Section 6
Exchange Rate Regimes
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Content
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•
•
•
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Exchange Rate Regimes
Central Bank Intervention
Fixing Exchange Rates
BOP Crises and Capital Flight
Sterilized Intervention
The World Monetary System
Summary
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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.
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Exchange Rate Regimes
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Exchange Rate Regimes
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Exchange Rate Regimes
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Exchange Rate Regimes
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Exchange Rate Regimes
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Exchange Rate Regimes
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Exchange Rate Regimes
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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 doubleentry 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.
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Central Bank Intervention
Central Bank
Assets
Liabilities
Foreign Assets (FA)
Domestic Assets (DCB)
Monetary Base or Currency
in Circulation (H)
Deposits from private banks
(Db)
FA + DCB
H + Db
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Central Bank Intervention
Private banks
Assets
Liabilities
Deposits at Central Bank (Db) Deposits from private
Domestic Assets and loans to individuals (D)
private individuals (DCB)
Db + DCB
D
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Central Bank Intervention
Consolidated Banking Sector
Assets
Liabilities
Foreign Assets (FA)
Net Domestic Assets
(DC= DCB + Db)
Currency in Circulation (H)
Deposits from private
individuals (D)
FA + DC
H+D
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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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Central Bank Intervention
Example:
Consolidated Banking Sector
Assets
Liabilities
FA: USD 1000
DC: USD 1500
H: USD 2000
D: USD 500
M = FA +DC = USD 2500
M = H + D = USD 2500
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Central Bank Intervention
•
The money supply is M
– M = FA + DC = H + D
• How does the central bank raises the money
supply?
1. Open Market operations
2. Rediscount operations
3. Foreign exchange operations
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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.
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Central Bank Intervention
An open market operation:
Consolidated Banking Sector
Assets
Liabilities
FA: USD 1000
DC: USD 1600
H: USD 2100
D: USD 500
M = FA + DC = USD 2600
M = H + D = USD 2600
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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.
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Central Bank Intervention
A rediscount operation
Consolidated Banking Sector
Assets
Liabilities
FA: USD 1000
DC: USD 1550
H: USD 2050
D: USD 500
M = FA + DC = USD 2550
M = H + D = USD 2550
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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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Central Bank Intervention
Example 1:
Consolidated Banking Sector
Assets
Liabilities
FA: USD 1060
DC: USD 1500
H: USD 2060
D: USD 500
M = FA +DC = USD 2560
M = H + D = USD 2560
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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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Central Bank Intervention
Example 2:
Consolidated Banking Sector
Assets
Liabilities
FA: USD 1060
DC: USD 1500
H: USD 2000
D: USD 560
M = FA +DC = USD 2560
M = H + D = USD 2560
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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.
M  FA  DC
FA  DC  M  0
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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.
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Central Bank Intervention
Example 3:
Consolidated Banking Sector
Assets
Liabilities
FA: USD 1060
DC: USD 1440
H: USD 2000
D: USD 500
M=FA +DC = USD 2500
M=H + D = USD 2500
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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.
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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.
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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?
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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*.
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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.
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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)
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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.
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Fixing Exchange Rates
One-Sided Peg: A rise in output
S
S0
0
M1
P
M2
P
M/P
1'
3'
i*
1
i* + (S0 – S)/S
L(i, Y1)
L(i, Y2)
USD Rates
of Return
3
2
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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.
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Fixing Exchange Rates
Policy Ineffectiveness: A rise in M
S
DD
2
S2
1
S0
AA2
AA1
Y1
Y2
Y
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Fixing Exchange Rates
• Monetary Policy
– Under a fixed exchange rate regime, the country
imports foreign inflation.
– The real interest rate is given by:
r  i 
e
– So, for a constant real interest rate, i = i* implies that
  *
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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).
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Fixing Exchange Rates
Policy Effectiveness: A rise in G
S
DD1
DD2
3
1
S0
2
S2
AA2
AA1
Y1
Y2
Y3
Y
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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
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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.
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Fixing Exchange Rates
• Devaluation
– A devaluation can be studied like a rise in money
supply.
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Fixing Exchange Rates
A Currency Devaluation
S
DD
2
S1
1
S0
AA2
AA1
Y1
Y2
Y
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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.
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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.
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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
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BOP Crises and Capital Flight
A rise in Se
S
1'
S0
2'
i* + (S1– S)/S
0
i* + (S0 – S)/S
i* + (S1 – S0)/S0
i*
M2
P
M1
P
M/P
Home currency
rates of return
2
1
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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.
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BOP Crises and Capital Flight
– Cross-border purchase of foreign assets that are
managed to hide movement of money and ownership
(Money Laundering).
– False invoicing of international trade transactions.
Capital is moved via the under-invoicing (overinvoicing) of exports (imports), where the difference
between the invoiced amount and the actually agreedupon payment is deposited in banking institutions in
another country. The most typically associated with
capital flight.
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BOP Crises and Capital Flight
• 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.
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Sterilized Intervention
• A sterilized intervention is a change in the
composition of assets at the central bank that
leaves the money supply unchanged.
– Example: A sale of foreign reserves against a purchase
of domestic assets.
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Sterilized Intervention
• In our current framework, a sterilized intervention
does not affect the exchange rate.
– Under our current framework, a sterilized intervention
does not affect money supply M.
• It does not affect the interest rate.
• It does not affect inflation.
– A sterilized intervention does not affect the exchange
rate in either short or long run.
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Sterilized Intervention
• Imperfect Asset Substitutability
– The ineffectiveness of sterilized intervention is linked
to the assumption of perfect asset substitutability
embedded in our version of uncovered interest parity:
i  i * (S  S ) / S
e
– A departure from this version is required for sterilized
intervention to matter.
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Sterilized Intervention
• Imperfect asset substitutability
– We need to take seriously the idea of a risk premium.
– Risk is the main factor that may lead to imperfect asset
substitutability in foreign exchange markets.
– Knowledge of the risk premium may allow central
banks to control both the money supply and the
exchange rate separately through sterilized intervention.
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Sterilized Intervention
• Imperfect asset substitutability
– Investors may be willing to earn lower expected returns
on less risky assets.
– Investors require higher expected returns to accept
holding on to riskier assets.
– This trade-off between expected returns and risk can be
exploited by central banks.
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Sterilized Intervention
• Imperfect asset substitutability
– The risk premium version of the uncovered interest
parity or foreign exchange market equilibrium is
i = i* + (Se – S)/S + r
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Sterilized Intervention
• Imperfect asset substitutability
– r is a risk premium that reflects the difference
between the riskiness of domestic and foreign bonds.
– The risk premium is a positive function of the stock of
domestic government debt:
r = r(B – A)
where:
B is the stock of domestic government debt
A is domestic assets of the central bank
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Sterilized Intervention
• A model of the risk premium
– In a risky world where assets are imperfect substitutes,
investors prefer holding on to a diversified portfolio of
assets.
– Starting from a well diversified portfolio, investors may
be willing to hold more domestic assets if expected
returns on domestic currency assets are higher.
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Sterilized Intervention
• A model of the risk premium
– The demand for domestic currency assets (i.e. domestic
government debt) by investors is an increasing function
of B-A: The higher the return, the higher the quantity
demanded:
Bd = F( r )
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Sterilized Intervention
• A model of the risk premium
– The supply of domestic currency assets to
investors is equal to the value of domestic
currency government debt B less what is held
by the central bank A:
Bs = B – A
– The equilibrium is Bs = Bd:
B – A = F( r )
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Sterilized Intervention
A model of the risk premium
r
Bd
r
B–A
domestic bonds
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Sterilized Intervention
• The Effects of a Sterilized Intervention
– The central bank purchases foreign assets sterilized by
a sale of domestic assets.
– The supply of money does not change. Abstracting
from changes in output, the domestic interest rate does
not change.
– The rise in the amount of domestic asset that investors
must hold: A drops from A1 to A2.
– This raises the amount of domestic currency assets that
investors must bear. They will do so, only if expected
returns are higher (through a higher risk premium).
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Sterilized Intervention
Sterilized intervention and the risk premium
r
Bd
r2
r1
1
B – A1
B – A2
(A2 < A1)
domestic bonds
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Sterilized Intervention
– Effectively, the rise in the risk premium engineers a
depreciation of the domestic currency.
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Sterilized Intervention
Sterilized intervention and the risk premium
S
S2
S1
1'
i* + (Se– S)/S + r(B –A2)
i* + (Se – S)/S + r(B –A1)
Domestic
Interest rate
0
Ms
P
1
M/P
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Sterilized Intervention
– Empirical evidence provides little support for the idea
that sterilized intervention has a significant direct effect
on exchange rates.
• Signaling effect of foreign exchange intervention
– Sterilized intervention may give an indication of where
the central bank expects (or desires) the exchange rate
to move.
– This signal can change market views of future policies
even when domestic and foreign bonds are perfect
substitutes.
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The World Monetary System
• Two Systems for Fixing Exchange Rates:
– Reserve currency standard
• Central banks peg the prices of their currencies in
terms of a reserve currency.
– Gold standard
• Central banks peg the prices of their currencies in
terms of gold.
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The World Monetary System
• Reserve Currency Standard
– A reserve currency standard system is similar to the
system based on the U.S. dollar set up at the end of
World War II
– Every central bank fixed the U.S. dollar exchange rate
of its currency through foreign exchange interventions.
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The World Monetary System
• Asymmetric Position of the Reserve Currency
– The reserve-issuing country has a big advantage
• It is not pegging its currency.
• It can use its monetary policy for domestic stabilization.
– The purchase of domestic assets by the central bank of
the reverse currency country leads to:
• Higher demand for foreign currencies: an upward pressure on
the exchange rate.
• Expansionary monetary policies by all other central banks
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The World Monetary System
• Gold Standard
– Each country fixes its currency in terms of gold.
– No single country occupies a privileged position within
the system.
– Exchange rates between any two currencies are fixed.
• Example: If the dollar price of gold is pegged at USD 35 per
ounce while the pound price of gold is pegged at GBP 14.58,
the USD/GBP exchange rate is constant at USD 2.40/GBP.
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The World Monetary System
• Symmetric Adjustment with a Gold
Standard
– If a country is losing reserves and its money
supply decreases, foreign countries are gaining
reserves and their money supplies increases.
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The World Monetary System
• Benefits of the Gold Standard
– It avoids the asymmetry inherent in a reserve
currency standard.
– It places constraints on the growth of countries’
money supplies.
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The World Monetary System
• Drawbacks of the Gold Standard
– Undesirable constraints on the use of monetary policy
to fight unemployment.
– Ensures a stable overall price level only if the relative
price of gold and other goods is stable.
– Makes central banks compete for reserves and bring
about world unemployment.
– Gives gold producing countries (like Russia and South
Africa) a lot of power.
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The World Monetary System
• Bimetallic standard
– The currency is based on both silver and gold.
– The U.S. was bimetallic from 1837 until the Civil War.
– In a bimetallic system, a country’s mint coins specified
amounts of gold or silver into the national currency
unit.
• Example: 371.25 grains of silver or 23.22 grains of gold yield a
silver or a gold dollar. Thus, gold is worth 371.25/23.22 = 16
times as much as silver.
– It might reduce price-level instability resulting from the
use of one of the metals alone.
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The World Monetary System
• The Gold Exchange Standard
– Central banks’ reserves consist of gold and currencies
whose prices are fixed in terms of gold.
• For example, each central bank fixes its exchange rate to the
USD, and the USD is a fixed to gold.
– It can operate like a gold standard in restraining
excessive monetary growth throughout the world, but it
allows more flexibility in the growth of international
reserves.
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Summary
• The central bank balance sheet shows a direct link between
foreign exchange intervention and the money supply.
• A central bank’s purchase of foreign assets raises the
country's money supply.
• The central bank can negate the money supply effect of
intervention through sterilization.
• A central bank can fix the exchange rate of its currency
against foreign currency if it trades unlimited amounts of
domestic money against foreign assets at the target rate.
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Summary
• A commitment to fix the exchange rate forces the central
bank to sacrifice its ability to use monetary policy for
stabilization.
• Fiscal policy is more effective on output under fixed
exchange rates than under floating rates.
• Balance of payments crises occur when market participants
believe the central bank will change the exchange rate
from its current level.
• Self-fulfilling currency crises can occur when an economy
is vulnerable to speculation.
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Summary
• A system of managed floating allows the central bank to
retain some ability to control the domestic money supply.
• A world system of fixed exchange rates based on a reserve
currency gives an asymmetric higher power to the reserve
currency country.
• A gold standard avoids the asymmetry inherent in a reserve
currency standard.
• A related arrangement was the bimetallic standard based
on both silver and gold.
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