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Fixed exchange rates and intervention on the foreign exchange market

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What are the features and benefits of the fixed exchange rate regime?

Under a fixed exchange rate regime, can the central bank still pursue an autonomous monetary policy?

What role for fiscal policy?

What happens if the central bank is unable to guarantee exchange rate parity?

The fixed exchange rate regime[edit | edit source]

Fixed exchange rates[edit | edit source]

Situations in which a country's exchange rate fluctuates little or not at all (administered fluctuations) against a base foreign currency = the government intervenes continuously to try to maintain parity → continuous interventions.

Source: Feenstra&Taylor, 2008

Why study fixed exchange rates?[edit | edit source]

Theoretical comparison with "pure" flexible exchange: advantages and disadvantages.

Historical interest

  • 1870-1914: gold standard (price of currency fixed in terms of gold).
  • 1945-1973: gold exchange standard (price of currency in terms of USD whose parity is defined in terms of gold).

Regional monetary arrangements (European Monetary System, EMS: 1979-1992).

Many developing countries peg their currencies to a "strong" currency (dollar or CFA franc), see the following table.

Since 1973: international monetary system is hybrid = floating exchange rate regime administered in many countries (> that the 3⁄4 of countries), cf. following table.

Details[edit | edit source]

Source: Feenstra&Taylor, 2008

Advantages of the fixed exchange rate[edit | edit source]

More transparent and simple.

More predictable: elimination of exchange rate risks and reduction of transaction costs for importing and exporting companies.

Advantageous for least developed countries where the financial system is not sufficiently developed to hedge against exchange rate risk in the long term.

For countries with weak institutions, and a monetary policy with little credibility (hyper inflation), it allows "importing" the credibility of a stronger central bank.

We will see in this chapter that all this choice depends on the cost of losing the autonomy of monetary policy.

Central bank interventions[edit | edit source]

Central bank balance sheet[edit | edit source]

Operation based on the principle of double writing

Source: Feenstra&Taylor, 2008

ASSETS

  • RI = Foreign currency bonds held by the CB, including gold. Their level changes when the CB intervenes in the foreign exchange market (sale or purchase).
  • A = Domestic or domestic assets. Claims of the CB on domestic institutions or banks. These are government bonds or loans to domestic private banks.

LIABILITIES (= CB's liabilities)

  • CV = Private bank deposits. Private banks hold deposits at BCV to partially cover their own liabilities. This is a commitment on the part of the BC because private banks can withdraw sums from the bank when they need them (private individuals do not hold deposits at the BC: the BC is the "bank of banks").
  • N = Currency in circulation. Commitment for historical reasons (at one time CBs had to hold a certain amount of precious metal - gold or silver) in case citizens wanted to exchange the national currency for gold.

Assumptions:

  • Monetary base:
  • Money supply: (where = money multiplier)

=> any change in the level of assets (including foreign currency) causes a change in the same direction of the money supply

Examples:

  • BC buys an asset (and makes the payment either in cash (increase of ) or by crediting the giro account of the commercial bank concerned (increase of CV) ⇒ ↗ .
  • BC sells an asset (for cash (decrease of ), or by debiting the giro account of the commercial bank concerned (CV decrease) ⇒ ↘.

Interventions on the foreign exchange market[edit | edit source]

Hypothesis: ↗ ⇒ on the money market: ↗ ⇒ ↗ ⇒ on the foreign exchange market: ES of currencies, so tends to ↘.

How do we prevent E? Purchase of currency by the CB ⇒ ↗ ⇒ ↗⇒ ↗ ⇒ ↘ until the interest rate returns to its initial level.

Consequence: intervention on the foreign exchange market leads to a ↗ of (and thus in the long run to a ↗ of ) = loss of monetary policy autonomy in fixed exchange rates.

Source: Feenstra&Taylor, 2008

Mundell's economic trilemma[edit | edit source]

The loss of control of the CB's monetary policy in fixed exchange rates is also known as Mundell's "trilemma" (or "impossible trilemma").

There are three possible policy objectives:

1. Stability in international interactions (fixed exchange rate):

2. Promotion of financial integration and efficiency (full mobility of capital ⇒ PTINC):

3. Economic stabilization policies (autonomy of monetary policy):

Clearly the three objectives cannot coexist and one of them must be sacrificed to achieve the other two.

Source: Feenstra&Taylor, 2008

Stabilization policies[edit | edit source]

Macro Policies in the Short Term[edit | edit source]

NB I: In the following we will make the hypothesis that the fixed exchange rate regime is credible ⇒

⇒ Delta P = Delta P^* = 0</math>

1. Expansionary monetary policy

  • ↗ ⇒ AA ⟶ AA' ⇒ ↗ ⇒ CB intervention
  • Currency sales ⇒ ↘ ⇒ AA' ⟶ AA to its initial position.
  • No impact except on (which ↘).

2. Expansive fiscal policy

  • ↗ ⇒ DD ⟶ DD' ⇒ ↘ ⇒ CB intervention
  • Buying currency ⇒ ⇒ AA ⟶ AA' until is restored.
  • Positive impact on , even more pronounced than with floating exchange rates.

1. Expansionary monetary policy

Économie internationale taux de change fixes et interventions sur le marché politique monétaire expansive 1.png

In the IS-LM model, the displacement of the LM curve is to the right (↗ initial) and return of LM to its initial position (↘ ).

2. Expansionary fiscal policy

Économie internationale taux de change fixes et interventions sur le marché politique budgétaire expansive 1.png

In the IS-LM model, the shift is made to the right of the IS curve (↗) and of the LM curve (↗ ) to keep and constant (no crowding out!).

Macro policies in the long term[edit | edit source]

NB I: In the following we will assume that the fixed exchange rate regime remains credible ⇒

NB II: Long term ⇒

Hypothesis: we start from a long term equilibrium (), then  :

  • Short-term: passage from the point to the point (↗ and ↗).
  • As , ↗ ⇒ AA and DD move left until they cross again at the point .

NB III: in the long term no effect on either or , but real appreciation (as in floating exchange rates).

Économie internationale taux de change fixes et interventions sur le marché politiques macro dans le long terme 1.png

Devaluations and balance of payments crises[edit | edit source]

Devaluation[edit | edit source]

Under a fixed exchange rate regime, the CB loses control of monetary policy, but in reality it has another instrument of intervention in the economic system, which consists of changing the exchange rate itself: devaluation or revaluation of the national currency.

At least in the short term, a devaluation of the national currency is in principle an economic policy instrument to revive the economy and intervene on .

On the other hand, under a fixed exchange rate regime, the CB can be confronted with situations of speculative attacks if the markets lose confidence in its ability to defend parity: self-fulfilling crises and forced devaluations.

Intentional Devaluation[edit | edit source]

Hp: credible CB devaluation ( goes from to

Économie internationale taux de change fixes et interventions sur le marché dévaluation intentionnelle 1.png

Short term: like ↗, AA ⟶ AA' and ↗ immediately to its new value (point ). But, point = ↗ ⇒ ↗ ⇒ ↗ ⇒

⇒ BC intervenes by buying currencies ⇒ (↗⇒ ↗) ⇒ additional shift of AA to the right ⟶ AA⇒ new equilibrium at point  : ↗, ↗,

Long term ⟺ , ↗ ⇒ DD and AA move left (not shown) to intersection at point ⟺ restoring to its long term value.

Forced devaluation[edit | edit source]

Lack of confidence in CB's ability to defend parity. Hypothesis: very low ⇒ ↗ ⇒ demand for foreign assets ↗⇒ AA ⟶ AA' ⇒ tends to ↗.

Économie internationale taux de change fixes et interventions sur le marché dévaluation forcée 1.png

⇒ Sale of foreign exchange by the CB (private agents get rid of their holdings of national currency = capital flight) ⇒ ↘ ⇒ ↘ ⇒ back to the initial point with a rise of .

But: in the meantime, the have decreased! ⇒ This reinforces the devaluation expectations: ↗ ⇒ new loss of ... until the forced devaluation (self-fulfilling crisis).

Summary: fixed exchange rates[edit | edit source]

Économie internationale taux de change fixes et interventions sur le marché résumé changes fixes 1.png
Économie internationale taux de change fixes et interventions sur le marché résumé changes fixes 2.png

Annexes[edit | edit source]

References[edit | edit source]