VIEWS: 0 PAGES: 24 POSTED ON: 2/23/2013
Chapter 17: outline Recap: • Fixing: central bank balance sheets and intervention • Implications in the AA-DD model for E and Y • Policy analysis—monetary and fiscal Discuss: • Policy analysis—devaluation • Sterilization—can it work? • What causes crises? • Fixed exchange rate regimes in practice: • – Gold-standard versus reserve-currency systems 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 integration). • 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! R=R* • 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 rises...to 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 nonexistent. • 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? versus 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 intervention: • 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 sterilization?) • 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 precipitous. • 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. versus 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 candidate. 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 reserve. 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?
Pages to are hidden for
"Fixing in practice"Please download to view full document