 worth of foreign assets (from foreigners) with newly issued money. This raises money in circulation and money supply by USD 60.

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24. Central Bank Intervention • Foreign Exchange Operations • Example 2: The central bank purchases USD 60 worth of foreign assets from domestic (depositors at) private banks. This raises deposits by USD 60. Overall, money supply is raised by USD 60.

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26. Central Bank Intervention • Sterilized Intervention • A sterilized intervention is an intervention in which the central banks either purchases or sells foreign reserves with net domestic assets.

27. Central Bank Intervention • Sterilized Intervention • Example 3: The central bank purchases USD 60 worth of foreign assets from foreigners. The bank pays using domestic assets. This raises foreign assets but lowers domestic credit. There is no effect on money supply.

28. Central Bank Intervention

29. Central Bank Intervention • The Balance of Payments and Money Supply • Earlier, we defined changes in official reserves (RFX) only briefly. Formally, the balance of payments (CA +KA) is the international payment gap that central banks must finance through their reserve transactions. • It is the net purchases of foreign assets by the home central bank less net purchases of domestic assets by foreign central banks.

30. Central Bank Intervention • If a country has a balance of payments surplus: • CA +KA > 0 • If the central bank does not sterilize, the resulting increase in the central bank’s foreign assets implies a rise in the money supply. • If the central bank sterilizes, the resulting in the central bank’s foreign assets is matched by a reduction in the central bank’s domestic assets, and the money supply does not change.

31. Fixing Exchange Rates • Preliminaries • Who fixes the exchange rate? • One-sided peg versus two-sided peg. • It is a single target or a target zone? • It is a credible policy?

32. Fixing Exchange Rates • Foreign Exchange Market Equilibrium • The foreign exchange market is in equilibrium when: i = i* + (Se – S)/S • As long as the fixed rate policy is credible, Se = S. That is, investors expect no appreciation or depreciation of their currency. The expected future exchange rate must equal the current exchange rate. • This implies that i = i*.

33. Fixing Exchange Rates • Money Market Equilibrium • The money market equilibrium requires that • M/P = L( i, Y) at home • M/P = L( i*, Y*) abroad • In a two-sided peg, both central banks work together to ensure that i = i*. • In a one-sided peg, the home central bank alone works to ensure that i = i*. • That is, the central bank takes the foreign interest rate i* as given.

34. Fixing Exchange Rates • One-Sided Peg • To hold the domestic interest rate at i*, the central bank’s foreign exchange intervention must adjust the money supply so that i=i* and M/P = L( i*, Y)

35. Fixing Exchange Rates • Example: Suppose the central bank has been fixing S at S0. • An increase in output would raise the money demand and thus lead to a higher interest rate and an appreciation of the home currency. • The central bank must intervene in the foreign exchange market by buying foreign assets to prevent this appreciation. • If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, it cannot keep the exchange rate fixed at S0.

36. S USD Rates of Return 0 L(i, Y1) i* 1 M1 P M/P Fixing Exchange Rates One-Sided Peg: A rise in output i* + (S0 – S)/S 1' S0 3' L(i, Y2) 3 M2 P 2

37. Fixing Exchange Rates • Monetary Policy • Under a fixed exchange rate regime, monetary policy tools are ineffective to affect output and the interest rate. • With sticky prices, a rise in M would otherwise change the interest rate, and thus the exchange rate. • Monetary policy must ensure that i = i*. • Thus, a rise in M must lead to an immediate reduction in M to prevent any short-run or long-run changes in the exchange rate.

38. S DD 2 S2 1 S0 AA2 AA1 Y Y1 Y2 Fixing Exchange Rates Policy Ineffectiveness: A rise in M

39. Fixing Exchange Rates • Monetary Policy • Under a fixed exchange rate regime, the country imports foreign inflation. • The real interest rate is given by: • So, for a constant real interest rate, i = i* implies that

40. Fixing Exchange Rates • Fiscal Policy • Under a fixed exchange rate regime, fiscal policy is more effective. • The rise in government expenditures stimulates output. • This raises money demand and puts pressure to raise the interest rate and change the exchange rate. • To prevent the rise in the interest rate and exchange rate, the central banks must raise money supply. That is, the central bank must buy foreign assets with money (i.e., increasing the money supply).

41. S DD1 DD2 3 1 S0 2 S2 AA2 AA1 Y Y1 Y2 Y3 Fixing Exchange Rates Policy Effectiveness: A rise in G

42. Fixing Exchange Rates • Devaluation • It occurs when the central bank lowers the value of its currency on the foreign exchange market. It is an increase in the target value of S. • 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 • Raise the central bank's foreign reserves

43. Fixing Exchange Rates • Revaluation • It occurs when the central bank lowers E. • To devalue or revalue, the central bank must announce its willingness to stand and trade, in unlimited amounts, at the new exchange rate.

44. Fixing Exchange Rates • Devaluation • A devaluation can be studied like a rise in money supply.

45. S DD 2 S1 1 S0 AA2 AA1 Y Y1 Y2 Fixing Exchange Rates A Currency Devaluation

46. BOP Crises and Capital Flight • Balance of payments crisis • A rapid change in official foreign reserves. • Generally sparked by a change in expectations about the future exchange rate. That is, a belief of a large future devaluation.

47. BOP Crises and Capital Flight • The belief in a large future devaluation might result from: • A large balance of payment imbalance. • To resolve the imbalance, a devaluation would promote exports and reduce imports. • A high domestic unemployment. • An expansionary monetary policy (a devaluation) could stimulate output and lower unemployment. • Low foreign reserves. • If the central bank sells foreign reserves to fix the exchange rate, low reserves signal that the regime is about to stop.

48. BOP 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

49. S 2' 1' S0 i* + (S1– S)/S Home currency rates of return i* + (S0 – S)/S 0 i* i* + (S1 – S0)/S0 L(i, Y) 2 M2 P M1 P 1 M/P BOP Crises and Capital Flight A rise in Se

50. BOP Crises and Capital Flight • Capital flight: • A rapid transfer of currencies and assets out of a country. • Mechanisms to transfer currencies and assets: • Transfers via the international payments mechanisms. These are just regular bank transfers. • Transfer of physical currency by the bearer. This cash smuggling activity is usually illegal. • Transfer of cash into collectibles or precious metals.