KC3002 International Finance

/International Macroeconomics

Hideyuki IWAMURA

Spring 2016

Faculty of International Studies

Lecture 7 Fixed Exchange Rates

1

Exchange rate regimes

2

What are the costs and benefits of fixed rates?

Yen return on dollar assets

under a fixed rateUnder fixed rates, the expected rate of yen return on

dollar assets is equal to the dollar interest rate.

∗

ie

R∗

0

01

E

EEe

−

=

+

This is because under fixed rates, people never expect

the dollar to depreciate or appreciate, that is, the

expected rate of dollar’s appreciation is zero.

∗

ie

R∗ =

∗

i=

A fixed rate implies expected

appreciation is zero. 3

Fixing the exchange rate : case 1Suppose the yen is fixed to the dollar, at ¥100/$,

the yen interest rate is equal to the dollar interest rate, 0.02,

and the FX market is in equilibrium.

The Bank of Japan(BOJ) raises the interest rate by 0.01.

Yen assets become more profitable and people try to sell

dollar assets and buy yen assets.

Supply of the dollar pressures the exchange rate to fall.

The BOJ can buy as many dollars as they want to sell at

the official price and keep the exchange rate from falling.

4

Fixing the exchange rate : case 1Any purchase of dollars by BOJ automatically results

in an increase in Japan’s money supply.

If BOJ buys dollars, it must pay for the dollars with new

printed yens. Therefore, Japan’s money supply increases.

The increase in money supply lowers the yen interest rate.

When the yen interest rate is finally pulled back down to

the dollar interest rate, people are indifferent between

yen and dollar assets.

No pressure on the exchange rate to change,

and the fixed rate is successfully maintained.

5

Fixing the exchange rate : case 2

Suppose the yen is fixed to the dollar, 100 yens per dollar,

and the yen interest rate is equal to the dollar interest rate.

Dollar assets become more profitable and people try to

sell yen assets and buy dollar assets.

Demand for the dollar pressures the exchange rate to rise.

The BOJ can sell as many dollars as they want to buy at

the official price, and keep the exchange rate from rising.

The Fed raises the interest rate.

6

Fixing the exchange rate : case 2

If BOJ sells dollars, the yens paid by the buyers will no longer

be in circulation. Therefore, Japan’s money supply decreases.

Any sale of dollars by BOJ automatically results in a

decrease in Japan’s money supply.

The decrease in money supply raises the yen interest rate.

When the yen interest rate is finally pushed up to the

dollar interest rate, people are indifferent between yen

and dollar assets.

No pressure on the exchange rate to change,

and the fixed rate is successfully maintained.

7

Monetary policy autonomyUnder fixed rates, the BOJ has to adjust its money supply

in order to keep the yen interest rate equal to the dollar

interest rate.

Under fixed rates, the BOJ cannot affect its money supply

in its own will, independently of the US interest rate.

Fixed rates imply the country’s loss of autonomy in monetary

policy.

� Case 1 : When reducing the money supply and raising

the interest rate above the dollar interest rate, it must

finally withdraw the money and pull the interest rate

back to the US level.

� Case 2 : When the dollar interest rises above the yen

interest rate, the BOJ must decrease the money supply

and push the yen interest rate up to the US level.

8

Expansionary monetary policy

under a fixed rate

9

Y

i

0.02

500

0LM

0IS

0E

100

i

1LM

An increase in the money

supply shifts LM right.

This lowers the interest rate

and threatens the exchange

rate to rise.

The BOJ must hastily reverse

itself and decrease the money

supply in order to raise the

interest rate and keep the

exchange rate fixed.

1. 2.

1

2

Expansionary monetary policy

under a fixed rateAn increase in the money supply lowers the interest rate

and raises the output.

A fall in the interest rate makes dollar assets more

attractive, forcing the yen to depreciate.

To keep the yen from depreciating, the BOJ sells dollars

and decreases the money supply so that the interest rate

continues to be equal to the dollar interest rate, 0.02.

After all, the interest rate and exchange rate stay

unchanged, and thus output stays constant.

Under a fixed rate, monetary policy is impossible to

undertake.10

Policy trilemma

A country cannot simultaneously

1. allow capital mobility

2. maintain fixed exchange rates

3. pursue an autonomous monetary policy

A country can pursue an autonomous monetary policy

under fixed rates, if it restricts cross-border lending and

borrowing. 【2 & 3】 → Capital control

A country can pursue an autonomous monetary policy

under free capital mobility, if it allows the exchange rate

to move freely. 【1 & 3】 → Floating exchange rates

11

Expansionary fiscal policy

under a fixed rate

12

Y

i

0.02

500 600

0LM

0IS

0E

100

i

1IS

1LM

Expansionary fiscal policy

shifts IS right.

This raises the interest rate

and threatens the exchange

rate to fall.

1. The BOJ must purchase dollars,

increase the money supply,

shift LM right in order to lower

the interest rate and keep the

exchange rate fixed.

2.

1 2

Expansionary fiscal policy

under a fixed rate

An increase in government purchases increases output,

which in turn raises the interest rate and appreciates the yen.

To keep the yen from appreciating, the BOJ purchases dollars

and increases the money supply.

The expansion in the money supply also raises output.

Under a fixed rate, an increase in the money supply has a

larger impact on output than it does under a floating rate.

13

Expansionary fiscal policy

under a fixed rate

14

Government purchases ↑

Goods market

Rise in aggregate demand

→ GDP ↑

Money market

Rise in money demand

→ Interest rate ↑

FX market

Rise in return on yen assets

→ Exchange rate ↓

Goods market

Fall in aggregate demand

→ GDP ↓

Under a floating rate, the first

increase in GDP is partly offset

by a subsequent rise in the

interest rate and yen’s

appreciation.

Under a fixed rate, the BOJ

increases the money supply

and keeps the interest rate and

the exchange rate constant.

Thus the first increase in GDP is

never offset.

Devaluation（切り下げ）

Devaluation occurs when the central bank raises the

domestic currency price of the foreign currency.

Devaluation makes the domestic goods relatively cheaper

and raises aggregate demand, thus increasing output.

When people expect a devaluation in the near future, it can

sometimes spark a sharp fall in official foreign reserves –

balance of payments crisis.

15

Costs of fixing : Trilemma

16

Shambaugh(2004) compared co-movements between the

interest rates for all pairs of countries under three alternative

regimes (a), (b), and (c).

(a) Open and Pegged: Open capital markets with fixed

exchange rates. Changes in the country’s interest rate

must be equal to changes in the interest rate of the base

country to which it is pegging.

(b) Open and Not Pegged: Open capital markets with

floating exchange rates.

(c) Closed: Closed capital markets.

Shambaugh(2004), “The Effect of Fixed Exchange Rates on Monetary

Policy,” Quarterly Journal of Economics, 119(1).

Costs of fixing : Trilemma

17Feenstra & Taylor(2014), p.728.

Costs of fixing : Output volatility

18

An increase in the base country interest rate should cause

output to fall in a country which pegs its exchange rate to the

base country, because the pegging country has to tighten its

monetary policy and raise its interest rate to match the base

interest rate.

Di Giovanni and Shambaugh(2008) examined how the GDP

growth in pegging country is related with one percent

increase in base country interest rates.

Di Giovanni and Shambaugh(2008), “The Impact of Foreign Interest Rates

on the Economy: The Role of the Exchange Rate Regime,” Journal of

International Economics, 74(2).

Costs of fixing : Output volatility

19Feenstra & Taylor(2014), p.730.

Benefits of fixing

20

Shambaugh and Klein(2006) compared bilateral trade

volumes for all pairs under (a), (b), and (c) with the

benchmark level of trade under a floating regime.

(a) The two countries are using a common currency.

(b) The two countries are linked by a direct exchange rate

peg. (A’s currency is pegged to B’s.)

(c) The two countries are linked by an indirect exchange rate

peg. (A’s currency and B’s currency are pegged to C’s.)

(d) The two countries are not linked by any type of peg.

Klein and Shambaugh(2006), “Fixed Exchange Rates and Trade,” Journal

of International Economics, 70(2).

Benefits of fixing

21

Feenstra & Taylor(2014), p.726.

Final Exam

� The final exam will be held 13:35 to 14:55 on July 22.

You can withdraw anytime provided that you’re sure you

finished the exam.

� The exam covers all the materials, though National

Income Accounting, Open-economy IS-LM Model, and

Fixed Exchange Rates are mainly focused on.

� This is a closed book exam.

� You are allowed to use a simple calculator.

� 10 multiple-choice questions, 2 computational questions,

and 2 essay/graphing questions.

� The model answers will be posted on my website.

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