Chapter 23
Internal and External Balance with Fixed Exchange Rates
Overview
This chapter presents the analysis of the macroeconomy of a country that has a fixed exchange
rate. As noted in the introduction, this analysis is important because some countries currently
have fixed exchange rates or floating rates that are so heavily managed that they resemble fixed
rates, and because there are ongoing discussions of proposals to return to a system of fixed rates
among the world’s major currencies. We focus on defense of the fixed exchange rate through
official intervention in the foreign exchange market.
To see the effects of defense through intervention, it is useful to describe the balance sheet of the
country’s central bank. The central bank holds two types of assets relevant to our discussion—
official international reserve assets (R) and domestic assets (D). Its two relevant liabilities are
domestic currency and deposits that (regular) banks place with the central bank. These two
liabilities are the country’s monetary base. With fractional reserve banking by regular banks, the
country’s money supply can be a multiple of the size of its base of “high-powered money.”
When the country has an official settlements balance surplus, and its central bank intervenes to
prevent its currency from appreciating, the central bank must sell domestic currency and buy
foreign currency. This increases the central bank’s holdings of official reserves and increases its
liabilities as the domestic currency is added to the economy. The domestic money supply
increases, probably by a multiple of the size of the intervention. If the money supply expands,
then in the short run interest rates decrease. The financial account tends to deteriorate, and the
increase in real spending and income increases the demand for imports, so the current account
balance also tends to decrease. The overall payments surplus decreases. This is pictured as a
downward shift in the LM curve toward a triple intersection of the new LM curve and the initial
IS and FE curves. (In addition, the price level is likely to increase, at least beyond the short run,
so that the current account also deteriorates as the country loses some international price
competitiveness.) Intervention to prevent a currency from depreciating (in the face of an overall
payments deficit) causes the opposite changes.
Rather than allowing these automatic adjustments toward external balance, the monetary
authority can resist by sterilization—taking an offsetting domestic action (like an open market
operation) to reduce or eliminate the effect of the intervention on the domestic money supply.
This is a wait-and-see strategy. There are limits to how long the country can continue to run an
overall payments imbalance. A key implication of this discussion is that a fixed exchange rate
greatly constrains a country’s ability to pursue an independent monetary policy, because the
monetary policy must be consistent with maintaining the fixed rate.
A change in fiscal policy has two opposing effects on the country’s overall payments balance. For
instance, a shift to expansionary fiscal policy tends to increase both interest rates and real GDP,
so the financial account tends to improve while the current account tends to deteriorate. If the
former predominates, then the country’s overall payments tend to go into surplus. If not
sterilized, the intervention to defend the fixed exchange rate expands the domestic money supply,
further expanding demand, domestic product, and income. In this case fiscal policy gains
effectiveness to change real GDP. If the latter effect is larger (as it may be after a short period of
time), then the opposite occurs. Both cases are shown as a shift first in the IS curve, with the
position of the new IS-LM intersection being above or below the FE curve, depending on how
steep or flat the FE curve is. The intervention then shifts the LM curve to a new triple
intersection.
In the extreme case of perfect capital mobility (with investors expecting the fixed rate to be
maintained), monetary policy has no independent effectiveness even in the short run, while fiscal
policy has a strong (full spending multiplier) effect on real GDP. The FE curve is a flat line, and
the LM curve is effectively this same flat line.
We can examine how shocks affect the economy of a country with a fixed exchange rate. A
domestic monetary shock has a limited effect. A change in fiscal policy is an example of a
domestic spending shock. An international capital flow shock shifts the FE curve. The
intervention to defend the fixed exchange rate results in effects on the domestic economy.
International trade shocks tend to cause payments imbalances that require intervention that
changes the domestic money supply in the way that magnifies the effect of the shock on real
GDP.
Countries often face both external and internal imbalances. Two combinations (high
unemployment-payments surplus and excessive inflation-payments deficit) can be addressed
with a change in government policy (expansionary or contractionary) but the other two seem to
pose dilemmas. A possible short-run solution is a monetary-fiscal policy mix that follows the
assignment rule. The change in monetary policy should address the external imbalance and the
change in fiscal policy should address the internal imbalance. In practice countries often find it
difficult or impossible to apply the assignment rule.
In the face of a payments imbalance, a country’s government that is not willing to adjust
domestic policies and the domestic economy may conclude that surrendering—changing or
abandoning the fixed exchange rate—is best. For instance, with an overall payments deficit the
country could devalue its currency. The devaluation should improve international price
competitiveness, so net exports increase. This tends to decrease the payments deficit, and also to
increase demand and domestic product. We can picture this as a rightward shift of the FE and IS
curves. A key challenge for the country is to prevent the devaluation and the subsequent increase
in demand from causing so much inflation that it eliminates the gain in price competitiveness.
The effect of a large, abrupt change in the exchange rate on the value of the country’s current
account (or trade) balance is not so straightforward. The value of the country’s current account,
measured in foreign currency (fc), is CA = Pfcx X PfcmM. The effects of a devaluation of the
country’s currency are: (1) no change or decrease in the foreign currency price of its exports
(Pfcx), (2) no change or increase in the volume of exports (X), (3) no change or decrease in the
foreign currency price of its imports (Pfcm), and (4) no change or decrease in the volume of
imports (M). The response of the trade balance could be unstable (that is, the value of the balance
could decline rather that improve) if the decrease in the foreign currency price of exports is large
relative to the other changes—an extreme example is perfectly inelastic demands for exports and
imports. The response will generally be stable (the balance will improve), at least if we allow
enough time, because sufficiently high elasticities result in large enough changes in the trade
volumes. One extreme example is the small-country case in which foreign elasticities are infinite
so that foreign currency prices are fixed. (Appendix H derives a general formula relating demand
and supply elasticities to the change in the value of the current account. It also discusses specific
cases and the Marshall-Lerner condition.)
We generally expect that the trade balance deteriorates at first, because the price changes occur
quickly while trade quantities change more slowly. After a moderate time period, the volume
effects become large enough that the balance improves. In this case the response of the current
account balance to a devaluation of the country’s currency traces out a pattern called the J curve.
Tips
The text includes the t-account showing the relevant assets and liabilities of a central bank. In
class presentations an instructor may want explicitly to use t-accounts to show the changes in
assets and liabilities that accompany unsterilized intervention and sterilized intervention.
The analysis of each policy change or economic shock is deliberately presented first using
schematics and words, and only then using the IS-LM-FE graph. Our goal is to impart the
process of thinking logically about international macroeconomics. We believe that the graph is a
great tool for organizing thinking, but it is not a substitute for understanding the logic of the
relationships. Indeed, some instructors may wish to make the IS-LM-FE graphs optional if these
are inappropriate for the preparation of the students and the objectives of the class. We believe
that it is possible to present this material using both class discussion and the text while indicating
to students that the IS-LM-FE graphs are not required and will not be tested.
The box on “A Tale of Three Countries” provides an application of the fixed-rate analysis to the
experiences during the early 1990s of Germany, France, and Britain in the Exchange Rate
Mechanism of the European Monetary System. Germany, the lead country, focused its policies
on domestic performance issues arising from German unification. France successfully defended
the pegged rate of the franc to the mark, but at substantial costs in terms of domestic
macroeconomic performance. Britain surrendered and the depreciation of the pound permitted
the British economy to reduce its unemployment rate, even as the rate in France and Germany
continued to rise.
Appendix G uses the aggregate demand-aggregate supply framework to examine some of the
same issues analyzed using the IS-LM-FE model. In the presentation in Appendix G, the
aggregate demand curve incorporates the effects of any unsterilized intervention to defend the
fixed exchange rate. In addition to the four types of shocks analyzed in the text and a
devaluation, Appendix G also examines shocks to aggregate supply.