Foreign Exchange Intervention - International Economics - Lecture Slides, Slides of Economics

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Fixed Exchange Rates and

Foreign Exchange Intervention

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 Yen, it must pay for the Yen with newly printed dollars. Therefore, the US money supply ( M US) must increase

Central Bank Intervention

and the Money Supply

• Any central bank sale of assets automatically

causes the money supply to decrease.

• Example: If the Fed sells its Yen reserves, the dollars paid by the buyer will no longer be in circulation. Therefore, the US money supply ( M US) must decrease
• In short, a country’s reserves of foreign

currencies moves in the same direction as its

money supply

Central Bank Intervention

and the Money Supply

How Can Central Banks Keep Exchange Rates

Fixed?

• On the other hand, when the value of the dollar

starts to rise against the euro (that is, E starts to

fall ), a central bank (such as the US Fed) could

pull it back down

• How? The Fed could buy euros with freshly

printed dollars.

• This will create an shortage of euros and a flood of dollars and thereby reverse the rise in the dollar’s value.
• Recall from the last slide that this increase in US reserves of Euros must be accompanied by an increase in US money supply.

How Can Central Banks Keep Exchange

Rates Fixed?

• To summarize, a central bank can
  • raise the value of the domestic currency ( E ↓) by reducing the money supply ( M s↓)
  • reduce the value of the domestic currency ( E ↑) by increasing the money supply ( M s↑)
• In this way, the central bank can keep the

exchange rate fixed at the desired level, as

long as it does not run out of foreign currency

Goods Market Equilibrium

• Equilibrium is achieved in the goods market

when the value of output Y equals aggregate

demand D.

Y = D ( EP */ P , Y – T , I , G )

• Note that P * and P are fixed in the short run, that T , I , and G are exogenous and fixed, and that E is fixed: after all, this is a fixed exchange rate system!
• So, only Y can vary and only Y can ensure goods market equilibrium
• Therefore, this equation determines the

equilibrium value of Y.

Goods Market Equilibrium

• We saw in Chapter 17 that
  • the goods market’s equilibrium equation gives us the upward rising DD curve, and that
  • 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

Goods Market Equilibrium

Y

I , G + T - C (other reasons) + CA (other reasons) +

Note that an increase in the (fixed) value of the foreign currency raises output. Such a policy— which could be very useful in a recession—is called a devaluation. Among the “ CA (other reasons)” factors would be tariffs or other protectionist policies. The theory suggests that such policies could also help boost output … so long as other countries don’t retaliate.

Goods Market Equilibrium

Goods Market Equilibrium

Goods Market Equilibrium

Y CA

I , G + − T − + C (other reasons) + + CA (other reasons) + +

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.

Monetary Policy Is Useless in a Fixed

Exchange Rate System

• Under a fixed exchange rate, central bank

monetary policy tools are powerless to affect

the economy’s money supply or its output.

The DD and AA curves: recap

• Although Chapter 17 was about the flexible

exchange rate system, the DD and AA curves

introduced there continue to apply to the

discussion of fixed exchange rates.

• Just remember what we saw a few slides

earlier: E can be increased (decreased) by

increasing (decreasing) M s