Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention

1. Chapter 17 Fixed Exchange Rates and Foreign Exchange Intervention International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice Obstfeld Udayan Roy http://myweb.liu.edu/~uroy/eco41/ December 2005

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, the US money supply (MUS) must increase • Any central bank sale of assets automatically causes the money supply to decline. • Example: If the Fed sells its Yen reserves, the US money supply (MUS) must decrease • So, a country’s reserves of foreign currencies moves in the same direction as its money supply

5. 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 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. • Note that this reduces the US money supply. • On the other hand, when E starts to decrease, the Fed could buy euros with dollars. This increases the US money supply.

6. Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate • 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, this equation determines the interest rate: R = R*. • Under fixed exchange rates, domestic interest rates can increase only if foreign interest rates increase.

7. 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.

8. 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)

9. 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. • Figure 17-2 shows the economy’s short-run equilibrium as point 1 when the central bank fixes the exchange rate at the level E0.

10. Exchange rate, E DD 2 E2 1 E0 AA2 AA1 Output, Y Y1 Y2 Figure 17-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate

11. The DD and AA curves: recap • Although Chapter 16 was about the flexible exchange rate system, the DD and AA curves introduced there continue to apply to the discussion of fixed exchange rates.

12. 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

13. Stabilization Policies With a Fixed Exchange Rate • Fiscal Policy • How does the central bank intervention hold the exchange rate fixed after the fiscal expansion? • 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). • The effects of expansionary fiscal policy when the economy’s initial equilibrium is at point 1 are illustrated in Figure 17-3.

14. Exchange rate, E DD1 DD2 3 1 E0 2 E2 AA2 AA1 Output, Y Y1 Y2 Y3 Figure 17-3: Fiscal Expansion Under a Fixed Exchange Rate A fiscal expansion shifts the DD curve to the right. 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).

15. Stabilization Policies With a Fixed Exchange Rate • Changes in the Exchange Rate • 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

16. Stabilization Policies With a Fixed Exchange Rate • 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.

17. Exchange rate, E DD 2 E1 1 E0 AA2 AA1 Output, Y Y1 Y2 Figure 17-4: Effects 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).

18. Exchange rate, E DD 2 E1 1 E0 AA2 AA1 Output, Y Y1 Y2 Balance of Payments Crisis and Capital Flight 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.

19. 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.

20. 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.

21. 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.