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Fixing in practice


									    Chapter 17: outline
•   Fixing: central bank balance sheets and
•   Implications in the AA-DD model for E and Y
•   Policy analysis—monetary and fiscal

•   Policy analysis—devaluation
•   Sterilization—can it work?
•   What causes crises?
•   Fixed exchange rate regimes in practice:
•   – Gold-standard versus reserve-currency
                   Chapter 17: motivation
    Who fixes?
•   Managed floaters
    – Light intervention. Sometimes called “dirty floating” as
    opposed to “clean floating.”
•   Regional currency arrangements
    – On the rise. Countries in a region may seek to jointly peg
    with their neighbors’ currencies (e.g. to promote trade and
•   Developing countries
    – Here some kind of “fear of floating” (why?) has convinced
    most countries to try to maintain a peg (commonly to $).
•   Understanding past lessons for the future
    – A return to the gold standard?

•   Why do countries do this? What are the costs and benefits
    of a fixed exchange rate?
    Theory: We do not need to develop a whole set of new
    models to describe this scenario.
    We just need to re-interpret our existing models wisely.
    Central bank operations: foreign assets
•   What if central bank sells $100 in foreign assets to a
    private buyer?
    – If buyers pays in cash (domestic currency) then
    currency in circulation will fall
    – If buyer pays by check, this will be cashed by central
    bank against its deposits of the private bank, and then
    the private bank will deduct the amount from the
    checking deposit.
    – Either way balance sheet shrinks, and M1 falls.

    Foreign assets $900       Deposits of
                              Private banks $500 (400)
    Domestic assets $1500     Currency in circulation
                              $1900 (2000)
                How do central banks fix E?
•   They have to stand ready to buy and sell ForEx for
    domestic currency at fixed E.
•   Suppose this is credible. If so, it must be consistent
    with asset market equilibrium.
•   Remember the asset approach, and UIP:
                    R = R* + (Ee – E ) / E
•   Now the last term vanishes and interest parity under
    fixed rates becomes very simple indeed!
•   It is now clear what central bank has to do. To ensure
    E is fixed requires central bank to hold R=R* .
•   But we know that R is determined in the domestic
    money market and there is a unique level of Ms that
    allows this. Interesting consequences…
    Money Market Equilibrium under a Fixed
                 Exchange Rate

                    Ms/P = L(R*,Y)

•   To hold the exchange rate fixed , the central bank
    must adjust the money supply so the money market is
    in equilibrium when R = R*
•   Let’s look at an example: Central bank fixes exchange
    rate and the asset market is initially in equilibrium.
    Suddenly output hold exchange rate fixed –
    restore asset market equilibrium at that rate (R*).
•   Question: What are the monetary measures to keep
    exchange rate constant?
              Fixing: the bottom line
•   Central bank has to ensure E = E0 and
    hence R = R*.
•   Thus it loses all control over M. M has to
    be at the unique level that allows the
    asset market to clear as above.
•   Apply the AA-DD model:
•   Monetary policy isn’t just weak—it is
•   But fiscal policy now becomes very
    powerful indeed.
         Another policy option: devalue

•   Suppose economy slumps, E is pegged, govt.
    has no fiscal policy tools (can’t borrow). What
    then? Devalue or sterilize. Can either work?
•   Central bank could decide to abandon the peg
    at E = E0 and declare a new peg at E = E1 ,
    where E1 > E0.
•   Is this expansionary in short run? In long run?
    – In short run yes: we move along DD. How?
•   What happens to the asset market?
    – AA must shift out automatically.
•   Can you see any problems with this?
•   Why not devalue every year? week?
          A maligned option: can sterilization work?
•   On the face of it sterilization does nothing:
    – Bank sells foreign assets, M1 falls
    – Bank simultaneously buys same quantity domestic assets
    (OMO) and M1 rises, back to original level.
•   In our model this ForEx sale is pointless. M has not
    changed, so the AA-DD equilibrium is unchanged. E
    doesn’t change!
    – Policy is futile. So why do banks do it so often?

      Foreign assets $900     Deposits of
                              Private banks $500
      Domestic assets         Currency in circulation
      $1600                   $2000
    Can sterilization work?

•   Why does sterilization fail in our model?
    – Assumed perfect asset substitutability between
    domestic and foreign interest bearing assets: UIP
    implies both pay R=R*.
    – So swapping of such assets with the public achieves
    nothing and UIP holds.
•   Is this realistic? Recall risk-adjusted
      UIP: R = R* + (Ee – E ) / E + RP
    – Under a fix, exchange rate term still vanishes. But
 now risk premium can allow R and R* to diverge.
•   Sterilization might work if sale (purchase) of foreign
    (domestic) assets by central bank raises (lowers) risk
    on the such assets in the market, allowing R < R*.
•   ρ = RP falls " ceteris paribus, E falls….
      Evidence on the effects of sterilized
•   Ambiguous:
    - Little evidence has been found that
    sterilized intervention is a major factor
    influencing exchange rates.
    - However there is a considerable
    evidence against the view that bonds are
    perfect substitutes.
    - So it is still a good research subject…..
•   Until now we assumed that the participants in
    foreign exchange market believe that the fixed
    exchange arte can be maintain forever.
•   In many situations central banks may find
    undesirable to maintain fixed exchange rate:
    running short on foreign reserves, high
    unemployment (needs a devaluation)
•   The market belief that the exchange rate might
    change leads to a balance of payments crisis
    – due to the expectations about the future
    exchange rate.
•   Next: how do balance of payments crises occur
    under fixed exchange arte regime?
    Balance of Payments Crises (or the dangers of

•   Can a government sterilize at will forever? There must
    be a limit you might think, to how long it can buy
    domestic bonds (OMO) and sell ForEx, and keep M
    stable under fixed E.
    – You might think that limit is when ForEx reserves hit
    zero. Then we have to float, no?
•   In an important model Paul Krugman (1979) showed
    that a crisis will occur much sooner and will be
•   Called a model of speculative attack.
•   Captures some features of real world BoP crises (but
    not all).
•   Illustrates dangers of sterilization when the economy’s
    fundamentals are a problem.
        Standard Method for Crisis Prevention

•   Suppose markets suspect you will devalue at some
    future date.
    – You face a new future expected exchange rate, and
    implied future depreciation means you must offer a
    higher R to maintain UIP under the fixed E.
•   Temporarily, at least, you have to raise the domestic
    interest rate R by cutting the money supply M. Do
    ForEx sales (“capital flight”).
    – For given CA, private non-reserve FA is in outflow.
•   The “interest rate defense”—and it can work.
    – But not painless. E,g interest rates sometimes reach
    100%+. Such pain forced UK Italy and Sweden out of
    the ERM in 1992. Similar issues in Mexico 1994, Asia
    1997, Argentina 2001.
    Mexico 1994 Balance of Payments Crisis

1987 – Mexico limits peso’s movements against the dollar
    (in order to limit inflation)
March 1994 – slowdown in economic growth +
    assassination of the ruling political party presidential
    Investors fear that government might sharply devalue
    – peso interest rate raised while foreign reserves
    declined dramatically

November 1994 – second political assassination and
   inauguration of new president – increase in
   devaluation expectation leads to another interest rate
   jump and complete exhaustion of the country’s foreign
    What causes currency crises?

- government that follows policies which are not consistent
     with maintaining fixed exchange arte over the long run
     – interest rate is pushed up
Ex: central bank buys bonds from the domestic government
     to allow the government to run fiscal deficits – central
     bank loses foreign reserves – it might find itself without
     means to support the exchange rate. The interest rate
     rises until the central bank runs out of foreign reserves
     and the fixed exchange rate is abandoned.
Special case: The collapse of the currency peg can be
     causes by a sharp speculative attack – currency
     traders acquire all of the central bank remaining
     foreign reserves
    What causes currency crises?

- Self-fulfilling crises: an economy can be vulnerable to
     currency speculation without the previous scenario.
Ex: Consider an economy in which domestic commercial
     bank liabilities are short term deposits likely to be
     unpaid in the event of a recession.
    If speculators suspect will be a devaluation interest
     rates climb raising banks’ borrowing costs.
To prevent collapse central bank lend money to banks,
     losing foreign reserves and possibly losing its ability to
     peg the exchange rate.
This case: the devaluation expectations among
     currency traders pushes the economy into crisis
     and forces the exchange rate to be changed.
      Fixing in practice: reserve currency system

•   One type, seen after WWII until early 1970s, is the
    reserve currency system. Countries tie exchange
    rate to one central (“key”) currency. In that case US$.
•   There are N countries, and N(N–1)/2 exchange rates
    but only N–1 officially pegged rates.
•   All other N(N–1)/2–N bilateral “cross” rates are fixed
    via triangular arbitrage trades through the US$.
•   In all N–1 countries other than the U.S., the monetary
    authority has given up autonomy. (Assuming capital
    mobility and hence UIP.)
•   But the U.S. still reserves the right to have an
    exogenous monetary policy! This reflects the
    asymmetry of the Reserve Center.
•   Faces no adjustment burden, may inflate/deflate. And
    such policy will be “exported” to others. This can lead
    to policy disputes as we shall see, e.g. 1973 (Ch. 18)
       Fixing in practice: gold standard system

•   An alternative is the gold standard system.
•   Countries tie currency to gold (e.g., $/oz, £/oz).
•   There are N countries, N officially gold parities.
•   All N(N–1)/2 bilateral “cross” rates are fixed via
    triangular arbitrage trades through gold parities.
•   Example: Gold standard was de jure established in
    U.S. on March 14, 1900 at 1 U.S. dollar = 1504.656
    milligrams of fine gold. Since June 22, 1816, 1 pound =
    7322.454 mg/gold. Implied E = 4.86653 $/£.
•   All countries give up monetary autonomy, all adjust.
    E.g.,if UK expands M, depositors run to $ via gold.
•   Drawbacks? Restricts excessive inflation (but what if
    gold is discovered?). Can’t fight unemployment.
•   Gold standard endured until the 1930s. Now a relic?

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