Chapter 18 Global Edition Fixed Exchange Rates and Foreign Exchange Intervention International Economics THEORY POLICY Ninth Edibon Paul R.Krugman Maurlce Obstfeld Marc J.Melltz PEARSON PEARSON Copyright 2012 Pearson Education.All rights reserved
Copyright © 2012 Pearson Education. All rights reserved. Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention
Preview Balance sheets of central banks Intervention in the foreign exchange markets and the money supply How the central bank fixes the exchange rate Monetary and fiscal policies under fixed exchange rates Financial market crises and capital flight Types of fixed exchange rates: reserve currency and gold standard systems Copyright 2012 Pearson Education. All rights reserved 18-2
Copyright © 2012 Pearson Education. All rights reserved. 18-2 Preview • Balance sheets of central banks • Intervention in the foreign exchange markets and the money supply • How the central bank fixes the exchange rate • Monetary and fiscal policies under fixed exchange rates • Financial market crises and capital flight • Types of fixed exchange rates: reserve currency and gold standard systems
Introduction Many countries try to fix or peg"their exchange rate to a currency or group of currencies by intervening in the foreign exchange markets Many with a flexible or floatingexchange rate in fact practice a managed floating exchange rate The central bank "manages the exchange rate from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility How do central banks intervene in the foreign exchange markets? Copyright G 2012 Pearson Education. All rights reserved 18-3
Copyright © 2012 Pearson Education. All rights reserved. 18-3 Introduction • Many countries try to fix or “peg” their exchange rate to a currency or group of currencies by intervening in the foreign exchange markets. • Many with a flexible or “floating” exchange rate in fact practice a managed floating exchange rate. – The central bank “manages” the exchange rate from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility. • How do central banks intervene in the foreign exchange markets?
Central Bank Intervention and the money Supply To study the effects of central bank intervention in the foreign exchange markets first construct a simplified balance sheet for the central bank This records the assets and liabilities of a central bank Balance sheets use double-entry bookkeeping each transaction enters the balance sheet twice Copyright 2012 Pearson Education. All rights reserved 18-4
Copyright © 2012 Pearson Education. All rights reserved. 18-4 Central Bank Intervention and the Money Supply • To study the effects of central bank intervention in the foreign exchange markets, first construct a simplified balance sheet for the central bank. – This records the assets and liabilities of a central bank. – Balance sheets use double-entry bookkeeping: each transaction enters the balance sheet twice
Central bank's balance Sheet Assets Liabilities Foreign Assets(official Deposits of domestic banks international reserves) Currency in circulation Foreign government bonds Foreign currency deposits Gold (official international reserves Domestic assets Domestic government bonds Loans to domestic banks Copyright 2012 Pearson Education. All rights reserved
Copyright © 2012 Pearson Education. All rights reserved. Central Bank’s Balance Sheet Assets Liabilities ◼ Foreign Assets (official international reserves) ◼ Foreign government bonds ◼ Foreign currency deposits ◼ Gold (official international reserves) ◼ Domestic Assets ◼ Domestic government bonds ◼ Loans to domestic banks ◼ Deposits of domestic banks ◼ Currency in circulation
Central Bank's Balance sheet(cont) o Assets= Liabilities Net worth If we assume that net worth is constant then An increase in assets leads to an equal increase in liabilities a decrease in assets leads to an equal decrease in liabilities Changes in the central bank's balance sheet lead to changes in currency in circulation or changes in deposits of banks which lead to changes in the money supply. Copyright G 2012 Pearson Education. All rights reserved 18-6
Copyright © 2012 Pearson Education. All rights reserved. 18-6 Central Bank’s Balance Sheet (cont.) • Assets = Liabilities + Net Worth – If we assume that net worth is constant, then • An increase in assets leads to an equal increase in liabilities. • A decrease in assets leads to an equal decrease in liabilities. • Changes in the central bank’s balance sheet lead to changes in currency in circulation or changes in deposits of banks, which lead to changes in the money supply
Assets, Liabilities, and the money Supply a purchase of any asset by the central bank will be paid for with currency or a check written from the central bank both of which are denominated in domestic currency, and both of which increase the supply of money in circulation The transaction leads to equal increases of assets and liabilities When the central bank buys domestic bonds or foreign bonds the domestic money supply Increases Copyright G 2012 Pearson Education. All rights reserved 18-7
Copyright © 2012 Pearson Education. All rights reserved. 18-7 Assets, Liabilities, and the Money Supply • A purchase of any asset by the central bank will be paid for with currency or a check written from the central bank, – both of which are denominated in domestic currency, and – both of which increase the supply of money in circulation. – The transaction leads to equal increases of assets and liabilities. • When the central bank buys domestic bonds or foreign bonds, the domestic money supply increases
Assets, Liabilities, and the money supply (cont) a sale of any asset by the central bank will be paid for with currency or a check written to the central bank both of which are denominated in domestic currency. The central bank puts the currency into its vault or reduces the amount of deposits of banks, causing the supply of money in circulation to shrink. The transaction leads to equal decreases of assets and liabilitⅰes. When the central bank sells domestic bonds or foreign bonds the domestic money supply decreases Copyright G 2012 Pearson Education. All rights reserved 18-8
Copyright © 2012 Pearson Education. All rights reserved. 18-8 Assets, Liabilities, and the Money Supply (cont.) • A sale of any asset by the central bank will be paid for with currency or a check written to the central bank, – both of which are denominated in domestic currency. – The central bank puts the currency into its vault or reduces the amount of deposits of banks, – causing the supply of money in circulation to shrink. – The transaction leads to equal decreases of assets and liabilities. • When the central bank sells domestic bonds or foreign bonds, the domestic money supply decreases
Example: Central Bank Balance Sheet Assets Liabilities Foreign assets $1,000 Deposits held by private banks $500 Domestic assets $1,500 Currency in circulation 2,000 Central Bank Balance Sheet After $100 Foreign Asset Sale(Buyer Pays with Currency) Assets Liabilities Foreign assets s900 Deposits held by private banks S500 Domestic assets 1,500 Currency in circulation 1,900 Copyright 2012 Pearson Education. All rights reserved 18-9
Copyright © 2012 Pearson Education. All rights reserved. Example: 18-9
Sterilization Because buying and selling of foreign bonds in the foreign exchange markets affects the domestic money supply a central bank may want to offset this effect This offsetting effect is called sterilization If the central bank sells foreign bonds in the foreign exchange markets(reduce the money supply it can buy domestic government bonds in bond markets(increase the money supply -hoping to leave the amount of money in circulation unchanged Copyright G 2012 Pearson Education. All rights reserved 18-10
Copyright © 2012 Pearson Education. All rights reserved. 18-10 Sterilization • Because buying and selling of foreign bonds in the foreign exchange markets affects the domestic money supply, a central bank may want to offset this effect. • This offsetting effect is called sterilization. • If the central bank sells foreign bonds in the foreign exchange markets (reduce the money supply), it can buy domestic government bonds in bond markets (increase the money supply)—hoping to leave the amount of money in circulation unchanged