Fixed Versus Floating Exchange Rate Regimes Exchange Rates Regimes of the World, 1870-2010

Fixed Versus Floating Exchange Rate RegimesExchange Rates Regimes of the World, 1870-2010

Fixed vs. Floating Rates

• Example: Britain and the ERM• In September 1992, Britain left an exchange rate peg with the EU to

float the pound.• A step towards the euro was a fixed exchange rate system created in

1979 called the Exchange Rate Mechanism (ERM).• The German mark (deutsche mark, DM) was the base currency or

center currency (or Germany was the base country or center country) in the fixed exchange rate system.

Britain and Europe in the 1990s

• Following an economic slowdown, in September 1992 the British Conservative government finally concluded that the benefits of being in ERM and the euro project were smaller than costs suffered due to a German interest rate rise that was a reaction to Germany-specific events. Two years after joining the ERM, Britain left.

• Did Britain make the right choice? Compare the economic performance of Britain with that of France, a large EU economy that maintained its ERM peg.

Maybe a good decision?

Key Factors in Exchange Rate Regime Choice: Integration and Similarity

• The fundamental source of this divergence between what Britain wanted and what Germany wanted was that each country faced different shocks.

• The fiscal shock that Germany experienced after reunification was not felt in Britain or any other ERM country.

• The issues that are at the heart of this decision are: economic integration as measured by trade and other transactions, and economic similarity, as measured by the similarity of shocks.

Economic Integration and the Gains in Efficiency

• “Economic integration” refers to the growth of market linkages in goods, capital, and labor markets among regions and countries.

• By lowering transaction costs, a fixed exchange rate might promote integration and hence increase economic efficiency. Why?

The greater the degree of economic integration between markets in the home country and the base country, the greater will be the volume of transactions between the two, and the greater will be the benefits the home country gains from fixing its exchange rate with the base country. As integration rises, the efficiency benefits of a common currency increase.

Economic Similarity and the Costs of Asymmetric Shocks

• A fixed exchange rate can lead to costs when a country-specific shock or asymmetric shock is not shared by the other country: the shocks are dissimilar.

• In the example, German policy makers wanted to tighten monetary policy to offset a boom, while British policy makers did not want to implement the same policy because they had not experienced the same shock.

• The simple, general lesson we can draw is that for a home country that unilaterally pegs to a foreign country, asymmetric shocks impose costs in terms of lost output.

If there is a greater degree of economic similarity between the home country and the base country, meaning that the countries face more symmetric shocks and fewer asymmetric shocks, then the economic stabilization costs to home of fixing its exchange rate to the base become smaller. As economic similarity rises, the stability costs of common currency decrease.

Economic Similarity and the Costs of Asymmetric Shocks

Simple Criteria for Fixed Exchange Rates

• The benefits of integration depend upon economic similarity:As integration rises, the efficiency benefits of a common currency

increase.As symmetry rises, the stability costs of a common currency

decrease.

• The key prediction of the theory is: pairs of countries above the FIX line (more integrated, more similar

shocks) will gain economically from adopting a fixed exchange rate. Those below the FIX line (less integrated, less similar shocks) will not.

Price Levels and Exchange Rates in the Long Run: PPP

Fixed Exchange Rates and Trade

• Perhaps, the strongest argument for fixed exchange rates is that they increase trade by eliminating trade-hindering frictions.

Benefits Measured by Trade Levels • All else equal, a pair of countries adopting the gold standard had

bilateral trade levels 30% to 100% higher than comparable pairs of countries that were off the gold standard. Thus, it appears that the gold standard did promote trade.

• What about fixed exchange rates today? Do they promote trade? Economists have exhaustively tested this hypothesis.

• In the study reported in the text, country pairs A–B were classified in four different ways:

• a. The two countries are using a common currency (i.e., A and B are in a currency union or A has unilaterally adopted B’s currency).

• b. The two countries are linked by a direct exchange rate peg (i.e., A’s currency is pegged to B’s).

• c. The two countries are linked by an indirect exchange rate peg, via a third currency (i.e., A and B have currencies pegged to C but not directly to each other).

• d. The two countries are not linked by any type of peg (i.e., their currencies float against one another, even if one or both might be pegged to some other third currency).


Fixed Exchange Rates and Trade: comparing fixed to floating

Price Convergence• Studies that examine the relationship between exchange rate

regimes and price convergence use the law of one price (LOOP) and purchasing power parity (PPP) as their benchmark criteria for an integrated market.

• If fixed exchange rates promote trade then we would expect to find that differences between prices (measured in a common currency) are smaller among countries with pegged rates than among countries with floating rates.

• That is, we should find that LOOP and PPP are more likely to hold under a fixed exchange rate than under a floating regime.


Fixed Exchange Rates and Monetary Autonomy

• When a country pegs, it gives up its independent monetary policy:It’s money supply M must adjust to keep the home interest rate i

equal to the foreign interest rate i (plus any risk premium).• The Trilemma, Policy Constraints, and Interest Rate Correlations

To resolve the trilemma, a country can do the following:1. Choose open capital markets, with fixed exchange rates (an “open peg”).2. Choose to open its capital market but allow the currency to float (an “open nonpeg”).3. Choose to close its capital markets (“closed”).

The Trilemma again

Measuring the costs of fixing the exchange rate: output volatility

• All else equal, an increase in the base-country interest rate should lead output to fall in a country that fixes its exchange rate to the base country.

• In contrast, countries that float do not have to follow the base country’s rate increase and can use their monetary policy autonomy to stabilize.

• One cost of a fixed exchange rate regime is a more volatile level of output.

Fixed Exchange Rates and Monetary Autonomy

Costs of Fixing Measured in Output Volatility

Fixed rates, fiscal discipline and inflation

• One common argument in favor of fixed exchange rate regimes in developing countries is that an exchange rate peg prevents the government from printing money to finance government expenditure.

• Under such a financing scheme, the central bank is called upon to monetize the government’s deficit (i.e., give money to the government in exchange for debt). This process increases the money supply and leads to high inflation.

• The source of the government’s revenue is, in effect, an inflation tax (called seigniorage) levied on the members of the public who hold money.

Inflation tax

• At any instant, money grows at a rate ΔM/M = ΔP/P = π.• If a household holds M/P in real money balances, then a moment

later when prices have increased by π, a fraction π of the real value of the original M/P is lost to inflation. The cost of the inflation tax to the household is π × M/P.

• The amount that the inflation tax transfers from household to the government is called seigniorage, which can be written as

YrLP

M)(eSeigniorag *

baseTax rateTax taxInflation

• If a country’s currency floats, its central bank can print a lot or a little money, with very different inflation outcomes. If a country’s currency is pegged, the central bank might run the peg well, with fairly stable prices, or run the peg so badly that a crisis occurs, the exchange rate ends up in free fall, and inflation erupts.

• Nominal anchors—whether money targets, exchange rate targets, or inflation targets—imply a “promise” by the government to ensure certain monetary policy outcomes in the long run.

• However, these promises do not guarantee that the country will achieve these outcomes.


Inflation and the exchange rate regime


Liability dollarization, national wealth and contractionary depreciations

• The Home country’s total external wealth is the sum total of assets minus liabilities expressed in local currency:

• A small change ΔE in the exchange rate, all else equal. affects the values of EAF and ELF expressed in local currency. We can express the resulting change in national wealth as

)()( FHFH ELLEAAW

FF LAEW

Destabilizing wealth shocks

• In a more complex short-run model of the economy, wealth affects the demand for goods. For example,• Consumers might spend more when they have more wealth. In this

case, the consumption function would become C(Y − T, Total wealth).

• Firms might find it easier to borrow if their wealth increases. The investment function would then become I(i, Total wealth).

• If foreign currency external assets do not equal foreign currency external liabilities, the country is said to have a currency mismatch on its external balance sheet, and exchange rate changes will affect national wealth.• If foreign currency assets exceed foreign currency liabilities, then

the country experiences an increase in wealth when the exchange rate depreciates.

• If foreign currency liabilities exceed foreign currency assets, then the country experiences a decrease in wealth when the exchange rate depreciates.

• In principle, if the valuation effects are large enough, the overall effect of a depreciation can be contractionary.

Destabilizing wealth shocks

Evidence of wealth changes with depreciation

• These countries experienced crises and large depreciations of between 50% and 75% against the U.S. dollar and other major currencies from 1993 to 2003.

• A large fraction of the external debt for each of these was denominated in foreign currencies.

Evidence of output contractions following real depreciations

Original Sin

• In the long history of international investment, one remarkably constant feature has been the inability of most countries—especially poor countries on the periphery of global capital markets—to borrow from abroad in their own currencies.

• The term “original sin” refers to a country’s inability to borrow in its own currency.

• Domestic currency debts were frequently diluted in real value by periods of high inflation. Creditors were then unwilling to hold such debt, obstructing the development of a domestic currency bond market. Creditors were then willing to lend only in foreign currency, that is, to hold debt that promised a more stable long-term value.

Original Sin

Foreign currency debt and the exchange rate regime

• One, and perhaps only, way for developing countries to minimize or eliminate valuation effects is by limiting the movement of the exchange rate.

• For countries that cannot borrow in their own currency, floating exchange rates are less useful as a stabilization tool and may be destabilizing. This outcome applies particularly to developing countries, and these countries will prefer fixed exchange rates to floating exchange rates, all else equal.

Developing countries and fixed rates

• A fixed exchange rate may be the only transparent and credible way to attain and maintain a nominal anchor, particularly in emerging markets and developing countries with weak institutions, a lack of central bank independence, strong temptations to use the inflation tax, and poor reputations for monetary stability.

• A fixed exchange rate may also be the only way to avoid large fluctuations in external wealth, which can be a problem in emerging markets and developing countries with high levels of liability dollarization.

• Such countries may be less willing to allow their exchange rates to float—a situation that some economists describe as a fear of floating.

Fixed exchange rate systems

• A fixed exchange rate system involves multiple countries. • Examples are the global Bretton Woods system in the 1950s and

1960s and the European Exchange Rate Mechanism (ERM) through which all potential euro members must pass.

• These systems were based on a reserve currency system in which there are N countries (1, 2, . . . , N) participating.

• One of the countries, the center country (the Nth country), provides the reserve currency, which is the base or center currency to which all the other countries peg.

• When the center country has monetary policy autonomy it can set its own interest rate i *. Another, noncenter, country, which is pegging, then has to adjust its own interest rate so that i equals i * in order to maintain the peg.

• The noncenter country loses its ability to conduct stabilization policy, but the center country keeps that power.

• The asymmetry can be a recipe for political conflict and is known as the Nth currency problem.

• Cooperative arrangements can be worked out to try to avoid this problem.

Fixed exchange rate systems

Cooperative and Noncooperative Adjustments to Interest Rates

Noncooperative equilibrium


Cooperative equilibrium

• A unilateral peg gives the benefits of fixing to both countries but imposes a stability cost on the noncenter country alone.

• The historical record casts doubt on the ability of countries to even get as far as announcing cooperation on fixed rates, let alone actually backing that up with true cooperative behavior.

• A major problem is that, at any given time, the shocks that hit a group of economies are typically asymmetric.

• The center country in a reserve currency system has tremendous autonomy, which it may be unwilling to give up, thus making cooperative outcomes hard to achieve consistently.


• Suppose a (noncenter) country that was previously pegging at a rate E1 announces that it will now peg at a different rate, E2 ≠ E1.

• By definition, if E2 > E1, there is a devaluation of the home currency; if E2 < E1, there is a revaluation of the home currency.

• We assume that the center (the United States) is a large country with monetary policy autonomy that has set its interest rate at i$. Home is pegged to the U.S. dollar at Ehome/$ and Foreign is pegged at E*foreign/$.


The home country in recession



The home country devalues but its interest rate still equals i$


The foreign country cooperates by taking its real appreciation.


Devaluing bad: beggar-thy-neighbor.

The Gold Standard

• Consider two countries, Britain pegging to gold at Pg (pounds per ounce of gold) and France pegging to gold at P*g (francs per ounce of gold).

• Under this system, one pound cost 1/Pg ounces of gold, and each ounce of gold cost P*g francs, according to the fixed gold prices set by the central banks in each country. Thus, one pound cost Epar = P*g /Pg francs, and this ratio defined the par exchange rate implied by the gold prices in each country.

• The gold standard rested on the principle of free convertibility. This meant that central banks in both countries stood ready to buy and sell gold in exchange for paper money at these mint prices, and the export and import of gold were unrestricted.

Under the gold standard

• Between 1870 and 1913, the number of countries on the gold standard rose from 15% of all countries to 70%.

• The re-adoption of gold after World War I reached 90% by the end of the 1920s and then fell to 25% by 1939.

• From 1870-1914 (“the first great globalization”), transport costs fell and protectionism declined – world trade grew.

• Also, the costs of asymmetry in aggregate demands were politically unimportant.

• Price stability was the goal of most governments, unemployment reduction was not.

Under the gold standard

• Not everyone was pleased. William Jennings Bryan in 1896:“Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.”• At the start of 20th century, expansion of gold supplies eased U.S. and

European deflations.• World War I reduced trade (almost entirely for the U.K., France,

Germany and Russia) (substantially for the US due to U-boats)• High government deficits required inflationary financing leading to

floating rates.

• The return to gold in the 1920s was a time of economic turmoil in Europe. The great hyperinflations occurred between 1922 and 1924.

• Beggar-thy-neighbor: re-pegging to gold was used to devalue currencies.

• Deflationary monetary policy: gold supplies grew more slowly than income leading to deflation.

• In 1931, Britain left gold (floated) and imposed capital controls. Germany and Austria just imposed capital controls.

• The US devalued on January 31, 1934 (Gold Reserve Act of 1934).• France (plus Switzerland and Italy) finally left gold in 1936.

The end of the gold standard

• The U.K. and U.S. chose floating with open capital markets.• Germany and much of South America chose capital controls and

pegged exchange rates.• France stayed on gold because it had accumulated large reserves from

the mid-1920s on (and did not expand the franc supply).• Countries that floated grew 26% more between 1935 and 1929 than

countries that remained on gold (and 5% more than countries that adopted capital controls).

The end of the gold standard

Gold and per capita GNI

• The model suggests that as the volume of trade and other economic transactions between nations increase, there will be more to gain from adopting a fixed exchange rate.

• As nineteenth-century globalization proceeded, it is likely that more countries crossed the FIX line and met the economic criteria for fixing.

• There were also other forces at work encouraging a switch to the gold peg before 1914.

• But the benefits were often less palpable than the costs, particularly in times of deflation or in recessions.

• As world trade fell by half, the rationale for fixing based on gains from trade was weakened.

The rise and fall of the gold standard

• Before World War I

The Gold Standard

Bretton Woods and after

The end of Bretton Woods

• As capital mobility grew and controls failed to hold, the trilemma tells us that countries pegged to the dollar stood to lose their monetary policy autonomy.

• The devaluation option came to be seen as the most important way of achieving policy compromise in a “fixed but adjustable” system. But increasingly frequent devaluations (and some revaluations) undermined the notion of a truly fixed rate system, and made it more unstable.

• It was also believed that this inflation would eventually conflict with the goal of fixing the dollar price of gold and that the United States would eventually abandon its commitment to convert dollars into gold, which happened in August 1971.

• How did the world react to the collapse of the Bretton Woods system?

Most advanced countries have opted to float and preserve monetary policy autonomy.

A group of European countries instead decided to try to preserve a fixed exchange rate system among themselves.

Some developing countries have maintained capital controls, but many of them (especially the emerging markets) have opened their capital markets.


• How did the world react to the collapse of the Bretton Woods system?

Some countries, both developed and developing, have camped in the middle ground: they have attempted to maintain intermediate regimes, such as “dirty floats” or pegs with “limited flexibility.”

Finally, some countries still impose some capital controls rather than embrace globalization.


Exchange Rate Crises

• A simple definition of an exchange rate crisis might be a “big” depreciation. In practice, in an advanced country, a 10% to 15% depreciation might be considered large. In emerging markets, probably 20% to 25%.

• Exchange rate crises can occur in advanced countries as well as in emerging markets and developing countries.

• The magnitude of the crisis, as measured by the subsequent depreciation of the currency, is often much greater in emerging markets and developing countries.

Output costs of crises

Causes of currency crises

• Exchange rate crises usually arrive with other economically harmful financial crises, especially in emerging markets.

• If banks and other financial institutions face adverse shocks, they may become insolvent, causing them to close or declare bankruptcy: this is a banking crisis.

• If the government faces adverse shocks, it may default and be unable or unwilling to pay the principal or interest on its debts: this is known as a sovereign debt crisis or default crisis.

• Three types of crises in international macro: exchange rate crises, banking crises, and default crises.

Empirically, these tend to occur simultaneously:

• The likelihood of a banking or default crisis increases significantly when a country is having an exchange rate crisis.

• The likelihood of an exchange rate crisis increases significantly when a country is having a banking or default crisis.

• When crises occur in pairs or triples, the costs of the crisis is magnified.

Banking crises and GDP growth

How a peg works: Assumptions

• The home country uses the peso.• Suppose the peso is pegged to the U.S. dollar, and we assume the

central bank has been maintaining a fixed exchange rate, with E fixed at E = 1 (one peso per U.S. dollar).

• The country’s central bank controls the money supply M by buying and selling assets in exchange for cash. The central bank trades domestic bonds (denominated in pesos), and foreign assets (denominated in dollars).

• The central bank stands ready to buy and sell foreign exchange reserves at the fixed exchange. If it has no reserves, it cannot do this and the exchange rate is free to float: the peg is broken.

• For now, assume that the peg is credible. Uncovered interest parity then implies that the home and foreign interest rates are equal: i = i*.

• Assume output or income is exogenous and denoted Y. • The foreign price level P* = 1 is constant at all times. • In the short run, the home country’s price is sticky and fixed at a level

P = 1. In the long run, if the exchange rate is kept fixed at 1, then the home price level will be fixed at 1 as a result of purchasing power parity.


• The home country’s demand for real money balances M/P is determined by the level of output Y and the nominal interest rate i and takes the usual form, M/P = L(i)Y. The money market is in equilibrium.

• There is no financial system and the only money is currency, also known as M0 or the monetary base. The money supply is denoted M. We consider only the effects of the actions of a central bank.


The central bank balance sheet

• The home central bank’s sole liability is the money in circulation.

• Suppose the central bank has purchased a quantity B pesos of domestic bonds. In effect, it lends money to the domestic economy. The central bank’s purchases are usually referred to as domestic credit created by the central bank. These purchases generate part of the money supply and are also called the bank’s domestic assets.

• The part of the home money supply created as a result of the central bank’s issuing of domestic credit is denoted B.

• Now suppose the central bank also uses money to purchase a quantity R dollars of foreign exchange reserves, usually referred to as reserves.

• Because the central bank holds only two types of assets, the last two expressions add up to the total money supply in the home economy:

• Expressed not in levels but in changes:


MMoney supply

BDomestic credit

RReserves

MChange in

money supply

BChange in

domestic credit

RChange inreserves

• The central bank balance sheet contains the central bank’s assets, B + R, and the money supply, its liabilities.

• We assume the exchange rate is fixed if and only if the central bank holds reserves. The exchange rate is floating if and only if the central bank has no reserves.


How reserves adjust to maintain the peg

• What level of reserves must the central bank have to maintain the peg? If the central bank can maintain a level of reserves above zero, we know the peg will hold. If not, the peg breaks. Solving for the level of reserves:

R = M – B

• Since money supply equals money demand, given by M/P = PL(i)Y, then:

credit DomesticdemandMoney Reserves

)( BYiLPR


• The equation tells us that when the central bank pegs, it sets the nominal interest rate. Domestic credit, B, determines how many reserves the central bank must hold. If it bought more reserves, the home money supply would rise, the interest rate would fall and the currency would depreciate – that is, the peg would break.

• Similarly, if the central bank sells reserves for pesos, the home money supply would decrease causing the peso to appreciate. The central bank would have to reverse course and buy back the reserves to keep the exchange rate peg.

• To keep the exchange rate fixed, the central bank must keep the home interest rate constant.

• It the does this by keeping the left-hand side of this equation constant:

• If B rises, R must fall. This means that the central bank sells reserves when it buys domestic credit if it keeps the exchange rate pegged.


demandMoney credit DomesticReserves

)( YiLPBR

• We first look at shocks to money demand and how they affect reserves by changing the money supply M.

• A Shock to Home Output or the Foreign Interest Rate Suppose output falls or the foreign interest rate rises. We treat either of

these events as an exogenous shock, all else equal.Suppose the endogenous shock decreases money demand by 10% at the

current interest rate.This fall in money demand would lower the interest rate in the money

market and put depreciation pressure on the home currency. To maintain the peg, the central bank must keep the interest rate unchanged. To achieve this goal, it must sell 100 million pesos ($100 million) of reserves, in exchange for cash, so that money supply contracts as much as money demand.

Defending the Peg I: Changes in the Level of Money Demand

The central bank’s balance sheet changes to:


• The Importance of the Backing Ratio The ratio R/M is called the backing ratio, and it indicates the

fraction of the money supply that is backed by reserves on the central bank balance sheet.

• In general, for a given size of a shock to money demand, a higher backing ratio will better insulate an economy against running out of reserves, all else equal.


• A fixed exchange rate that always operates with reserves equal to 100% of the money supply is known as a currency board system. The backing ratio for a currency board is equal to 100%.

• Under a currency board, the central bank can cope with any shock to money demand without running out of reserves.

• Currency boards are considered a hard peg because their high backing ratio ought to confer on them greater resilience in the face of money demand shocks.


• Why Does the Level of Money Demand Fluctuate? Money demand shocks originate either in shocks to home output

Y or the foreign interest rate i* (because under a credible peg i = i*).

Since output fluctuations are more volatile in emerging markets and developing countries, the prudent level of reserves is likely to be much higher in these countries.

If the peg is not fully credible and simple interest parity fails to hold, the home interest rate will no longer equal the foreign interest rate; additional disturbances to home money demand can be caused by the spread between the two.


Risk Premiums in Advanced and Emerging Markets

• When the returns to foreign and domestic assets are risky, we must add risk premiums to our equation for uncovered interest parity (UIP).

• For example, when additional risks affect home bank deposits, a risk premium is added to compensate investors for the perceived risk of holding a home domestic currency deposit as

premiumrisk

Default

premiumrisk

rate Exchange

peso/$

peso/$*

E

Eii

e

• The first part of the interest rate spread is the currency premium:

• The second part of the interest rate spread is known as the country premium:


premiumrisk

rate ExchangepremiumCurrency

peso/$

peso/$

E

E e

Country premium Default

risk premium

• Because of fluctuations in interest rate spreads, pegs in emerging markets are subject to even greater interest rate shocks than the pegs of advanced countries, as a result of credibility problems.

• The credibility of monetary policy and credibility of property rights cause currency premiums to fluctuate.

• Many economists refer to contagion in global capital markets when crises in some parts of the global capital markets trigger adverse changes in market sentiment in faraway places.


• The central bank balance sheet diagram helps us to see how a central bank manages a fixed exchange rate and what adjustments need to be made in response to a shock in money demand.

• We take a look at the fixed exchange rate system in Argentina known as the Convertibility Plan, which began in 1991 and ended in 2002.

• In this plan, a peg was maintained as one peso per dollar.

The Argentine Convertibility Plan before the Tequila Crisis

The Argentine Convertibility Plan before the Tequila Crisis

Argentina’s Central Bank Operations, 1993–1997 (continued) In panel (b), the balance sheet of the central bank at these key dates is shown. Prior to the crisis, domestic credit was essentially unchanged, and reserves grew from $8 billion to $11 billion as money demand grew from M1 to M2 in line with rapid growth in incomes (move from point 1 to 2).

Argentina’s Central Bank Operations, 1993–1997 (continued) After the crisis hit in December 1994, interest rate spreads widened, money demand fell from M2 to M3, but domestic credit stood still (to point 3) and $1 billion in reserves were lost.

Argentina’s Central Bank Operations, 1993–1997 (continued) In 1995 there was a run on banks and on the currency, and the central bank sterilized by expanding domestic credit by 5 billion pesos and selling $5 billion of reserves as money demand remained constant (to point 4). Reserves reached a low level of $5 billion.

Argentina’s Central Bank Operations, 1993–1997 (continued) By 1996 the central bank replenished its reserves, reversing the earlier sterilization. Domestic credit fell by 5 billion pesos and reserves increased by $5 billion (to point 5, same as point 3). Further sterilized purchases of $4 billion of reserves brought the backing ratio up to 100% in 1997 (to point 6).

• An increase in B by 100 changes the central bank’s balance sheet to

Defending the Peg II: Changes in the Composition of Money Supply

There is no change in monetary policy as measured by home money supply (or interest rates) because the sale and purchase actions by the central bank are perfectly offsetting. This is called sterilized intervention.

• Sterilization is impossible in the case of a currency board because a currency board requires that domestic credit always be zero and that reserves be 100% of the money supply at all times.

• If the change in money demand is zero, then ΔM = 0; hence, the change in domestic credit, ΔB > 0, must be offset by an equal and opposite change in reserves, ΔR = −ΔB < 0.

• Holding money demand constant, a change in domestic credit leads to an equal and opposite change in reserves, which is called a sterilization.

Defending the Peg II: Changes in the Composition of Money Supply

The Central Bank Balance Sheet and the Financial System

In general, money supply is equal to net foreign assets plus net domestic assets. The only real difference is the ability of the central bank to borrow by issuing nonmonetary liabilities, whether domestic or foreign.

The Central Bank Balance Sheet and the Financial System

• Sterilization Bonds allow a central bank to borrow to buy reserves without changing monetary policy (money supply and interest rates are unchanged, given the peg) and increase the backing ratio.

• Sterilization is just a way to change the backing ratio, all else equal.

• By issuing sterilization bonds, central banks can borrow from domestic residents to buy more reserves. With sufficient borrowing of this kind, the central bank can end up with negative net domestic credit and reserves in excess of 100% of the money supply.

China did just that

The great reserve accumulation in emerging markets, 1997-2009

How Pegs Break: Inconsistent Fiscal Policies

• We begin with a first-generation crisis model of inconsistent fiscal policies.

• We assume that output is fixed, and we allow the price level to change, according to purchasing power parity (PPP). The government runs a persistent deficit (DEF) and is unable to borrow from any creditor. It turns to the central bank for financing.

• In this type of environment, economists speak of a situation of fiscal dominance in which the monetary authorities ultimately have no independence.

• Domestic credit B increases by an amount ΔB = DEF every period and is growing at a constant positive rate, ΔB/B = μ.

• Every change in the level of domestic credit leads to an equal and opposite change in the level of reserves. Reserves must eventually run out. At that point, the peg breaks and the central bank shifts from a fixed exchange rate regime to a floating regime, in which the money supply equals domestic credit, M = B.

• The crisis happens because authorities are willing to let it happen because of overriding fiscal priorities.

How Pegs Break: Inconsistent Fiscal Policies

Documents

Fixed Versus Floating Exchange Rate Regimes Exchange Rates Regimes of the World, 1870-2010