Fixed Exchange Rates and Foreign Exchange Intervention Chapter 18 Krugman and Obstfeld 9e ECO41 International Economics Udayan Roy

Fixed Exchange Rates and Foreign Exchange Intervention

Chapter 18 Krugman and Obstfeld 9eECO41 International Economics

Udayan Roy

Why Study Fixed Exchange Rates?

• Four reasons to study fixed exchange rates:– Managed floating– Regional currency arrangements– Developing countries and countries in transition– Lessons of the past for the future

• Any central bank purchase of assets automatically results in an increase in the domestic money supply.– Example: If the US central bank (“The Fed”) buys

some financial asset, it must pay for it with newly printed dollars. Therefore, the US money supply (MUS) must increase.

Central Bank Interventionand the Money Supply

• Any central bank sale of assets automatically causes the money supply to decrease.– Example: If the Fed sells some financial asset, the

dollars paid by the buyer will no longer be in circulation. Therefore, the US money supply (MUS) must decrease.

• In short, the central bank’s reserves of financial assets moves in the same direction as its money supply.

Central Bank Interventionand the Money Supply

RECAP Fig. 17-8: Short-Run Equilibrium: The Intersection of DD and AA

17-5

The output market is in equilibrium on the DD curveThe asset markets are in equilibrium on the AA curve

The short run equilibrium occurs at the intersection of the DD and AA curves

RECAP: Shifting the AA and DD Curves

• The AA curve shifts right if:– Ms increases– P decreases– Ee rises– R* rises– L decreases for some

unknown reason

16-6

• The DD curve shifts right if:¨ G increases¨ T decreases¨ I increases¨ P decreases¨ P* increases¨ C increases for some

unknown reason¨ CA increases for some

unknown reason Knowing how some specified change shifts the DD and AA curves will help us predict the consequences of the specified change.

How a Central Bank Fixes the Exchange Rate

E2

Y2

2

Y3

E3 3

Suppose the central bank wants to fix the value of the exchange rate at E1.

If, for whatever reason, the AA curve shifts left, then the short-run equilibrium shifts from point 1 to point 2 and the exchange rate falls. To return to the exchange rate to the target value of E1, all that the central bank has to do is to increase the money supply and shift the AA curve back where it originally was.

If, for whatever reason, the AA curve shifts right, then the short-run equilibrium shifts from point 1 to point 3 and the exchange rate rises. To return to the exchange rate to the target value of E1, all that the central bank has to do is to decrease the money supply and shift the AA curve back where it originally was.


E2

Y2

2

Y3

E3 3

We have seen before that the AA curve shifts because of changes in P, Ee, R* and L-shocks.And now we see that, under fixed exchange rates, such changes will have no effect on E and Y.


Y3

E3 3

Let us return to the case in which the AA curve shifts right for some reason and moves the equilibrium from point 1 to point 3.

To bring the exchange rate back to E1, the central bank must reduce the money supply to shift the AA curve back where it was.

But there’s a slight problem. To reduce the money supply the central bank must sell financial assets from its reserves, as we saw earlier. But what if the central bank has exhausted its reserve of assets and has no assets left to sell?

In this case, the central bank will no longer be able to keep the exchange rate fixed. The country will be forced to return to flexible exchange rates.

More on this later!


17-10

Suppose the central bank wants to fix the value of the exchange rate at E1. If, for whatever reason, the DD curve shifts left and the short-run equilibrium shifts from point 1 to point 2, then all that the central bank has to do is to decrease the money supply and shift the AA curve to the left and take the short-run equilibrium to point 3.

2

DD2

3

AA2

Y3


17-11

We have seen before that the DD curve shifts left when there is a decrease in G, I, or P*, or changes in other unspecified factors that decrease C or CA, or an increase in T or P.We see now that, under fixed exchange rates, such changes will reduce Y, and by a bigger amount than under flexible exchange rates.

2

DD2

3

AA2

Y3


17-12

Suppose the central bank wants to fix the value of the exchange rate at E1. If, for whatever reason, the DD curve shifts right and the short-run equilibrium shifts from point 1 to point 2, then all that the central bank has to do is to increase the money supply and shift the AA curve to the right, thereby taking the short-run equilibrium to point 3.

2

DD2

3

AA2

Y3


17-13

We have seen before that the DD curve shifts right when there is an increase in G, I, or P*, or changes in other unspecified factors that increase C or CA, or a decrease in T or P.We see now that, under fixed exchange rates, such changes will increase Y, and by a bigger amount than under flexible exchange rates.

2

DD2

3

AA2

Y3

Devaluation

17-14

Suppose the exchange rate has been fixed at E1 in the past. Now suppose the central bank wishes to continue to fix the exchange rate but at the higher value of E2. This is called devaluation.

The central bank can shift only the AA curve. So, it would have to increase the money supply and shift the AA curve to the right till the equilibrium exchange rate increases to the desired level of E2.

Y2

E2 2

Therefore, we see that a devaluation raises output. Conversely, a revaluation reduces output.

Devaluation

17-15

The increase in the central bank’s target exchange rate will raise the expected exchange rate (Ee↑). This, we saw before, will shift the AA curve further to the right, taking the equilibrium to point 3.

The central bank will therefore have to reduce the money supply a bit to shift the AA curve to the left till the economy returns to point 2.

Y2

E2 2

3

Summary: The Behavior of OutputExogenous Change Effect on Output (Y)

Government Spending (G) +

Business Investment Spending (I) +

Net Tax Revenues (T) –

Foreign Price Level (P*) +

C-shocks +

CA-shocks +

Domestic Price Level (P) –

Target Exchange Rate (Etarget) +

Expected Future Exchange Rate (Ee) 0

Foreign Interest Rate (R*) 0

L-shocks 0

Only DD shifts

Only AA shifts

Both DD and AA shift

Summary: The Behavior of OutputExogenous Change Effect on Output (Y)

Government Spending (G) +

Business Investment Spending (I) +

Net Tax Revenues (T) –

Foreign Price Level (P*) +

C-shocks +

CA-shocks +

Domestic Price Level (P) –

Target Exchange Rate (Etarget) +

Expected Future Exchange Rate (Ee) 0

Foreign Interest Rate (R*) 0

L-shocks 0

Whenever there is an effect on Y, the magnitude of the effect is bigger under fixed exchange rates than under flexible exchange rates.

THE INTEREST RATE

The Interest Rate

• Recall that the foreign exchange market is in equilibrium when: R = R* + (Ee – E)/E– When the central bank fixes the exchange rate at E =

Etarget, people will expect it to continue. So, Ee = Etarget.– Therefore, (Ee – E)/E = (Etarget – Etarget)/Etarget = 0.– Therefore, R = R*.– Under fixed exchange rates, the domestic interest rate

is tied to the foreign interest rate.

The Interest Rate

• R = R* + (Ee – E)/E = R* + (Ee/E) – 1 • If a devaluation occurs and takes everybody by

surprise, then initially E will increase but Ee will not.

• Therefore, R will temporarily fall below R*.• Eventually, E and Ee will again be equal and,

therefore, so will be R and R*.

The Interest RateFixed Exchange Rates Y R

Government Spending (G) + 0

Business Investment Spending (I) + 0

Net Tax Revenues (T) – 0

Foreign Price Level (P*) + 0

C-shocks (unspecified factors that increase C) + 0

CA-shocks (unspecified factors that increase CA) + 0

Domestic Price Level (P) – 0

Target Exchange Rate (Etarget) + –

Expected Future Exchange Rate (Ee) 0 0

Foreign Interest Rate (R*) 0 +

L-shocks (unspecified factors that increase L) 0 0

As R = R*, only R* affects R.

The inverse effect of Etarget on R is true only when the change in Etarget takes people by surprise.

If the change in Etarget is anticipated, then there will be an equal change in Ee. As a result, R = R* will continue to hold. Therefore, the change in Etarget will have no effect on R.

THE CURRENT ACCOUNT

The Current Account

• Recall from Chapter 17, that there are two ways to express a country’s current account

• Method 1: • Method 2:

The Current Account

• Method 1: • Suppose E, P*, P, T and CA-shocks are

unchanged, but some other exogenous variable undergoes a change.

• In this case, as the current account is inversely related to after-tax income, the effect on CA will be the opposite of the effect on Y.

Summary: The Behavior of Y and CA

Exogenous Change Effect on Output (Y) Current Account (CA)

Government Spending (G) + –

Business Investment Spending (I) + –

Net Tax Revenues (T) – +

Foreign Price Level (P*) + +

C-shocks + –

CA-shocks + +

Domestic Price Level (P) – –

Target Exchange Rate (Etarget) + +


Foreign Interest Rate (R*) 0 0

L-shocks 0 0

The Current Account

• Method 1: • Suppose taxes increase (T↑) and all other

exogenous variables remain unchanged.• We saw before that Y decreases. Therefore,

after-tax income decreases (Y – T↓).• as the current account is inversely related to

after-tax income, the current account increases (CA↑)







C-shocks + –

CA-shocks + +





L-shocks 0 0

The Current Account

• Assumption: When Y changes and T is unchanged, C changes in the same direction but by less.

• Therefore, when Y changes and T is unchanged, Y − C changes in the same direction

• It then follows from that all the exogenous factors other than I, G, T and C-shocks that affect Y must affect CA in the same way







C-shocks + –

CA-shocks + +





L-shocks 0 0







C-shocks + –

CA-shocks + +





L-shocks 0 0

The Current Account

• Note that, as under flexible exchange rates, contractionary fiscal policies (“fiscal austerity” or “belt tightening”) can raise a country’s current account balance in the short run.

• So can protectionist policies such as tariffs and quotas.

COMPARING FLEXIBLE AND FIXED EXCHANGE RATE REGIMES

Comparing the Regimes

• As output (Y) and the current account (CA) are usually the two main topics, let us look at how the various exogenous variables affect Y and CA in the two exchange rate regimes

It’s Basically the Same!Fixed Exchange Rates Y CA





C-shocks (unspecified factors that increase C) + –

CA-shocks (unspecified factors that increase CA) + +





L-shocks (unspecified factors that increase L) 0 0

Flexible Exchange Rates Y CA





C-shocks + –

CA-shocks + +


Money Supply (Ms) + +

Expected Future Exchange Rate (Ee) + +

Foreign Interest Rate (R*) + +

L-shocks – –






C-shocks + –

CA-shocks + +





L-shocks 0 0






C-shocks + –

CA-shocks + +





L-shocks – –

Recall that expansionary monetary policy is an increase in Ms under flexible exchange rates and an increase in Etarget under fixed exchange rates. Note that their effects are the same: output and the current account both increase.






C-shocks + –

CA-shocks + +





L-shocks 0 0






C-shocks + –

CA-shocks + +





L-shocks – –

As we saw earlier, under fixed exchange rates, any variable that shifts the AA curve is totally reversed by the central bank in order to keep the exchange rate fixed. That explains the zeroes on the left table.

BALANCE OF PAYMENTS CRISES

Fig. 18-4: Effect of the Expectation of a Currency Devaluation

If a devaluation (an increase in E) is widely expected, there is an increase in Ee. As a result, the AA curve shifts right.

To keep E fixed, the central bank must sell its foreign currency reserves and thereby reduce the domestic money supply and bring the AA curve back to where it was.

So, the mere expectation of a devaluation may cause the central bank to lose a lot of its reserves.

If its reserves are inadequate, the central bank may be forced to devalue or to simply switch to flexible exchange rates.

Balance of Payments Crises and Capital Flight

• Balance of payments crisis– It is a sharp fall in official foreign reserves sparked

by a change in expectations about the future exchange rate.

• The expectation of a future devaluation causes:– A balance of payments crisis marked by a sharp

fall in reserves– A rise in the home interest rate above the world

interest rate• An expected revaluation causes the opposite

effects of an expected devaluation.


• Capital flight– The reserve loss accompanying a devaluation scare

• The associated debit in the balance of payments accounts is a private capital outflow.

• Self-fulfilling currency crises– It occurs when an economy is vulnerable to

speculation.– The government may be responsible for such

crises by creating or tolerating domestic economic weaknesses that invite speculators to attack the currency.


THE MONEY SUPPLY

What is Monetary Policy Under Fixed Exchange Rates?

• As the central bank in a fixed exchange rate system must keep the money supply at the precise level necessary to keep the exchange rate fixed at the target rate, it becomes unable to use the money supply to pursue any other objective (such as fighting a recession)

The Money Supply is no longer a policy tool

• Under a fixed exchange rate, the money supply is an endogenous variable

• It is no longer a policy tool• The monetary policy tool is now Etarget, the rate

at which the exchange rate is pegged


• We saw in Chapters 16 and 17 that in an economy with flexible exchange rates, monetary policy consists of changes in the money supply (Ms)– Ms↑ is expansionary monetary policy– Ms↓ is contractionary monetary policy

• But in a fixed exchange rate system, the money supply is no longer controlled by the central bank


• The central bank does, however, control the target rate Etarget at which the exchange rate is kept fixed– Etarget ↑ (devaluation) is expansionary monetary

policy– Etarget ↓ (revaluation) is contractionary monetary

policy

• Equilibrium in the money market requiresMS/P = L(R, Y)

– But equilibrium in the foreign exchange market determines R (=R*).

– Therefore, Ms = P × L(R*, Y).– We saw in Ch. 15 that R (= R*) is inversely related

to money demand, and Y is directly related to money demand.

– To simplify,

Money Market Equilibrium Under a Fixed Exchange Rate

• Suppose P, L0, and R* remain unchanged, but some other exogenous variable changes.

• If Y increases, then Ms must increase. • In other words, the effects on Y and Ms must

be in the same direction.

Money Market Equilibrium Under a Fixed Exchange Rate

Behavior of Money Supply

• We saw earlier that if P increases, Y decreases.• So, the effect of P on Ms is ambiguous.


• We saw earlier that R* has no effect on Y.• Therefore, an increase in R* leads to a

decrease in Ms.


• We saw earlier that L0, which represents any of the unspecified factors that affect L, has no effect on Y.

• Therefore, any increase in L0 leads to an increase in Ms.

Summary: The Behavior of Y and Ms

Fixed Exchange Rates Y MS

Government Spending (G) + +

Business Investment Spending (I) + +

Net Tax Revenues (T) – –


C-shocks (unspecified factors that increase C) + +

CA-shocks (unspecified factors that increase CA) + +

Domestic Price Level (P) – ?



Foreign Interest Rate (R*) 0 –

L-shocks (unspecified factors that increase L) 0 +

THE LONG RUN UNDER FIXED EXCHANGE RATES

Summary: Long-Run, Flexible Exchange Rates

• q = 1, absolute PPP• Y = Yp

This is a recap of Chapter 16, which discussed flexible exchange rates.

How will these results change under fixed exchange rates?

The first two are real variables. Under the principle of monetary neutrality, they will not change.

We saw earlier that R = R*. Also, it is obvious that E = Etarget and Eg = 0.

Only P and π remain to be determined.

Inflation

• As we saw in Chapter 16, under either absolute purchasing power parity or relative purchasing power parity we get

• But under fixed exchange rates, the rate at which the exchange rate appreciates must be zero:

• Therefore,

The Price Level

• Absolute PPP: • Therefore,

• Relative PPP: , a constant• Therefore,

Summary: Long-Run, Fixed Exchange Rates

• q = 1, absolute PPP• q = q0, relative PPP• Y = Yp

• , absolute PPP• , relative PPP

One major weakness of a fixed exchange rate system is that the country adopting such a system loses control of its inflation and interest rates.

Documents

Fixed Exchange Rates and Foreign Exchange Intervention Chapter 18 Krugman and Obstfeld 9e ECO41 International Economics Udayan Roy