Chapter 18 Krugman and Obstfeld 9e
ECO41 International Economics
Udayan Roy

• 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

Central Bank Intervention and 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 some financial asset, it must pay for it with newly printed dollars. Therefore, the US money supply
(M
US
) must increase.

Central Bank Intervention and the Money Supply
• Any central bank sale of assets automatically causes the money supply to decrease .
– Example: If the Fed sells some financial asset, the dollars paid by the buyer will no longer be in circulation. Therefore, the US money supply (M
US
) must decrease.
• In short, the central bank’s reserves of financial assets moves in the same direction as its money supply .

The output market is in equilibrium on the DD curve
The asset markets are in equilibrium on the AA curve
RECAP Fig. 17-8: Short-Run Equilibrium: The
Intersection of DD and AA
The short run equilibrium occurs at the intersection of the DD and
AA curves
17-5

• 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:
– M s increases
– P decreases
– E e rises
– R* rises
– L decreases for some unknown reason
Knowing how some specified change shifts the DD and AA curves will help us predict the consequences of the specified change.
16-6

How a Central Bank Fixes the Exchange Rate
E 3
E 2
Y 2
2
Y 3
3
Suppose the central bank wants to fix the value of the exchange rate at E 1 .
If, for whatever reason, the AA curve shifts left, then the short-run equilibrium shifts from point 1 to point 2 and the exchange rate falls.
To return to the exchange rate to the target value of E
1
1 , all that the central bank has to do is to increase the money supply and shift the AA curve back where it originally was.
originally was.

How a Central Bank Fixes the Exchange Rate
E 3 3
We have seen before that the AA curve shifts because of changes in P, E e , R* and L-shocks.
And now we see that, under fixed exchange rates, such changes will have no effect on
E and Y.
E 2 2
Y 2 Y 3

How a Central Bank Fixes the Exchange Rate
E 3
Y 3
3
Let us return to the case in which the AA curve shifts right for some reason and moves the equilibrium from point 1 to point 3.
To bring the exchange rate back to E1, the central bank must reduce the money supply to shift the AA curve back where it was.
But there’s a slight problem. To reduce the money supply the central bank must sell financial assets from its reserves, as we saw earlier. But what if the central bank has exhausted its reserve of assets and has no assets left to sell?
In this case, the central bank will no longer be able to keep the exchange rate fixed. The country will be forced to return to flexible exchange rates.
More on this later!

How a Central Bank Fixes the Exchange Rate
3
2
DD 2
AA 2
Suppose the central bank wants to fix the value of the exchange rate at E 1 .
If, for whatever reason, the DD curve shifts left and the short-run equilibrium shifts from point 1 to point 2, then all that the central bank has to do is to
decrease the money supply and shift the AA curve to the left and take the short-run equilibrium to point 3.
Y 3
17-10

How a Central Bank Fixes the Exchange Rate
3
2
DD 2
AA 2
We have seen before that the DD curve shifts left when there is a decrease in G, I, or
P*, or changes in other unspecified factors that decrease C or CA, or an increase in T or
P.
We see now that, under fixed exchange rates, such changes will reduce Y , and by a bigger amount than under flexible exchange rates .
Y 3
17-11

How a Central Bank Fixes the Exchange Rate
2
Y 3
3
DD 2
AA 2
Suppose the central bank wants to fix the value of the exchange rate at E 1 .
If, for whatever reason, the DD curve shifts
right and the short-run equilibrium shifts from point 1 to point 2, then all that the central bank has to do is to
increase the money supply and shift the AA curve to the right,
thereby taking the short-run equilibrium to point 3.
17-12

How a Central Bank Fixes the Exchange Rate
2
3
DD 2
AA 2
We have seen before that the DD curve shifts right when there is an increase in G, I, or
P*, or changes in other unspecified factors that increase C or CA, or a decrease in T or P.
We see now that, under fixed exchange rates, such changes will increase Y , and by a bigger amount than under flexible exchange rates .
Y 3
17-13

E 2
Devaluation
Y 2
2
Suppose the exchange rate has been fixed at E 1 in the past. Now suppose the central bank wishes to continue to fix the exchange rate but at the higher value of E 2 . This is called devaluation .
The central bank can shift only the AA curve.
So, it would have to
increase the money supply and shift the AA curve to the right till the equilibrium exchange rate increases to the desired level of E 2 .
Therefore, we see that a devaluation raises output . Conversely, a revaluation reduces output .
17-14

E 2
Devaluation
2
3
The increase in the central bank’s target exchange rate will raise the expected exchange rate (E e ↑). This, we saw before, will shift the
AA curve further to the right, taking the equilibrium to point 3.
The central bank will therefore have to reduce the money supply a bit to shift the AA curve to the left till the economy returns to point 2.
Y 2
17-15

Exogenous Change
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Target Exchange Rate (E target )
Expected Future Exchange Rate (E e )
Foreign Interest Rate (R*)
L-shocks
Effect on Output (Y)
+
+
–
+
+
+
0
0
0
+
–
Only DD shifts
Both DD and AA shift
Only AA shifts

Exogenous Change
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Target Exchange Rate (E target )
Expected Future Exchange Rate (E e )
Foreign Interest Rate (R*)
L-shocks
Effect on Output (Y)
+
+
–
+
+
+
0
0
0
+
–
Whenever there is an effect on Y, the magnitude of the effect is bigger under fixed exchange rates than under flexible exchange rates.

• Recall that the foreign exchange market is in equilibrium when: R = R* + (E e – E)/E
– When the central bank fixes the exchange rate at E =
E target , people will expect it to continue. So, E e = E target .
– Therefore, (E e – E)/E = (E target – E target )/E target = 0 .
– Therefore, R = R* .
– Under fixed exchange rates, the domestic interest rate is tied to the foreign interest rate.

• R = R* + (E e – E)/E = R* + (E e /E) – 1
• If a devaluation occurs and takes everybody by surprise , then initially E will increase but E e will not.
• Therefore, R will temporarily fall below R* .
• Eventually, E and E e will again be equal and, therefore, so will be R and R*.

Fixed Exchange Rates
Government Spending (G)
Y R
+ 0
Business Investment Spending (I) + 0
Net Tax Revenues (T) – 0
Foreign Price Level (P*)
C-shocks ( unspecified factors that increase C
)
+
+
0
0
CA-shocks ( unspecified factors that increase CA
) + 0
Domestic Price Level (P) – 0
Target Exchange Rate (E target ) + –
Expected Future Exchange Rate (E e ) 0 0
Foreign Interest Rate (R*)
L-shocks ( unspecified factors that increase L
)
0 +
0 0
As R = R*, only R* affects R.
The inverse effect of E target on R is true only when the change in E target takes people by surprise.
If the change in E target is anticipated, then there will be an equal change in
E e . As a result, R = R* will continue to hold. Therefore, the change in E target will have no effect on R.

• Recall from Chapter 17, that there are two ways to express a country’s current account
• Method 1: 𝐶𝐴 = 𝐶𝐴
𝐸∙𝑃
∗
, 𝑌 − 𝑇
𝑃
• Method 2: 𝐶𝐴 = 𝑌 − 𝐶 𝑌 − 𝑇 − 𝐼 − 𝐺

• Method 1: 𝐶𝐴 = 𝐶𝐴
𝐸∙𝑃
∗
, 𝑌 − 𝑇
𝑃
• Suppose E, P*, P, T and CA-shocks are unchanged, but some other exogenous variable undergoes a change .
• In this case, as the current account is inversely related to after-tax income, the effect on CA will be the opposite of the effect on Y .

Summary: The Behavior of Y and CA
Exogenous Change
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Target Exchange Rate (E target )
Expected Future Exchange Rate (E e )
Foreign Interest Rate (R*)
L-shocks
Effect on Output (Y) Current Account (CA)
+ –
+
–
+
+
–
+
+
–
+
0
0
0
+
–
+
–
+
0
0
0

• Method 1: 𝐶𝐴 = 𝐶𝐴
𝐸∙𝑃
∗
, 𝑌 − 𝑇
𝑃
• Suppose taxes increase (T↑) and all other exogenous variables remain unchanged.
• We saw before that Y decreases. Therefore, after-tax income decreases (Y – T↓).
• as the current account is inversely related to after-tax income, the current account increases (CA↑)

Summary: The Behavior of Y and CA
Exogenous Change
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Target Exchange Rate (E target )
Expected Future Exchange Rate (E e )
Foreign Interest Rate (R*)
L-shocks
Effect on Output (Y) Current Account (CA)
+ –
+
–
+
+
–
+
+
–
+
0
0
0
+
–
+
–
+
0
0
0

• Assumption: When Y changes and T is unchanged,
C changes in the same direction but by less.
• Therefore, when Y changes and T is unchanged, Y
− C changes in the same direction
• It then follows from 𝑌 − 𝐶 𝑌 − 𝑇 − 𝐼 − 𝐺 = 𝐶𝐴 that all the exogenous factors other than I, G, T and C-shocks that affect Y must affect CA in the same way

Summary: The Behavior of Y and CA
Exogenous Change
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Target Exchange Rate (E target )
Expected Future Exchange Rate (E e )
Foreign Interest Rate (R*)
L-shocks
Effect on Output (Y) Current Account (CA)
+ –
+
–
+
+
–
+
+
–
+
0
0
0
+
–
+
–
+
0
0
0

Summary: The Behavior of Y and CA
Exogenous Change
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Target Exchange Rate (E target )
Expected Future Exchange Rate (E e )
Foreign Interest Rate (R*)
L-shocks
Effect on Output (Y) Current Account (CA)
+ –
+
–
+
+
–
+
+
–
+
0
0
0
+
–
+
–
+
0
0
0

• 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 .

• As output (Y) and the current account (CA) are usually the two main topics, let us look at how the various exogenous variables affect Y and
CA in the two exchange rate regimes

Fixed Exchange Rates
Government Spending (G)
Y CA
+ –
Business Investment Spending (I) + –
Net Tax Revenues (T) – +
Foreign Price Level (P*)
C-shocks ( unspecified factors that increase C
)
+
+
+
–
CA-shocks ( unspecified factors that increase CA
) + +
Domestic Price Level (P) – –
Target Exchange Rate (E target ) + +
Expected Future Exchange Rate (E e ) 0 0
Foreign Interest Rate (R*)
L-shocks ( unspecified factors that increase L
)
0 0
0 0
Flexible Exchange Rates
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Money Supply (M s )
– –
+ +
Expected Future Exchange Rate (E e ) + +
Foreign Interest Rate (R*) + +
L-shocks – –
Y CA
+ –
+ –
– +
+ +
+ –
+ +

Fixed Exchange Rates
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Y CA
+
+
–
–
–
+
+ +
+ –
+ +
Domestic Price Level (P) – –
Target Exchange Rate (E target ) + +
Expected Future Exchange Rate (E e ) 0 0
Foreign Interest Rate (R*)
L-shocks
0 0
0 0
Flexible Exchange Rates
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Money Supply (M s )
– –
+ +
Expected Future Exchange Rate (E e ) + +
Foreign Interest Rate (R*) + +
L-shocks – –
Y CA
+ –
+ –
– +
+ +
+ –
+ +
Recall that expansionary monetary policy is an increase in M s under flexible exchange rates and an increase in E target under fixed exchange rates. Note that their effects are the same: output and the current account both increase.

Fixed Exchange Rates
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Y CA
+
+
–
–
–
+
+ +
+ –
+ +
Domestic Price Level (P) – –
Target Exchange Rate (E target ) + +
Expected Future Exchange Rate (E e ) 0 0
Foreign Interest Rate (R*)
L-shocks
0 0
0 0
Flexible Exchange Rates
Government Spending (G)
Business Investment Spending (I)
Net Tax Revenues (T)
Foreign Price Level (P*)
C-shocks
CA-shocks
Domestic Price Level (P)
Money Supply (M s )
– –
+ +
Expected Future Exchange Rate (E e ) + +
Foreign Interest Rate (R*) + +
L-shocks – –
Y CA
+ –
+ –
– +
+ +
+ –
+ +
As we saw earlier, under fixed exchange rates, any variable that shifts the AA curve is totally reversed by the central bank in order to keep the exchange rate fixed. That explains the zeroes on the left table.

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
E e . 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.

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.

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.

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.

What is Monetary Policy Under Fixed
Exchange Rates?
• As the central bank in a fixed exchange rate system must keep the money supply at the precise level necessary to keep the exchange rate fixed at the target rate, it becomes unable to use the money supply to pursue any other objective (such as fighting a recession)

The Money Supply is no longer a policy tool
• Under a fixed exchange rate, the money supply is an endogenous variable
• It is no longer a policy tool
• The monetary policy tool is now E target , the rate at which the exchange rate is pegged

What is Monetary Policy Under Fixed
Exchange Rates?
• We saw in Chapters 16 and 17 that in an economy with flexible exchange rates, monetary policy consists of changes in the money supply (M s )
– M s ↑ is expansionary monetary policy
– M s ↓ is contractionary monetary policy
• But in a fixed exchange rate system, the money supply is no longer controlled by the central bank

What is Monetary Policy Under Fixed
Exchange Rates?
• The central bank does, however, control the target rate E target at which the exchange rate is kept fixed
– E target ↑ (devaluation) is expansionary monetary policy
– E target ↓ (revaluation) is contractionary monetary policy

• Equilibrium in the money market requires
M S /P = L(R, Y)
– But equilibrium in the foreign exchange market determines R (=R*).
– Therefore, M s = P × L(R*, Y).
– We saw in Ch. 15 that R (= R*) is inversely related to money demand, and Y is directly related to money demand.
– To simplify, 𝑀 𝑠 = 𝑃 ×
𝐿
0
×𝑌
𝑅 ∗

• 𝑀 𝑠 = 𝑃 ×
𝐿
0
×𝑌
𝑅 ∗
• Suppose P, L
0
, and R* remain unchanged, but some other exogenous variable changes .
• If Y increases, then M s must increase.
• In other words, the effects on Y and M s must be in the same direction .

• 𝑀 𝑠 = 𝑃 ×
𝐿
0
×𝑌
𝑅 ∗
• We saw earlier that if P increases, Y decreases.
• So, the effect of P on M s is ambiguous .

• 𝑀 𝑠 = 𝑃 ×
𝐿
0
×𝑌
𝑅 ∗
• We saw earlier that R* has no effect on Y.
• Therefore, an increase in R* leads to a decrease in M s .

• 𝑀 𝑠 = 𝑃 ×
𝐿
0
×𝑌
𝑅 ∗
• We saw earlier that L
0
, which represents any of the unspecified factors that affect L, has no effect on Y.
• Therefore, any increase in L
0 increase in M s .
leads to an

Summary: The Behavior of Y and M s
Fixed Exchange Rates
Government Spending (G)
Y M S
+ +
Business Investment Spending (I) + +
Net Tax Revenues (T) – –
Foreign Price Level (P*)
C-shocks ( unspecified factors that increase C
)
+
+
+
+
CA-shocks ( unspecified factors that increase CA
) + +
Domestic Price Level (P) – ?
Target Exchange Rate (E target ) + +
Expected Future Exchange Rate (E e ) 0 0
Foreign Interest Rate (R*)
L-shocks ( unspecified factors that increase L
)
0 –
0 +

Summary: Long-Run, Flexible Exchange
Rates
• q = 1 , absolute PPP
• Y = Y p
• 𝜋 = 𝑀 𝑠 𝑔
− 𝑌 𝑝 𝑔
• 𝑅 = 𝑅 ∗ + 𝑀 𝑠 𝑔
− 𝑌 𝑝 𝑔
− 𝜋 ∗
•
• 𝑃 =
𝐸 𝑔
𝑀 𝑠
∙ 𝑅
∗
+𝑀 𝑠 𝑔
−𝑌 𝑝 𝑔
−𝜋
∗
= 𝑀 𝑠 𝑔
𝐿
0
∙𝑌 𝑝
− 𝑌 𝑝 𝑔
− 𝜋 ∗
• 𝐸 =
𝑀 𝑠
∙ 𝑅
∗
+𝑀 𝑠 𝑔
−𝑌 𝑝 𝑔
−𝜋
∗
𝐿
0
∙𝑌 𝑝 ∙𝑃 ∗
This is a recap of Chapter 16, which discussed flexible exchange rates.
How will these results change under
fixed exchange rates?
The first two are real variables. Under the principle of monetary neutrality, they will not change.
We saw earlier that R = R * . Also, it is obvious that E = E target and E g
= 0 .
Only P and π remain to be determined.

• As we saw in Chapter 16, under either absolute purchasing power parity or relative purchasing power parity we get 𝐸 𝑔
= 𝜋 − 𝜋 ∗
• But under fixed exchange rates, the rate at which the exchange rate appreciates must be zero: 𝐸 𝑔
= 𝜋 − 𝜋 ∗ = 0
• Therefore, 𝝅 = 𝝅 ∗

• Absolute PPP: 𝑞 =
𝐸×𝑃
∗
𝑃
• Therefore, 𝑷 = 𝑬 𝒕𝒂𝒓𝒈𝒆𝒕
= 1
× 𝑷 ∗
• Relative PPP: 𝑞 =
𝐸×𝑃
∗
𝑃
= 𝑞
• Therefore, 𝑷 =
𝑬 𝒕𝒂𝒓𝒈𝒆𝒕
×𝑷
∗ 𝒒 𝟎
0
, a constant

Summary: Long-Run, Fixed Exchange
Rates
• q = 1 , absolute PPP
• q = q 0 , relative PPP
• Y = Y p
• 𝜋 = 𝜋 ∗
• 𝑅 = 𝑅 ∗
• 𝑃 = 𝐸 𝑡𝑎𝑟𝑔𝑒𝑡 × 𝑃 ∗
, absolute PPP
One major weakness of a fixed exchange rate system is that the country adopting such a system loses control of its inflation and interest rates.
• 𝑃 =
𝐸 𝑡𝑎𝑟𝑔𝑒𝑡
×𝑃
∗ 𝑞 0
, relative PPP