Monetary Policy and the Choice of an Exchange Rate Regime ÉCOLE DES HAUTES ÉTUDES COMMERCIALES MBA PROGRAM NOVEMBER 2001

Monetary Policy and the Choice Monetary Policy and the Choice of an Exchange Rate Regimeof an Exchange Rate Regime

ÉCOLE DES HAUTES ÉTUDES COMMERCIALES

MBA PROGRAM

NOVEMBER 2001

The monetary transmission mechanism The monetary transmission mechanism • By the monetary transmission mechanism we mean the

process by which a change in the instrument of monetary policy (usually the discount rate) changes the level of an intermediate target (usually aggregate demand) so as to reach the final target (usually the rate of inflation).

• In a closed economy, a stylized representation of the monetary transmission mechanism could be the following:

i SB and Credit AD (given AS) – The central bank changes its discount rate and this affects the

economy’s level of short-run interest rates ( i = r at the initial level of the inflation rate), the change in credit conditions affects the rate at which changed settlement balances and credit expand ( SB and Credit) , aggregate demand responds ( AD) and this ultimately influences the inflation rate ( ).

The monetary transmission mechanism The monetary transmission mechanism

• In the open economy, things do not stop there:

• Caeteris paribus, a change in the level of domestic interest rates changes the interest rate differential between the country and the rest of the world (i -i*)

• If capital inflows respond to (i -i*), this affects the overall balance of payments and, depending on the exchange rate regime, this will have additional effects.

• In order to understand why, we have to go back to the balance of payments and discuss the capital and financial account

The balance of payments and the capital The balance of payments and the capital and financial accountand financial account

• When we first introduced the balance of payments, we made the distinction between current account transactions (transactions with the non-residents which generate income and expenditure) and capital and financial account transactions (transactions with the non-residents implying a sale or a purchase of real or financial assets).

• When we sell assets to non-residents, we obtain financial resources that can be used to finance our expenditures.– We receive financing from the non-residents: capital inflows (CI)

• When we buy assets from the non-residents, we provide them with financial resources that they can use to finance their expenditures. – We finance the non-residents: capital outflows (CO)

• The capital and financial account (CFA) is equal to the difference between capital inflows and outflows:– CFA = CI - CO


• Now, suppose we measure both the current account (CA) and the capital and financial account (CFA) in foreign currency.

• Let us interpret the sum of the current account and capital account (CA + CFA):– What does it mean to have CA + CFA = 0 ?– What does it mean to have CA + CFA > 0 ?– What does it mean to have CA + CFA < 0 ?

• If we omit the “errors and omissions” term of the balance of payments, this sum tells us by how much our current inflows of foreign currency (supply) exceed our needs (demand). When foreign currency is in excess supply, its price tends to go down unless the central bank decides to buy up the excess supply. When foreign currency is in excess demand, its price tends to go up unless the central bank decides to supply the market with its own reserves of foreign currency.


• Note that this means:

– CA + CFA = R

– Or stated differently: CA + CFA - R = 0

• Note that by definition CA + CFA - R is the balance of payments.

• In conclusion, balance of payments equilibrium implies:

R = 0 when CA + CFA = 0

R > 0 when CA + CFA > 0

R < 0 when CA + CFA < 0

• We now build on this to explain how the exchange rate is

determined.

The foreign exchange marketThe foreign exchange market

Quantity of foreign currency (ex. $US)

E

S0

E0

D0

• The supply of foreign currency is a function of the value of exports and other sources of foreign income. It is also a function of the value of capital inflows.•The demand for foreign currency is a function of the value of imports and other sources of external spending. It is also a function of capital outflows.

•S = D means CA + CFA and R = 0.

•There is no pressure on the exchange rate and E remains at E0

Price of foreign currency (ex. $US)

The foreign exchange marketThe foreign exchange market

Quantity of foreign currency (ex.$US)

ES = f (X$+…, NCI)

E0

• To simplify the diagrammatic representation of the foreign exchange market, we will lump capital inflows and outflows into the supply curve•Net supply S now depends upon net capital inflows (NCI).•S = f (value of X plus other income, NCI)•D = f(value of M plus other external spending)

D = f (M$+…)

The impact of a decrease in net capital inflowsThe impact of a decrease in net capital inflows

Quantity of foreign currency (ex.: $US)

E

S0

D0

• A decrease in net capital inflows contracts the net supply of foreign currency in the domestic economy.•At the initial level of the exchange rate, there is an excess demand for foreign currency.•In order to keep the exchange rate constant, the central bank would have to supply the market with its own reserves (R < 0)•If the central bank does not supply the market with its reserves, the market clearing exchange rate will move up to E1.

S1

E0

R 0

E1

The monetary transmission mechanism The monetary transmission mechanism under fixed and flexible exchange rates under fixed and flexible exchange rates

• Let’s go back to the first step of our stylized monetary transmission mechanism: i

• We must now add:– i (i -i*) either R (fixed exchange rate) or E (freely

floating exchange rate)

• It turns out that the final impact on aggregate demand and on the rate of inflation will be quite different depending on the exchange rate regime.

• Suppose the central bank wants to slow down aggregate demand in order to keep inflation in check.


• Normally, this would lead to: i

• and– ( i - i* )

• This should be expected to increase short-run capital inflows

• The important conclusion we then reach is:– In a fixed exchange rate regime, the central bank will be induced

to act in a way that will restore the previous interest rate i. Its restrictive monetary policy will be undone.

– In a floating rate regime, the exchange rate will go down. This will provide a second channel through which a restrictive monetary policy contracts aggregate demand.

An independent monetary tightening: fixed versus An independent monetary tightening: fixed versus

floating exchange ratesfloating exchange rates

Quantity of foreign currency (ex.: $US)

E

S1

D0

• As i-i* goes up, net short-run capital inflows are stimulated.

•The net supply of foreign currency goes up and there is an initial excess supply of foreign currency.

•If the central bank wants to keep the exchange rate constant at E0, it must purchase the excess supply (R > 0)

•If the central bank does not buy the excess supply the exchange rate drops to E1

S0

R > 0

E0

E1

Fixed exchange rate: The central bank buys the excess supply of foreign

currencyASSETS

• Domestic money market instruments

• Domestic bonds

• Net advances to the government

• Net advances to the domestic

financial institutions

• Foreign exchange reserves

LIABILITIES + CAPITAL

• Government deposits

• Deposits of the domestic financial institutions

• Domestic notes and coins

• Capital

The central bank first increased its discount rate in order to slow the expansion of settlement balances and credit in the financial system. In a fixed exchange rate regime, domestic financial institutions can avoid paying the higher bank rate by selling the excess supply of foreign exchange to the central bank. The restrictive monetary policy does not work.

In a fixed exchange rate regime, restrictive In a fixed exchange rate regime, restrictive monetary policy does not work...monetary policy does not work...

SB’

D’

Inter-bank overnight rate

Settlement balances

D

SB

Initial discount rate

New discount rate

The Central bank raises its discount rate which raises the target rate of the operating band by exactly the same amount...

SB’

Normally, the banks would have to pay more for their settlement balances...

But in a fixed exchange rate regime, capital inflows would lead to an excess supply of foreign currency and the banks would obtain settlement balances by selling the excess supply to the central bank

What about an expansionary monetary policy ? Try it under

both a flexible and a fixed exchange rate regime.


• Let’s summarize:• Fixed exchange rate

– When the national central bank acts alone in increasing its key interest rate, this stimulates net capital inflows. These capital inflows must be purchased by the central bank in order to keep the exchange rate constant. The central bank cannot slow the expansion of settlement balances. In the end neither i nor E change. The central bank cannot conduct a nationally independent monetary policy.

• Flexible exchange rate– The central bank does not buy the excess supply of foreign

currency and the exchange rate falls. In addition to the rise in i, this is a second reason why aggregate demand is affected downward. The central bank can conduct a nationally independent monetary policy.

– The monetary transmission mechanism is then: i E and SB and Credit AD

http://www.bank-banque-canada.ca/english/monetary/

Fixed and flexible exchange rates: some Fixed and flexible exchange rates: some additional issuesadditional issues

• Of course, in a floating regime, the exchange rate may respond to a variety of shocks which have nothing to do with monetary policy.

• A good example of this would be a terms of trade shock.• Let’s suppose that an economy experiences a deterioration

in its terms of trade.• We already saw that this should affect negatively

aggregate demand.• We will now see that it also affects the foreign exchange

market.• To make the example particularly relevant, let’s suppose

that the deterioration in the terms of trade occurs at a time when the inflation rate is below the target level.

The impact of a deterioration in the terms of trade (ex.: PThe impact of a deterioration in the terms of trade (ex.: PXX

falls while Pfalls while PM M remains constant) remains constant)

Quantity of $US

E

S0

D0

E1

•A fall in PX reduces the value of the country’s exports.•The net supply of foreign exchange contracts.

•If the exchange rate was flexible, E would rise. This would provide a cushion to absorb the negative impact of the terms of trade shock.

•If the exchange rate was fixed, the central bank would have to sell its reserves and as we saw, this implies a restrictive monetary policy

S1

E0

R < 0


• When the terms of trade deteriorate, the central bank is forced to respond with a restrictive monetary policy under a fixed exchange rate regime.

• If inflation was already below target, this restrictive monetary policy is totally untimely.

• In fact, an expansionary monetary policy would be welcome.

• In a floating regime, the rising exchange rate does just that because it stimulates in itself aggregate demand and partly compensate for falling absorption.

• A country may prefer to have some exchange rate flexibility when its terms of trade are subject to frequent and important shocks. This is the Bank of Canada’s main argument in favor of a flexible exchange rate.


• Another important class of shocks to consider in a shock to capital inflows, that is the amount of capital inflows could change for exogenous reasons from the point of view of the domestic economy.

• Emerging markets are particularly affected by this type of shocks since world capital markets often tend to look upon these markets as if they were all alike.

• A financial crisis in one particular emerging market may lead to a drastic fall in capital inflows to all emerging markets.

• An example: the financial crisis in Brazil in 1999 led to a drastic fall in capital flows to Argentina .

The impact of an exogenous fall in capital inflowsThe impact of an exogenous fall in capital inflows

Quantity of $US

E

S0

D0

E1

• A fall in CI leads to a reduction in the net supply of foreign currency. With less foreign financing (lower credit availability), aggregate demand will tend to fall. •If the exchange rate was flexible, E would rise. This would provide a cushion to absorb the negative impact of the reduction in capital inflows. •If the exchange rate was fixed, the central bank would have to sell its reserves and this implies would imply a restrictive monetary policy. The negative consequences of the fall in CI would be magnified.

S1

E0

R < 0

Fixed exchange rates: Are there Fixed exchange rates: Are there advantages to tying one’s hands ?advantages to tying one’s hands ?

• The previous discussion may have seemed to tilt the balance in favor of flexible exchange rates.

• One of the main advantage of a flexible exchange rate is that it permits the central bank to conduct an independent monetary policy.

• The benefits for a country to have its own independent monetary policy depend very much on what it does with this independence.

• The decision to fix the exchange rate is sometimes seen as the most efficient way to discipline the central bank and the rest of the public sector.

Choosing a strategy for inflation stabilization

• You will have understood from our previous discussion that there is one key to inflation stabilization:– Only a very small part of the government deficit (if any) should be

financed by money creation. • This way, the central bank can be given the effective

powers to bring down the inflation rate with the usual tools of monetary policy.

• But this may not sufficient in the short run:– The public has to be convinced that the monetary financing of the

government deficit has gone for ever.– The only way to do that is to implement a bold fiscal reform that

will reduce the deficit to what can voluntarily be financed in the financial markets.

– The public also has to be convinced that the central bank will carry its job with competence, efficiency and consistency


• There is no quick fix for inflation stabilization:– Inflation stabilization requires solid and competent public

institutions capable of:• Establishing priorities • Collecting in an efficient way the (non-prohibitive)

taxes required to finance these priorities• Concentrating on achieving the targets set by these

priorities in a cost efficient way.• Saying no to the demands that fall outside these

priorities or would imply prohibitive levels of taxation or an unacceptably high budget deficit.

• As you can see, inflation stabilization requires some solid efforts at institutions building, in other words, it requires political and institutional convergence to the standards of the most stable countries.

• In certain countries, a drastic course to political and institutional convergence has been chosen: Tying the hands of the state.


• In Argentina, was adopted in 1991 a monetary system which they name “convertibility”.

• Under the convertibility law, the central bank is strictly forbidden to provide credit to the government.

• Moreover, at least two thirds of the central banks assets must be foreign reserves assets.

• These two things make it virtually impossible for the national treasury to obtain financing (directly or indirectly) from the central bank.

• Under this self-imposed discipline, the government had no choice but implement a bold fiscal reform aiming at enlarging the tax base and combat tax evasion.


• The other part of the strategy was to fix the value of the

peso in dollar “for ever” .

• This, in addition to the foreign exchange reserves

requirement, transformed the central bank into a virtual

currency board.

• The strategy worked as inflation rapidly fell. Argentina

lived in a 200 % per month inflation environment in the

middle of 1989. Today, Argentina lives in a zero inflation

environment and even in the last two years, a deflationary

environment.

Simplified balance sheet of the argentine currency board

ASSETS

• Domestic bonds and money market

instruments (at most 1/3)

• Net assets in foreign currency (at

least 2/3)

LIABILITIES + CAPITAL

• Government deposits

• Domestic financial institutions deposits

• Domestic notes and coins

• Capital

Given the fixed exchange rate, this basically means that SB = R = CA + CFA

The inflation rate in Argentina

0

500

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3500

1945

1948

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1963

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1978

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%

Fixed exchange rates may work for inflation stabilization but…

• Click here to read a polemical essay about

Argentina’s current financial crisis.

• Click here to read about a possible way out.

• And here is my own analysis for those of you who

read French (optional).

http://www.jubilee2000uk.org/analysis/articles/A_Cross_o_%20Dollars.htm

http://www.jubilee2000uk.org/worldnews/lamerica/A_way_out_Argentina.htm

http://www.hec.ca/pages/martin.coiteux/msc/textes/Heuredeverite.pdf

Monetary Policy and the Choice Monetary Policy and the Choice of an Exchange Rate Regimeof an Exchange Rate Regime

ÉCOLE DES HAUTES ÉTUDES COMMERCIALES

MBA PROGRAM

NOVEMBER 2001

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Monetary Policy and the Choice of an Exchange Rate Regime ÉCOLE DES HAUTES ÉTUDES COMMERCIALES MBA PROGRAM NOVEMBER 2001