Why Study Fixed Exchange Rates?

–Managed floats/dirty floats–Regionally fixed currencies: euro, cfa–Developing countries–Transition economies–Lessons of the past for the future

• De facto exchange rate regimes and monetary policy frameworks as of April 2008

http://www.imf.org/external/np/mfd/er/2008/eng/0408.htm

• Foreign Exchange Market Equilibrium Under

Fixed Exchange Rate:

R = R* + (Ee – E)/E = R* + 0 = R*

• Money Market Equilibrium Under Fixed Rate– Central Bank must adjust the money supply so:

MS/P = L(R*, Y)– Intervention in foreign exchange market assures

that

R = R* and MS/P = L(R*, Y)

Central Bank Balance Sheet

Assets Liabilities

Foreign Assets Currency in circulation

Gold

Foreign Govt Bonds

Domestic Assets Commercial bank deposits

Bank IOU’s

Gov’t Bonds Net Worth = 0 by assumption

Balance of Payments and Ms

• B of P = CA + Nonofficial Financial Account• If BoP > 0

– Excess supply of foreign exchange• Domestic currency threatens to appreciate• Foreign currency threatens to depreciate

– CB BUYS foreign exchange … props it up– CB assets increase Ms increases

• If B of P < 0 … the reverse … Ms decreases• Sterilized intervention

BofP>0 … Buy foreign & Sell domestic assets … easy

BofP<0 … Sell foreign & buy domestic assets … limited

Real money supplyM1

P

Real money demand, L(R, Y1)

Domestic-currency return on foreign-currency deposits, R* + (E0 – E)/E

Real domesticmoney holdings

DomesticInterest rate, R

Exchange rate, E

0

M2

P

3

3'E0

2

R*

1

1'

L(R, Y2)

Asset Market Equilibrium with Fixed Exchange Rate, E0: Response to increase in output

DD

Monetary Expansion Is Ineffective Under a Fixed Exchange Rate

Ms up R threatens to fall Currency Threatens to DepreciateCB props up its currency (sells reserves) on fe mkt Ms down

Output, Y

Exchange rate, E

E2

Y2

2

E0

Y1

1

AA2

AA1

DD1

Fiscal Expansion Is Effective Under Fixed Exchange Rate (at least in short-run)G up Y up R threatens to rise Currency Threatens to AppreciateCB props up foreign currency (buys reserves) on fe mkt Ms up Y stays up

Output, Y

Exchange rate, E

E0

Y1

1

AA2

AA1

DD2

E2

Y2

2

3

Y3

DD

Effects of a Currency Devaluation

Output, Y

Exchange rate, E

E1

Y2

2

E0

Y1

1

AA2

AA1

– Fiscal expansion causes P to rise in long-run.• No real appreciation in the short-run (P unchanged)• There is real appreciation in the long-run

» P rises while E is unchanged• Real appreciation shifts DD in; Higher Price shifts AA

in …Y back to where it started in long-run

– Devaluation is neutral in the long-run. • CA surplus Central Bank Buys Reserves Ms up• Excess demand and increased money supply raise P

– In proportion to devaluation– In proportion to money supply increase

Stabilization Policies With a Fixed Exchange Rate

M2

P

Capital Flight, Money Supply, and Interest Rate

Real money supplyM1

P

R*

1Real domesticmoney holdings

DomesticInterest rate, R

Exchange rate, E

0R* + (E0 – E)/E

R* + (E1– E)/E

2

R* + (E1 – E0)/E0

L(R, Y)

2'E0

1'

Managed Floating and Sterilized Intervention

• Perfect Asset Substitutability – (their bonds are as good as ours)

Ineffectiveness of Sterilized Intervention– Sterilized intervention leaves Ms unchanged.– Central banks cannot control Ms and E at same

time – The Impossible Trilogy:

• Fixed Exchange Rate• Independent Monetary Policy• Capital Mobility

Imperfect asset substitutability• Assets in different countries have different risks• Their expected returns can then differ and central

banks may be able to control both Ms and E through sterilized foreign exchange intervention.

Managed Floating and Sterilized Intervention

Foreign exchange market equilibrium requires: R = R* + (Ee – E)/E +

where: is a risk premium on domestic bonds

– depends positively on amount of government debt held outside CB:

= (B – A) where:

B is the stock of domestic government debtA is domestic assets of the central bankB – A = govt debt held outside of central bank

Sterilized Intervention: Imperfect Substitutability Keeping Your Currency from Appreciating

…Or Getting Your Currency to Depreciate– Sterilized purchase of foreign assets Ms constant

–Buy foreign assets (foreign currency) and sell domestic assets (gov’t bonds)

• More government debt now held by the public

• Riskiness of government debt (B – A) UP.• Interest rate parity equilibrium now requires a

higher domestic interest rate:

R = R* + (Ee – E)/E + (B – A)• But R is unchanged since M/P is unchangedPressure to depreciate offsets pressure to appreciate

Managing Expectations: Signaling Effect of Sterilized Intervention

Effect of a Sterilized Central Bank Purchase of Foreign Assets Under Imperfect Asset Substitutability

Ms

PReal money supply

Real domesticmoney holdings

DomesticInterest rate, R

Exchange rate, E

0R* + (Ee – E)/E + (B –A1)

Risk-adjusted domestic-currency return on foreign currency deposits,R* + (Ee– E)/E + (B –A2)

L(R, Y)

2'E2

E11'

R1

1

Sterilized purchase of foreign assets

Reserve Currencies in Int’l Monetary SystemPossible systems for fixing the exchange rates:

– Reserve currency standard• Central banks peg their currencies in terms of

a reserve currency ($).–Central banks hold $ as reserve Asymmetric adjustment

– Gold standard• Central banks peg the prices of their currencies in

terms of gold ... or some other commodity … or commodity basket

Symmetry• Straitjacket … M – policy constrained

Docile labor

Europe Before the War: The Double Bluff

Thus this remarkable system depended for its growth on a double bluff or deception. On the one hand the labouring classes accepted from ignorance or powerlessness, or were compelled, persuaded, or cajoled by custom, convention, authority, and the well-established order of society into accepting, a situation in which they could call their own very little of the cake that they and nature and the capitalists were co-operating to produce. And on the other hand the capitalist classes were allowed to call the best part of the cake theirs and were theoretically free to consume it, on the tacit underlying condition that they consumed very little of it in practice.

The Gold Standard• Each country fixes the price of its currency in

terms of gold no country has a privileged position

– Exchange rates between any two currencies fixed by arbitrage.• If the $ price of gold is pegged at $35/oz by the Fed

while the £ price is pegged at £14.58/oz by the BoE, the par $/ £ exchange rate must be $2.40/ £.

E = ($35/oz)/(£14.58/oz ) = $2.40/ £.

Symmetric Adjustment Under Gold Standard• A country loses reserves money supply shrinks

price level falls q depreciates CA improves• Foreign countries gain reserves money supplies

expand prices rise q appreciates CA down – Benefits:

• Avoids asymmetry of a reserve currency standard.– Surplus country also adjusts

• Places constraints on the growth of money supplies.

– Drawbacks:• Constrains use of monetary policy to fight unemployment• Stable price level only if relative price of gold stable.• Makes central banks compete for reserves and bring

about world unemployment

1930s beggar-thy-neighbor.

• WW I: Capital flight breakdown of gold standard• Interwar turbulence

• Legacies of WW I– Redrawn borders disrupted trade patterns– Old debts/reparations– Labor empowered: The eight hour day

Excessive claims hyperinflation

The Lenin Dictum: Lenin is said to have declared …

• Gold Standard Nostalgia

The Lenin Dictum• Lenin is said to have declared that the best way to

destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. … they not only confiscate, but they confiscate arbitrarily… As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.

• ‘20s Halting return to gold Prelude to depression• The Economic Consequences of Mr. Churchill General Strike• US monetary expansion – help to Britain Roaring ’20s• Capital flow reversal European downturn

• Bubble and collapse

• ‘30s World in Depression: UK couldn’t …US wouldn’t lead• Protection – beggar thy neighbor• British leave gold – US defends gold standard

Golden fetters• Halting recovery: monetary expansion/fiscal measures/rearmament

• The Bretton Woods System: IMF a bank/World Bank a fund• $ pegged to gold … N – 1 currencies pegged to elastic $• IMF: Int’l lender of last resort support pegs/allow devaluation when fundamental disequilibrium

Impossible Trilogy: • Fixed rates/Independent M-Policy/Free capital flows…Pick two

Problems/breakdown: Speculative attacks/$ Shortage/$ Glut• Nixon Economic Program: Close gold window/surcharge/controls

Bretton Woods: $ Standard…more flexible than gold• Each central bank fixed the dollar exchange rate of its

currency through foreign exchange market trades for $s (dollar assets).

• Exchange rates between any two currencies fixed by arbitrage.– The reserve-issuing country (USA) can use monetary

policy for macroeconomic stabilization even though it has fixed exchange rates.

– The purchase of domestic assets by the central bank of the reserve currency country leads to:• Excess demand for foreign currencies in the foreign

exchange market• Expansionary monetary policies by all other central

banks• Higher world output … and/or INFLATION

Reserve Currencies in Int’l Monetary System

Achieving Internal and External BalancePegged rates• Fiscal policy effective• Exchange rate can be changed

• Devaluation/revaluation

• Tools: – Expenditure changing: fiscal policy– Expenditure switching: exchange rate setting

• Need as many tools as you have objectives

• For external balance, XX• G up Y up CA down … unless E up (devaluation)

• For internal balance, II• E down (revaluation) CA down Y down … unless G up