4.2.4-05 双语教学自编教材: 公共政策专题材料二
货币政策
Monetary Policy
Edited by: Dr. Xing Qaingguo
1. Tools of Monetary Policy
2. Conduct of Monetary Policy
3. The International Financial System
西南财经大学
SWUFE
September 1, 2003
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1-7
8-11
12-16
Chapter 1 Tools of Monetary Policy
Supply and Demand in the Market for Reserves
The quantity of reserves demanded equals required reserves and plus the excess reserves
demanded. Excess reserves are insurances against deposit outflows, and the cost of holding
these excess reserves is their opportunity cost, the interest rate that could have earned on
lending these reserves out, which is equivalent to the federal funds rate. Thus as the federal
funds rate decreases, the opportunity cost of holding excess reserves falls and, holding
everything else constant, including the quantity of required reserves, the quantity of reserves
demanded rises. Consequently, the demand curve for reserves, Rd, slopes downward as in the
following figure.
Rs
Federal funds Rate, iff
i*ff
1
Rd
Quantity of Reserves, R
When discount lending increases, the quantity of reserves supplied to the banking system
also increases. When banks borrow from the Fed, their principal benefit is not to borrow these
funds from the federal market. Discount loans are a substitute for borrowing federal funds. For
this reason, the supply curve for reserves, Rs, slope upward, as shown in the above figure.
Market equilibrium occurs where the quantity of reserves demanded equals the quantity
supplied, Rs=Rd. Point 1 is the intersection of demand curve and supply curve, with an
equilibrium federal rate of i*ff.
An open market purchase leads to a greater quantity of reserves supplied. This is true at any
given federal funds rate. Therefore, an open market shifts the supply curve to the right from Rs1
to Rs2 and moves the equilibrium from point 1 to point 2, lowering the federal funds rate from
i1ff to i2ff. The same reasoning implies that an open market sale decrease the quantity of reserves
supplied, shifts the supply curve to the left and causes the federal funds rate to rise. The result is
that an open market purchase causes the federal funds rate to fall, whereas an open market sale
causes the federal funds rate to rise.
We have also seen that increases in discount lending raise the quantity of reserves supplied.
With the federal funds rate constant, banks borrow mote from the Fed as the discount rate falls.
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A lower discount rate thus leads to a greater quantity of reserves supplied and shifts the supply
curve to the right from Rs1 to Rs2. the conclusion is that when the Fed lowers the discount rate,
the federal funds rate falls. When the Fed raises the discount rate, the federal funds rate rises.
When the Fed raises requirements, required reserves increase, which increases the demand for
Rs1
Federal funds rate, iff
Rd2
i1ff
1
i2ff
2
Rd1
Quantity reserves, R
reserves. The demand curve shifts from Rd1 toRd2, the equilibrium moves form point 1 to point 2,
and the federal funds rate rises from i1ff to i2ff.
Federal Funds Rate, iff
i2ff
i1ff
2
1
Rd2
Rd1
Quantity of Reserves, R
Open Market Operation
There are two types of open market operations: Dynamic open market operations are intended
to change the level of reserves and the monetary base, and defensive open market operation s
are intended to offset movements in other factors that affect reserves and the monetary base,
such as changes in Treasury deposits with the Fed. The Fed conducts most of its open market
operations in Treasury securities because the market of these securities is the most liquid and
has the largest trading volume. If reserves are predicted to decrease, there will be a defensive
open market operation, in this case a purchase of securities, to offset the expected decline in
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reserves and the monetary base. However, if Treasury deposits with the Fed are predicted to fall,
a defensive open market sale would be needed the offset the expected increase in reserves.
The Federal Reserve Bank of New York, representing the Fed, deals with the Treasury
securities transaction with primary dealers, government securities dealers who operate out of
private firms or commercial banks. There are two types of defensive open market operations. In
a repurchase agreement (often called a repo), the Fed purchase securities with an agreement that
the seller will repurchase them in a short period of time, anywhere from 1 to 15 days from the
original date of purchase. When the Fed wants to conduct a temporary open market sale, it
engages in a matched sale-purchase transaction (sometimes called a reserve repo) in which the
Fed sells securities and the buyer agrees to sell them back to the Fed in the near future.
Advantages of Open Market Operations
Open market operations have several advantages over the other tools of monetary policy.
1. Open market operations occur at the initiative of the Fed, which has complete control over
their volume. In discount loans operation, altering the discount rate cannot completely
control the discount loans volumes.
2. Open market operations are flexible and precise; they can be used to any extent—very small
ones or in large volumes.
3. Open market operations are easily reversed. If a mistake is made in conducting an open
market operation, the Fed can immediately reverse it. In fact, the adjustments are made
every day.
4. Open market operations can be implemented quickly; they involve no administrative delays.
When the Fed decides that it wants to change the monetary base ore reserves, it just places
orders with securities dealers, and the trades are expected immediately.
Operation of the Discount Window
The Fed’s discount loans to the banks are of three types: adjustment credit, seasonal credit, and
extended credit.
Adjustment credit loans are the discount loans that play the most important role in the
monetary policy. They are intended to be used by banks to help them with short-term liquidity
problems that may result from a temporary deposit outflow, and the rate charged on them is the
basic discount rate established by the Federal reserves banks and approved by the Board of
Governors. Seasonal credit is given to meet the needs of a limited number of banks in vacation
and agricultural areas that have a seasonal pattern. Extended credit, given to banks that have
experienced severe liquidity problems because of deposit outflows, is not expected to be repaid
quickly.
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In addition to its use as a tool to influence reserves, the monetary base, and the money
supply, discounting is important in preventing financial panics. When the Federal Reserves
System was created, its most important role was intended to be as the lenders of last resort; to
prevent bank failures from spinning out of control, it was to provide reserves to banks when no
one else would, thereby preventing bank and financial panics.
Case Reading: Discounting to Trouble Banks
In May 1974, the public learned that Franklin national Bank, the twentieth-largest bank in the
United States, with a deposit close to 3 million, had suffered large losses in foreign exchange
trading and had made many bad loans. Large depositors, whose accounts exceeded $100,000,
began to with draw their deposits, and the failure of the bank was imminent. Because the
immediate failure of Franklin national would have had repercussions on other vulnerable banks,
possibly leading to more bank failures, the Fed announced that discount loans would be made
available to Franklin national so that depositors, including the largest, would not suffer any
losses.
By the time Franklin National was emerged into the European-American Bank in October
1974, the Fed had lent Franklin National the sum of $1.74 billion, nearly 5% of the total amount
of reserves in the banking system. The quick Fed action was completely successful in
preventing any other bank failures, and a possible bank panic was avoided.
A 1984 episode involved Continental Illinois National Bank and the Fed in a similar action.
Continental Illinois had made many bad loans, rumor of financial trouble in early May 1984
cause large depositors to withdraw over $10 billion of deposit from the bank. The FDIC
arranged a rescue effort in July 1984 that culminated in a $4.5 billion commitment of funds to
save the bank; still, the Fed had to lend Continental Illinois over $5 billion—making its $1.75
billion loans to Franklin National look like small potatoes! The Fed’s action prevented further
bank failure, and again a potential bank panic was averted.
Case Reading: Discounting to Prevent a Financial Panic
October 19,1987, dubbed “Black Monday”, was recorded in the history as the largest one-day
decline in stock prices to date (the Down Jones Industrial Average declined by more than 500
points). The next day, Tuesday, the financial market almost stopped functioning. Felix Rohatyn,
one of the most prominent men on Wall Street, stated flatly: “Tuesday was the most dangerous
we had in 50 years.” Much of the credit for the prevention of a market meltdown after Black
Monday must be given to the Federal Reserve System and the Chairman of the Board of
Governors, Alan Greenspan.
The stress of keeping market functioning during the sharp decline in stock prices on
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Monday, October 19, means that many brokerage houses and specialists were severely in need
of additional funds to finance their activities. However, understandably enough, New York
banks, as well as foreign and regional U.S. banks, growing very nervous about the financial
health of securities firms, began to cut back credit to the securities industry at the very time
when it was most needed. Panic was in the air. One chairman of a large specialist firm
commented that on Monday, “from 2 P.M. on, there was total despair. The entire investment
community fled from the market. We were felt alone on the field.” It was time for the Fed, like
the cavalry, to come to the rescue.
Upon learning of the plight of the securities industry, Alan Greenspan, the president of the
Federal Reserve Bank of New York and the Fed official most closely in touch with Wall Street,
became fearful of a spreading collapse of securities firms. To prevent this from occurring,
Greenspan announced before the market opened on Tuesday, October 20, the Federal Reserve
System’s “readiness to serve as a source of liquidity to support the economic and financial
system.” In addition to this extraordinary announcement, the Fed made it clear that it would
provide discount loans to any bank that would make loans to the securities industry. As one
New York banker said, the Fed’s message was, “we’re here. Whatever you need, we’ll give
you.”
The outcome of the Fed’s timely action was that a financial panic was averted. The market
rally rescued that day, with the Down Jones Industrial Average climbing over 100 points.
Evaluating Proposed Reforms of Discount Policy
Should discounting be abolished? Milton Friedman and other economists have proposed that
the Fed should terminate its discount facilities in order to establish better monetary control.
Friedman contended that the presence of FDIC eliminates the possibility of bank panics;
therefore, the use of discounting is no longer as necessary. Abolishing discounting would
eliminate fluctuations in the monetary base duo to change in the volume of discount loans and
so reduce unintended fluctuations in the monetary supply.
Critics of Friedman’s proposal emphasize that the FDIC is effective at preventing panics
because the Fed stands behind it and play the role of lender of last resort. Secondly, as we have
seen in the case of the Black Monday crash, and this kinds of cases happened once a few years
at present, the existence of the Federal Reserve’s discount facilities can help avert a financial
panic unrelated to bank failures.
Should the discount rate be tied to a market rate of interest? An alternative proposal, much
less radical than abolishing discounting, is that the discount rate be tied to a market rate of
interest, such as the three-month U.S. Treasury bill or the federal funds rate.
The advantages of trying the discount rate to a market rate of interest are many. First, the
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Fed could continue to use discounting to perform its last role of lender of last resort. Second,
most fluctuations between market interest rates and the discount rate would be eliminated. Third,
if the penalty discount rate concept (setting the discount rates much higher than market interest
rates) were used, the administration of the discount window would be greatly simplified. Fourth,
because discount rate changes would be automatic, there would be no false signals about the
federal Reserve’s intentions, and the announcement effect would be disappear. Even though the
Federal Reserve does not formally tie the discount rte to a market rate interest, the Fed already
pursues a discount policy that is not too far away from market rates on interest.
Evaluating Proposed Reforms of Reserve Requirements
Should reserves requirements be abolished? If you study only the simple multiplier, you might
think that eliminating reserve requirements would result in an infinite money supply. However,
as our more sophisticated money supply model indicates, this reasoning would be incorrect.
Banks would still want to hold reserves to protect themselves against deposit outflows, and
there would still be a demand for currency. Both these factors would limit the size of the money
supply. The case for keeping reserve requirements must rest on the proposition that having
reserve requirements results in a more stable money multiplier and hence a more controllable
money supply.
Should reserve requirements be raised to 100%? At the same time that Milton Friedman
suggested abolishing discounting, he also suggested that required reserves be set equal to 100%
of deposits. With a 100% reserve requirement, the money supply could be strictly controlled by
the Fed because it would be equal to the monetary base. The outcome might be that the Fed
would enjoy complete control of the official money supply, but the economically relevant
money supply might be even less under the Fed’s control because it would be affected by the
nonblank financial intermediaries.
Key Terms
Defensive open market operation
Lender of last resort
Discount window
Match sale-purchase transaction
Primary dealer
Primary dealer
Repurchase agreement
Reference Book
Frederic S Mishkin: The Economics of money, Banking and Financial Markets, 北京大学出版
社& Person Education, 2002.
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Chapter 2 Conduct of Monetary Policy: Goals and Targets
Goals of Monetary Policy
Six basic goals are continually mentioned by the personnel at the Federal Reserve and other
central banks when they discuss the objectives of monetary policy: high employment; economic
growth; price stability; interest rate stability; stability of financial markets; and stability of
foreign exchange markets.
Case Reading: The Growing European Commitment to Price Stability
Not surprisingly, given Germany’s experience with hyperinflation in the 1920s, Germans have
had the strongest commitment to price stability as the primary goal for monetary policy. Other
Europeans have been coming around to the view that the primary goal for a central bank should
be price stability. The increased importance of this goal was reflected in the December 1991
Treaty of European Union, known as the Maastricht Treaty. This treaty created the European
System of Central Banks, which functions very much like the Federal Reserve System. The
statute of the European System of central Banks sets price stability as the primary objective of
this system and indicates that the general economic policies of the European Union are to be
supported only if they are not in conflict with price stability.
General Bank Strategy
Tools
of
Central Operating Targets
Intermediate Target
Goals
Banks
Open
market Reserve
aggregates Monetary
aggregates High employment
operation
(reserves,
nonborrowed (M1, M2, M3)
Discount policy
reserves, monetary base, Interest rates (short- Financial
Reserve
nonborrowed base)
requirements
Interest rates (short term
and long-term)
Price stability
market
stability
such as federal funds
rate)
On the table above, the categories in the brackets are called operating target, or alternatively the
instruments, because they are more responsive to their policy tools.
Result of Targeting on the Money Supply
Why a monetary aggregate target involves losing control of the interest rate? The reasoning is
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simple. The central bank expects the demand curve for money to be at Md*, it fluctuates
between Md1 and Md2 because of unexpected increases or decreases in output or changes in the
price level. And the corresponding interest rates are i1 and i2.
Again, if the central bank set interest rate at i*, the expected money demand curve to be at
Md*, but it changes between Md1 and Md2 because of unexpected changes in output, the price
level, or the public’s preferences toward holding money.
The conclusion from the supply and demand analysis is that interest rate and monetary
Interest Rate, i
Ms
Interest Rate, i
i2
i2
i*
i*
Ms1
Ms*
Ms2
Target i*
Md2
i1
Md2
Md*
i1
Md*
Md1
Md1
M*
M1
Result of Targeting on the Money Supply
M*
M2
Result of Targeting on the Interest Rate
aggregate targets are incompatible: a central bank can hit one or the other but not both.
Criteria for Choosing Intermediate Targets
1. Measurability. Quick and accurate measurement of an intermediate variable is necessary
because the intermediate target will be useful only if it signals rapidly when policy is off
track. According to this criterion, interest rate in one of the choices.
2. Controllability. A central bank must be able to exercise effective control over a variable if it
is to function as a useful target. For this reason, the money supply is a good category. A
central bank does have the ability to exercise a powerful effect on the money supply,
although its control is not perfect.
3. Predictable effect on goals. The most important characteristic a variable must have to be
useful as an intermediate target is that it must have a predictable impact on a goal. However,
the linkage of the money supply and interest rates with the goals—output, employment, and
the price level –is a matter of much debate.
Free Reserves
Some variables were supposed to describe supply and demand conditions in the money market.
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Included among these variables was free reserves FR, equal to excess reserves in the banking
system ER minus the volume of discount loans DL
FR = ER –DL
The Fed interpreted in increase in free reserves as an easing of money market conditions and
use open market sales to withdraw reserves from the banking system.
Case Reading: Bank Panics of 1930—1933: Why Did the Fed Lets them Happen?
The Federal Reserve System was totally passive during the bank panics of the Great depression
period and did not perform its intended role of lender of last resort to prevent them. In
retrospect, the Fed’s behavior seems quite extraordinary, but hindsight is always clearer than
foresight.
The primary reason for the Fed’s inaction was that Federal Reserve officials did not
understand the negative impact that bank failure could have on the money supply and economic
activities. Friedman and Schwartz report that the Federal Reserve officials “tended to regard
bank failures as regrettable consequences of bank management or bad banking practices, or as
inevitable reactions to prior speculative excesses, or as a consequences but hardly a cause of the
financial and economic collapse in process.” In addition, bank failures in the early stages of the
bank panics “were concentrated among smaller banks and, since the most influential figures
were big-city bankers who deplored the existence of smaller banks, their disappearance may
have been viewed with complacency.”
Friedman and Schwartz also pointed out that political infighting might have played an
important role in the passivity of the Fed during this period. The Federal Reserve Bank of New
York, which until 1928 was the dominant force in the Federal Reserve System, strongly
advocated an active program of open market purchases to provide reserves to the banking
system during the bank panics. However, other powerful figures in the Federal Reserve System
opposed the New York bank’s position, and the bank was outvoted.
The Taylor Rule
The Federal Reserve currently conducts monetary policy by setting a target for the federal funds
rate. But how should this target be chosen? John Taylor of Stanford University has come up
with an answer, which he called Taylor rule, expressed in the following form:
Federal funds rate = inflation + equilibrium real fed funds rate + 1/2 (inflation gap) + 1/2 (output gap)
Where the inflation gap is defined as current inflation minus a target rate; and output gap is
defined as the percentage deviation of real GDP from an estimated of its potential full
employment level.
Caring about both inflation and output fluctuations is consistent with many statements by
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Federal Reserve officials that controlling inflation and stabilizing real output are important
concern of the Fed.
Case Reading: International Policy Coordination
By 1985, the decrease in competitiveness of American corporations as a result of the strong
dollar was raising strong sentiment in Congress for restricting imports. This protectionist threat
to the international trading system stimulated finance ministers and the heads of central banks
from the Group of Five industrial countries—the United States, the United Kingdom, France,
Western Germany, and Japan—to reach an agreement at New York’s Plaza hotel in September
1985 to bring down the value of the dollar. From September 1985 until the beginning of 1987,
the value of the dollar did undergo a substantial decline, falling by 35% on average relative to
foreign currencies. At this point, there was growing controversy over the decline in the dollar,
and another meeting of policy makers from the G-5 countries plus Canada took place in
February 1987 at the Louvre Museum in Paris. There the policy makers agreed that exchange
rates should be stabilized around the levels currently prevailing. Although the value of the dollar
did continue to fluctuate relative to foreign currencies after the Louvre Accord, its downward
rend had been checked as intended.
Because the subsequent exchange rate movements were pretty much in line with the Plaza
Agreement and the Louvre Accord, these attempt in international policy coordination have been
considered successful. However, other aspects of the agreement were not adhered to by all
signatories. For example, West German and Japanese policy makers agreed that their countries
should pursue more expansionary policies by increasing government spending and cutting taxes,
and United States agreed to try to bring down its budget deficit. At that time, the United States
was not particularly successful in lowering its deficit, and Germans were reluctant to pursue
expansionary policies because of their concern about inflation.
Key Terms
Free reserves
Intermediate targets
Taylor rule
Operating target
International policy coordination
Reference Book
Frederic S Mishkin: The Economics of money, Banking and Financial Markets, 北京大学出版
社& Person Education, 2002.
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Chapter 3
The International Financial System
Foreign Exchange Intervention and Money Supply
Central banks regularly engage in international financial transactions called foreign exchange
interventions in order to influence exchange rates. In our international financial arrangement,
called managed float regime, or dirty float, exchange rates fluctuate from day to day, but the
central banks attempt to influence their countries’ exchange rates by buying and selling
currencies. The holdings of assets denominated in a foreign currency, called international
reserves, involves in the money supply in certain manners.
Suppose that the Fed decides to sell $1 billion of its foreign assets in exchange for $1
billion of U.S. currency. The Fed’s purchase has two effects. First, it reduces the Fed’s holding
of international reserves by $1 billion. Second, because its purchase removes it from the hands
of the public, currency in circulation falls by $1 billion. We can see this in the following
T-account for the Fed.
Federal Reserve System
Assets
Foreign
Liabilities
assets —$1billion
Currency in circulation
—$1billion
(international reserve)
If instead of paying for foreign assets sold by the Fed with currency, the persons buying the
foreign assets pay for them by checks written on accounts at domestic banks, then the Fed
deducts the $1 billion from the deposit accounts these banks have with the Fed. The result is
that deposits with the Fed (reserves) decline by $1billion.
Federal Reserve System
Assets
Foreign assets
Liabilities
—$1billion
Deposit with the Fed
—$1billion
(reserves)
(international reserve)
From the above analysis, we have reached an important correspondent conclusion: a central
bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign
exchange market leads to an equal decline in its international reserves and the monetary base.
The opposite holds: a central bank’s purchase of foreign assets in the foreign exchange market
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results in an equal rise in its international reserves and the monetary base.
The intervention we have just described, in which a central bank allows the purchase or
sale of domestic currency to have an effect on the monetary base without offset action, is called
an unsterilized foreign exchange intervention. A foreign exchange intervention with an
offsetting open market operation that leaves the monetary base unchanged is called a sterilized
exchange intervention.
Unsterilized Intervention
If the Federal Reserve decides to sell dollars in order to buy foreign assets in the foreign
exchange market, this works just like an open market purchase of bonds to increase the
monetary base.
A sale of dollars and the consequence open market purchase of foreign assets increase the
monetary base. The resulting rise in the monetary supply leads to a higher price level in the long
run, which leads to a lower expected future exchange rate. The resulting decline in the expected
appreciation of the dollar raise the expected return on foreign deposits, shifting the RETF
schedule rightward from RETF1 to REFF2. In the short run, the domestic interest rate iD falls,
shifting RETD fromRETD1 to RETD2. The short run outcome is that the exchange rate falls from
E1 to E2. In the long run, however, the interest rate returns to iD1, and RETD returns to RETD1.
The exchange rate therefore rises from E2 to E3 in the long run.
Exchange Rate, Et
RETD2 RETD1
RETF1 RETF2
E1
1
E3
3
E2
2
iD2 iD1 Expected Return (in $ terms)
Our analysis leads us to the following conclusion about unsterilized interventions in the
foreign exchange market: an unsterilized intervention in which domestic currency is sold to
purchase foreign assets leads to a gain in international reserves, an increase in the money supply,
and a depreciation of the domestic currency. And it is true for the opposite statement: an
unsterilized intervention in which domestic currency is purchased by selling foreign assets leads
to a drop in international reserves, a decrease in the money supply, and an appreciation of the
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domestic currency.
Balance of Payments
The balance of payments is a bookkeeping system for recording all payments that have a direct
bearing on the movement of funds between a nation and foreign countries. It has four
components: current account; capital account; method of financing; balance of payment.
The current account shows international transaction that involves currently produced goods
and services. The difference between merchandise exports is called the trade balance. When
merchandise imports are greater than exports, we have a trade deficit; if exports are greater than
imports, we have a trade surplus.
The capital account describes the flow of capital between the United States and other
countries. Capital outflows are American purchase of foreign assets, and capital inflows are
foreign purchase of American assets.
Official reserve transaction balance equals the current account balance plus the items in the
capital account. When we refer to a surplus or a deficit in the balance of payments, we actually
means a surplus or deficit n the official reserve transaction balance.
Evolution of The International Financial System
Before World War I, the world economy operated under the gold standard, meaning that the
currencies of most countries were convertible directly into gold.
As long as countries abided by the rules under the gold standard and kept their currencies
backed by and convertible into gold, exchange rates remained fixed. However, adherence to the
gold standard meant that a country had no control over its monetary policy because its money
supply was determined by gold flows between countries. Further more, monetary policy
throughout the world was greatly influenced by the production of gold and gold discoveries,
while the gold production did not match the economic growth.
As the allied victory in World War II was becoming certain in 1944, the Allies met in
Bretton Woods, New Hampshire, to develop a new international monetary system to promote
world trade and prosperity after the war. In the agreement worked out among allies, central
banks bought and sold their own currencies to keep their exchange rates fixed at a certain level,
called a fixed exchange rate regime. The agreement lasted from 1945 to 1971 and was known as
the Bretton Woods System.
The Bretton Woods agreement created the International Monetary Funds, headquartered in
Washington, D.C., which had 30 original member countries in 1945 and currently has over 180.
the IMF was given the task of promoting the growth of world trade by setting rules for the
maintenance of fixed exchange rates and by loans to countries that were experiencing
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balance-of-payments difficulties. As part of its role of monitoring the compliance of member
countries with its rules, the IMF also took on the job of collecting and standardizing
international economic data.
The Bretton Woods agreement also set up the international Bank for Reconstruction and
Development, commonly referred to as the World Bank, also headquartered in Washington D.C.
The funds for loans are obtained primarily by issuing World Bank Bonds, which are sold in the
capital markets of the developed countries.
Because the United States emerged from World War II as the world’s largest economic
power, with over half of the world’s manufacturing capacity and the greater part of the world’s
gold, the Bretton Woods system of fixed rates was based on the convertibility of U.S. dollar into
gold at $35 per ounce. The U.S. dollar, which was used by other countries to dominate the
assets that they held as international reserves, was called the reserve currency. However, with
the creation of the euro in 1999, the supremacy of the U.S. dollar may be subject to a serious
challenge.
Since 1970, the IMF has been issuing a paper substitute for gold, called special drawing
rights (SDRs). Like gold in the Bretton Woods system, SDRs function as international reserves.
Unlike gold, whose quantity is determined by gold discoveries and the rate of production, SDRs
can be created by the IMF whenever it decides that there is a need for additional international
reserves to promote world trade and economic growth.
How A fixed Exchange Rate Regime Works
There are two situations, one is the domestic currency is initially overvalued, the other is the
domestic currency is initially undervaluated.
When the exchange rate Epar is overvalued, the central bank must purchase domestic
currency and sell foreign assets to keep the exchange rte at Epar. However, the purchase of
domestic currency leads to a fall in the money supply and causes the interest rate on the
domestic deposit iD to rise. And another result is that it loses international reserves. If the
country’s central bank eventually runs out of international reserves, it cannot keep its currency
from depreciation, and then a devaluation must occur, meaning that the par exchange rate is
reset at a lower level.
However, when the exchange rate E is undervalued, the central bank must shift RET to
keep the exchange rate at Epar. As a result, it gains international reserves. In this case, the central
bank might not want to acquire these international reserves, it might want a revaluation—to
reset the par value of its exchange rate at a higher level.
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Key Terms
balance of payment
foreign exchange intervention
reserve currency
balance-of-payment crisis
gold standard
revaluation
Bretton Wood system
International Monetary Fund
special drawing rights
capital account
international reserves
official reserve transactions
devaluation
managed float regime
trade balance
sterilized foreign exchange intervention
fixed exchange regime
unsterilized foreign exchange intervention
RETD2
Exchange rate, Et
Exchange rate, Et
RETD1
(F/D)
RETD2
RETD1 RETF1
(F/D)
E1
Epar
E1
2
Epar
1
2
1
iD1
iD2
iD2
Expected Return
iD1
Expected Return
The case of overvalue exchange rate
The case of overvalue exchange rate
Reference Book
Frederic S Mishkin: The Economics of money, Banking and Financial Markets, 北京大学出版
社& Person Education, 2002.
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