Chapter 17: Fixed exchange rates
Topics: Mechanics of fixed exchange rates
Monetary Policy
Fiscal Policy
Sterilization
Gold Standard
Bretton Woods
Currency Crises
1. Foreign exchange market intervention
The models we have considered so far assume that exchange rates are allowed to move
freely. But prior to 1973, most countries tried to hold exchange rates fixed, and many
developing countries still do today. Even today many developed countries influence
exchange rate somewhat to prevent large fluctuations.
How to fix the exchange rate: Not just a matter of declaring a particular exchange rate, but a
country’s central bank also (potentially) intervenes in the foreign exchange market to ensure
a desired exchange rate level. The central bank must always be willing to trade the currency
with participants in the foreign exchange market at the official rate, and absorb whatever
excess supply or satisfy whatever excess demand exists at that rate. This means decreasing
or increasing Ms to pin the E-rate at the desired level.
a) Balance Sheets of central bank
Look at the mechanics of central bank intervention in foreign exchange market.
Use the balance sheet of the central bank, showing assets and liabilities.
Assets: hold domestic assets: domestic bonds (treasury bills - get paid a certain
number of dollars in future) Hold bonds issued by foreign governments,
denominated in foreign currency.
Liabilities: private banks give deposits, which private banks own and can
withdraw. There is also the domestic currency in circulation.
When the central bank buys (sells) an asset from (to) the public, its payment
(receipt) directly enters (leaves) the money supply.
See chart, p. 489
b) Foreign exchange intervention and the money supply
Foreign exchange intervention example on p. 491: If a bank sells foreign assets,
and is paid with cash, the foreign assets held drop by $100, and the currency in
circulation drops by $100. The money supply decreases. If the payment is a
check drawn on a private domestic bank, we instead decrease the deposits held by
private banks by $100.
Sterilization: A country may wish to intervene in the foreign exchange market
without affecting the domestic money supply. To do so, it carries out sterilized
foreign exchange intervention. See the examples on pp. 492-3. It is a
controversial issue as to whether this has any different effect than the straight
intervention policy described above. Here the Bank (as before) sells $100 of
foreign assets and receives a check drawn on a private bank. At the same time,
the Bank buys $100 of domestic assets (government bonds, for example). There
is no net effect on liabilities, but the foreign and domestic assets each change by
$100. The net effect is a swap of domestic assets for foreign assets.
Understand Table 17-2.
Balance of Payments implications
Recall that one entry in the BOP accounts is the change in foreign asset holdings
of the central bank. And recall that if a country is running an official Balance of
Payments deficit, the central bank is selling off assets to help cover the shortfall in
capital inflows needed to finance the current account. We can see here this has an
implication for the money supply. When the central bank sells off foreign assets
to maintain BOP balance, it is automatically decreasing the domestic money
supply.
c) How to maintain a fixed exchange rate
So central bank must intervene in the foreign exchange market to make the
equilibrium exchange rate equal the desired level. Recall that the equilibrium in
foreign exchange market is based on the interest rate parity condition. To
maintain a fixed E-rate, the central bank must adjust monetary policy so that the
nominal interest rate equals that in the other country.
Consider a case (shown in Fig. 17-1) where a rise in output makes real money
demand rise. The rise in money demand would tend to raise the interest rate in
the U.S, and would make holding dollar assets more attractive. This would make
the value of the dollar in the private foreign exchange market appreciate above the
fixed exchange rate set by the central bank. Since the central bank has committed
itself to selling dollars at the official rate, people can take foreign currencies to the
central bank and purchase dollars cheaply there, and then sell them in the private
foreign exchange market for a higher price and make a profit. This process will
automatically increase the supply of money. So if a country wishes to maintain a
fixed exchange rate, the country must dedicate its monetary policy to pursuing
this objective.
2. Policies under Fixed Exchange Rates
Under fixed E, short-run monetary and fiscal policies have very different effects
than under flexible exchange rates.
Monetary policy: Under a fixed exchange rate, monetary policy tools are
powerless to affect the country’s money supply or output, as seen in Fig. 17-2.
Recall that with a floating E-rate, an increase in MS shifts AA to the right and the
eqm Y rises, so the dollar would depreciate. But this conflicts with the
commitment by the central bank to maintain a fixed exchange rate. It has
committed itself to trade dollars with anyone at the office rate. As the dollar
begins to depreciate, people in the foreign exchange market will see that they can
buy dollars cheap in the private market and then sell them to the central bank at
the official exchange rate, which gives more units of foreign currency per dollar.
As people take advantage of this, the central bank will find itself buying up lots of
dollars, and thereby shrinking the domestic money supply. This process will end
only once the market exchange rate is once again the same as the official rate.
This will happen once the central bank has decreased the money supply back to
the original level.
Fiscal policy: Fiscal expansion is shown in Fig. 17-3. The DD line shifts to the
right. Instead of ending up at point 2 in the Figure (as under floating rates), we
must end up at point 3. Why? Well, to maintain the fixed E-rate, the central bank
must deal with the excess money demand caused by the expansion. To avoid this
pushing up the interest rate, the bank must buy foreign assets, increasing the
money supply. So fiscal expansion is even more effective than with a floating
rate.
Exchange rate devaluation: Sometimes the country fixing the exchange rate
decides to change its official level. If it makes its currency depreciate, we call it a
devaluation. If it makes its currency appreciate, we call it a revaluation. See Fig.
17-4
Long-run adjustment to fiscal policy and exchange rate changes: Ultimately
prices adjust, so that the full employment level is restored. With fiscal expansion,
prices rise, home output becomes more expensive, and demand falls back to the
initial level. Nevertheless, the real exchange rate (Ep*/P) falls. To fix the rate
throughout the adjustment process, the central bank must increased the money
supply in proportion to the long-run appreciation in P.
A devaluation under a fixed rate regime does not change long-run demand or
supply conditions in the output market, so the increase in the price level matches
the increase in the exchange rate. Devaluation in a fixed rate regime is neutral in
the long run. Nevertheless, the market’s belief in an impending change in the Erate may cause a balance of payments crisis, a sharp change in official foreign
reserves caused by expectations of a change. As shown in Fig. 17-5, a change in
expectations shifts out the expected domestic currency return on foreign currency
deposits. If the interest rate remains at R*, there will be capital flight. To prevent
this, the bank must sell foreign reserves and shrink the money supply, thus
increasing the interest rate to restore equilibrium at point 2’. Expectations are
huge here; interest rates may climb due to speculation, raising banks’ borrowing
costs. Can be a big problem.
3. Some History of Fixed Exchange Rate Regimes
a) General costs and benefits of fixed exchange rate regimes:
We saw that certain costs and benefits apply whenever a country commits itself to
fixed exchange rate regimes. The main benefit is that it lowers uncertainty about
cross-border trade and investment. The main cost is that the country loses the
ability to use monetary policy. If a country wishes to increase money supply, it
must devalue its currency, that is, lower its official pegged exchange rate.
b) Internal and External balance:
In addition there are some other criteria on which various exchange rate regimes
might be judged:
1. External Balance: Keeping the current account deficit near a
“sustainable” level, that is, where any net imports on the current
account side are fully financed by willing private capital inflows on
the capital account side. Recall from the Balance of Payments
accounts, that one category of the capital account was “official reserve
assets.” Recall that if foreigners are not buying U.S. goods or U.S.
assets with the dollars we are paying them to buy foreign goods, then
the U.S. central bank must be selling off some of its foreign reserve
assets to make up the shortfall in the balance of payments. This
situation is not sustainable over a long time, because eventually the
central bank will deplete its reserves of foreign assets. As a result, this
situation would be an imbalance in the external accounts of the U.S.
and be called “external imbalance.”
2. Internal Balance: Keeping output near the full-employment level and
keeping prices levels stable (low inflation). This is a matter of
preventing the economy from going into recession, where people
suffer because of unemployment, or from overheating, which can
produce excessive inflation.
We now will use these criteria to evaluate some particular fixed exchange rate
regimes that have been used in the past.
c) Gold Standard
The gold standard is one particular form of fixed exchange rate regime. The U.S.
and most other developed countries followed this from 1870 to WWI.
Defining features:
- Peg domestic currency to gold instead of another currency. So if gold
costs $35 per ounce at the Federal Reserve and it costs 100 DM per
ounce at the German central bank, then the exchange rate is 35$ per
-
-
ounce/ 100 marks per ounce = 0.35 $/DM.
Central bank pegs price of gold by being willing to trade domestic
currency for gold or vice versa with anyone at that official price. It
must allow people to ship gold in and out of the country as they wish.
The central bank’s foreign reserve assets are in the form of gold.
One unique benefit of the gold standard is that it has an automatic mechanism that
it helps to maintain external balance. However, the gold standard makes it hard
for countries to maintain internal balance. Demand shocks that lower output
below the full employment level are amplified by the fact that the gold standard
implies that money supplies must be allowed to fall at the same time. There are
some additional reasons why the Gold standard is bad at maintaining internal
balance:
- New gold discoveries can lead to price instability. If there is an
increase in the supply of gold, there would be pressure for the price of
gold to fall. People would take the gold to central banks and demand
currency. This would increase the supply of money in the world,
which would lead to inflation.
- Conversely, as economies grow, there is no way to increase their
money supplies if the supply of gold in the world is not growing at that
time.
- Further, the gold standard gives the countries that produce gold
significant power over other countries (Russia, and South Africa were
big supplies.)
So our overall evaluation of the gold standard would be as follows: It is very good
at helping a country maintain external balance, but is bad for maintaining internal
balance.
d) Reserve Currency Standard: Bretton Woods System
This was set up after WWII and lasted until 1973. The architects wished to reestablish fixed exchange rates. But they had an appreciation for Keynesian theory,
and wished to build a system that would allow more flexibility for governments to
pursue policies to promote “internal balance” – full employment and low
inflation. The system would be classified as a Reserve Currency Standard: another
form of exchange rate regime.
How it worked: Currencies pegged to U.S. dollar, and the dollar alone was pegged
to gold (at $35/ounce). The dollar was the reserve currency. Central banks held
dollars as foreign reserve, to trade in the foreign exchange market to control their
exchange rate. The dollar has a special position in system. If are N countries, then
are N-1 bilateral exchange rates to be pegged. U.S. dollar was the “Nth currency”.
The system included Features to allow more flexibility in the system than was
present under the Gold Standard:
1) International Monetary Fund (IMF): lend currencies to a country with a
temporary current account deficit. This helps the country to finance a
current account deficit without depleting the country’s foreign
exchange reserves. Each country contributes a quota to IMF funds; a
country can borrow from these funds based on the quota it contributed.
If it needs to borrow more than this, the IMF imposes conditions on the
borrowing, such as changes in domestic macroeconomic policies. This
is referred to as IMF Conditionality.
2) Adjustable parities: If the IMF agrees the exchange rate is in
fundamental disequilibrium, fixed at a level too far away from
equilibrium, it may allow the country to change the level at which the
exchange rate is fixed.
The IMF also required currency convertibility for current account
transactions. Convertibility means that people can freely exchange a
currency for other national currencies. This was intended to promote
international trade. For example, if DM were not convertible, a German
would be unable to acquire the French francs needed to purchase goods
from a French supplier he wanted. This would limit international trade to
barter, which is less efficient.
The IMF did not require convertibility for capital account transactions.
That is, governments were permitted to restrict the sale of domestic assets
to foreigners. This was to help prevent currency speculators from
destabilizing the system.
e) Collapse of Bretton Woods
U.S. policy in 1960s made the Bretton-Woods system unsustainable. Conflict of
objectives:
1) internal balance: U.S. was below full employment (See graph)
2) external balance: want to keep current account deficit generally near
sustainable level, financed by private capital inflows. Otherwise, would
have to be financed out of selling gold reserves. Let this level be X in XX
curve. So now XX represents CA at which not losing reserves.
The U.S. was below the full employment level, and used expansionary monetary
and fiscal policy to increase output. It decided to meet internal balance objectives
at the expense of external balance objectives.
But expectations by private traders led to what is called a “currency crisis” or a
“speculative attack”. And the private traders are called “speculators.” The U.S. in
the late 1960s had a large current account deficit inconsistent with external
balance, for the reasons above. When people come to expect the dollar to
depreciate in the future, the expected returns on the foreign assets (gold here)
shifts to the right. To maintain the exchange rate at E-bar, the Federal Reserve
had to raise the U.S. interest rate. This was necessary to make people willing to
hold dollar assets despite the expected dollar depreciation.
When it becomes clear that the Federal Reserve was running out of gold reserves,
they gave in, and allowed the value of the dollar to depreciate. Speculative
pressures in 1973 forced a devaluation of the dollar relative to gold. Repeated
pressures to devalue further forced the U.S. to dismantle the whole Bretton
Woods system: it let the dollar float flexibly in terms of gold. This forced the
currencies that had pegged to the dollar to also float.