978-0134519579 Chapter 18

Chapter 18

Fixed Exchange Rates and

Foreign Exchange Intervention

■ Chapter Organization

Why Study Fixed Exchange Rates?

Central Bank Intervention and the Money Supply.

The Central Bank Balance Sheet and the Money Supply.

Foreign Exchange Intervention and the Money Supply.

Sterilization.

The Balance of Payments and the Money Supply.

How the Central Bank Fixes the Exchange Rate.

Foreign Exchange Market Equilibrium under a Fixed Exchange Rate.

Money Market Equilibrium under a Fixed Exchange Rate.

A Diagrammatic Analysis.

Stabilization Policies with a Fixed Exchange Rate.

Monetary Policy.

Fiscal Policy.

Changes in the Exchange Rate.

Adjustment to Fiscal Policy and Exchange Rate Changes.

Balance of Payments Crises and Capital Flight.

Managed Floating and Sterilized Intervention.

Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention.

Case Study: Can Markets Attack a Strong Currency? The Case of Switzerland.

Foreign Exchange Market Equilibrium under Imperfect Asset Substitutability.

The Effects of Sterilized Intervention with Imperfect Asset Substitutability.

Evidence on the Effects of Sterilized Intervention.

Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention 131

Reserve Currencies in the World Monetary System.

The Mechanics of a Reserve Currency Standard.

The Asymmetric Position of the Reserve Center.

The Gold Standard.

The Mechanics of a Gold Standard.

Symmetric Monetary Adjustment under a Gold Standard.

Benefits and Drawbacks of the Gold Standard.

Bimetallic Standard.

The Gold Exchange Standard.

Case Study: The Demand for International Reserves.

Summary

APPENDIX 1 TO CHAPTER 18: Equilibrium in the Foreign-Exchange Market with Imperfect Asset

Substitutability.

Demand.

Supply.

Equilibrium.

APPENDIX 2 TO CHAPTER 18: The Timing of Balance of Payments Crises.

Online Appendix: The Monetary Approach to the Balance of Payments.

■ Chapter Overview

Open-economy macroeconomic analysis under fixed exchange rates is dual to the analysis of flexible

exchange rates. Under fixed exchange rates, attention is focused on the effects of policies on the balance of

payments (and the domestic money supply), taking the exchange rate as given. Conversely, under flexible

exchange rates with no official foreign-exchange intervention, the balance of payments equals zero, the

money supply is a policy variable, and analysis focuses on exchange rate determination. In the

intermediate case of managed floating, both the money supply and the exchange rate become, to an extent

that is determined by central bank policies, endogenous.

This chapter analyzes various types of monetary policy regimes under which the degree of exchange-rate

flexibility is limited. The reasons for devoting a chapter to this topic, more than 30 years after the

breakdown of the Bretton Woods system, include the prevalence of managed floating among industrialized

countries, the common use of fixed exchange rate regimes among developing countries, the existence of

regional currency arrangements such as the Exchange Rate Mechanism through which some European

nations peg to the euro, the recurrent calls for a new international monetary regime based upon more

132 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition

aggressive exchange-rate management, and the irrevocably fixed rates among countries that use the euro (a

topic addressed in depth in Chapter 20).

The chapter begins with an analysis of a stylized central bank balance sheet to show the link between the

balance of payments, official foreign-exchange intervention, and the domestic money supply. Also

described is sterilized intervention in foreign exchange, which changes the composition of interest-bearing

assets held by the public but not the money supply. This analysis is then combined with the exchange rate

determination analysis of Chapter 15 to demonstrate the manner in which central banks alter the money

supply to peg the nominal exchange rate. The endogeneity of the money supply under fixed exchange rates

emerges as a key lesson of this discussion.

The tools developed in Chapter 17 are employed to demonstrate the impotence of monetary policy and the

effectiveness of fiscal policy under a fixed exchange rate regime. The short-run and long-run effects of

devaluation and revaluation are examined. The setup already developed suggests a natural description of

balance of payments crises as episodes in which the public comes to expect a future currency devaluation.

Such an expectation causes private capital flight and, as its counterpart, sharp official reserve losses.

Different explanations of currency crises are explored, both those that argue that crises result from

inconsistent policies and those that maintain crises are not necessarily inevitable but instead result from

self-fulfilling expectations. (See Appendix 2 to this chapter for a more detailed analysis.)

Equipped with an understanding of the polar cases of fixed and floating rates, the student is in a position to

appreciate the more realistic intermediate case of managed floating. The discussion of managed floating

focuses on the role of sterilized foreign-exchange intervention and the theory of imperfect asset

substitutability. The inclusion of a risk premium in the model enriches the analysis by allowing

governments some scope to run independent exchange rate and monetary policies in the short run. The

chapter reviews the results of attempts to demonstrate empirically the effectiveness of sterilized foreign–

exchange operations that, however, are generally negative. Also discussed is the role of central bank

intervention as a “signal” of future policy actions and the credibility problems entailed by such a strategy.

The case study at the end of the chapter considers how the need for reserves in a crisis—and the potential

difficulty of acquiring them during one—leads to a strong incentive to hold reserves in a precautionary

manner if they want to cushion a balance of payments crisis.

At this point, the discussion abandons the small country framework in favor of a systemic perspective to

discuss the properties of two different fixed exchange rate systems: the reserve-currency systems and the

gold standards. A key distinction between these systems is the asymmetry between the reserve center and

the rest of the world compared to the symmetric adjustment among all countries under the gold standard. It

is shown that this asymmetry gives the reserve center exclusive control over world monetary conditions (at

Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention 133

least when interest parity links countries’ money markets).

The chapter ends with a discussion of the pros and cons of the gold standard and the gold-exchange

standard. Appendix 1 presents a more detailed model of exchange rate determination with imperfect asset

substitutability. Appendix 2 provides an analysis of the timing of balance of payments crises. One online

appendix describes the monetary approach to the balance of payments and its usefulness as a tool of policy

analysis, and another considers liquidity traps.

■ Answers to Textbook Problems

1. An expansion of the central bank’s domestic assets leads to an equal fall in its foreign assets, with no

change in the bank’s liabilities (or the money supply). The effect on the balance-of-payments

2. An increase in government spending raises income and also money demand. The central bank

3. A one-time unexpected devaluation initially increases output; the output increase, in turn, raises

money demand. The central bank must accommodate the higher money demand by buying foreign

134 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition

4. As shown in Figure 18-1, a devaluation causes the AA curve to shift to A′A′, which reflects an

expansion in both output and the money supply in the economy. Figure 18-1 also contains an XX

Figure 18-1

5. Exchange rate stability may be preferred to monetary policy autonomy for several reasons. First, a

country with a history of high inflation may need to commit to a fixed exchange rate regime to get

inflation under control. This is most often seen in countries without independent central banks that

use monetary policy as a means of supporting expansionary fiscal policy. Second, a reduction in

Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention 135

exceed any gain from exchange rate stability.

6. By raising output, fiscal expansion raises imports and thus worsens the current account balance. The

7. The reason that the effects of temporary and permanent fiscal expansions differ under floating

exchange rates is that a temporary policy has no effect on the expected exchange rate while a

8. By expanding output, a devaluation automatically raises private saving because part of any increase

in output is saved. Government tax receipts rise with output, so the budget deficit is likely to decline,

9. An import tariff raises the price of imports to domestic consumers and shifts consumption from

136 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition

The fall in imports for one country implies a fall in exports for another country, and a corresponding

inward shift of that country’s DD curve necessitating a monetary contraction by the central bank to

10. If the market expects the devaluation to “stick,” the home nominal interest rate falls to the world level

afterward, money demand rises, and the central bank buys foreign assets with domestic money to

prevent excess money demand from appreciating the currency. The central bank thus gains official

11. If the Bank of Japan holds U.S. dollars instead of Treasury bills, the adjustment process is symmetric.

Any purchase of dollars by the Bank of Japan leads to a fall in the U.S. money supply as the dollar

12. A central bank that is maintaining a fixed exchange rate will require an adequate buffer stock of

foreign assets on hand during periods of persistent balance of payments deficits. If a central bank

Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention 137

13. An ESF intervention to support the yen involves an exchange of dollar-denominated assets initially

owned by the ESF for yen-denominated assets initially owned by the private sector. Because this is

14. With imperfect asset substitutability, a central bank can change the domestic interest rate without

affecting the exchange rate. For example, if the central bank wants to lower the domestic interest rate,

138 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition

15.

Assets

Liabilities

FA: 900

Deposits held by banks: 400

DA: 1500

Currency: 2000

The central bank’s foreign assets still drop, and consequently, liabilities must still drop, also. In this

16. Yes, there is some room within a target zone for domestic interest rates to move independently of the

foreign rate. For a one-year rate, we might see that when R* rises 1%, the home currency depreciates

17. In a three-country world, a central bank fixes one exchange rate but lets the others float. It is still

18. Consider an example where France sells domestic assets (DA) for gold. If other central banks want to

hold onto their monetary gold, they will raise interest rates (by selling domestic assets to reduce the

Chapter 18 Fixed Exchange Rates and Foreign Exchange Intervention 139

19. When a country devalues against the reserve currency, the value of its reserves in foreign currency is

unchanged, but the local currency value is now different. A devaluation, where the foreign currency

can now buy more local currency, leads to an increase in the value of reserves measured in local

20. An economy caught in a liquidity trap has an AA curve with a flat section at output levels far below

full-employment output Yf. When the interest rate is equal to zero, then holding the expected

exchange rate fixed, interest rate parity determines the exchange rate as Eh/f = Ee/(1 − Rf). Thus, any

devaluation of the exchange rate, they could conceivably stimulate the economy through monetary

policy. A permanent devaluation, if credible, will change the expected exchange rate. In the diagram

e

E

e

E

140 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition

21. As Switzerland is in a liquidity trap, the AA and DD curve are intersecting along the flat portion of

22. The interest rate parity condition states that RSWI = REU + %ΔESfr/€. When RSWI = 0, this means that the

euro rate of interest must be equal to the expected appreciation of the Swiss franc (depreciation of the