Chapter 19 – Exchange-Rate Policy and the Central Bank
Chapter 19
Exchange-Rate Policy and the Central Bank
Chapter Overview
In this chapter we turn to a discussion of exchange rate regimes and consider the link
between a country’s exchange rate policy and its domestic monetary policy. We will also
examine instances in which exchange rate stabilization becomes the overriding objective
of central bankers, so much so that a decision to fix the exchange rate may be made.
Finally, we turn our attention to instances where a country might give up its currency
entirely.
Learning Objectives: Establish an understanding of:
1. Links between exchange rates and monetary policy
2. Mechanics of exchange‐rate management
3. Costs, benefits, and risks of fixed exchange rates
4. Fixed‐exchange‐rate regimes
Important Points of the Chapter
On most days, policymakers at the Fed and the ECB concentrate on the domestic
economy and let their exchange rates take care of themselves. In small countries, where
exchange rates can have a dramatic impact, central bankers do not have that luxury.
Domestic policy and exchange rate policy are connected, particularly because exchange
rate policy is linked to interest rate policy.
Application of Core Principles
Principle #4: Markets. Arbitrage will cause prices (and interest rates) to equalize across
markets. As a result, free movements of capital across a country’s borders means that if it
wants a fixed exchange rate it must give up domestic monetary policy.
Principle #5: Stability. In developing countries, government officials may try to avert
the crises caused by large movements of capital by imposing inflow controls or outflow
controls.
Principle #4: Markets. In a foreign exchange intervention when the Fed buys foreign
bonds, the supply of dollars changes and U.S. interest rates fall, decreasing the demand
for the dollar. The demand and supply shifts together drive the value of the dollar down.
Principle #5: Stability. Central bank officials in small, emerging market countries may
feel that the best policy is to maintain a predictable value for their currency, and so they
fix the exchange rate.
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Chapter 19 – Exchange-Rate Policy and the Central Bank
Principle #4: Markets. In the summer of 1997, a speculative attack on the Thai currency
(the baht) occurred driving down its value.
Principle #5: Stability. The alternative to flexible, market determined exchange rates are
“hard-peg” systems. However, given the possibility for speculative attack, pegs must
indeed be hard to be sustainable.
Teaching Tips/Student Stumbling Blocks
This chapter focuses on the conditions under which the government might
intervene in the market for foreign currency to influence the exchange rate, which
may enhance economic stability and improve economic welfare. That is, Core
Principles 4 and 5 are used to discuss the advantages and disadvantages of market
intervention by policymakers in order to influence market outcomes and maintain
a fixed exchange rate.
To begin this material you might find it helpful to start with a review of the
material on purchasing power parity from Chapter 10.
Features in this Chapter
Your Financial World: Emerging-Markets Crises and You
If your portfolio is well-diversified, a financial crisis in an emerging market should have
little effect on your investments.
Applying the Concept: Malaysia Imposes Capital Controls
At the end of the 1990’s Malaysia believed that its economy was fundamentally sound
and that its financial crises was similar to a bank panic. Its officials therefore took the
extreme step of implementing strict capital controls, limiting investors’ ability to move
funds out of the country. This also allowed them to fix the value of their currency and
lower domestic interest rates. Though critics condemned the policy, Malaysia recovered
in less than half the time of other countries in crisis.
Applying the Concept: The Gold Standard: An Exchange-Rate Regime Whose Time Has
Passed
Those who advocate a return to the gold standard claim that it would eliminate inflation.
But no economist today advocates a return to the gold standard because it obligates the
central bank to fix the price of something we don’t really care about. There is also the
fact that under the gold standard the amount of money in the economy would depend on
the amount of gold available, and any disruption in supply would have dramatic monetary
policy effects. The case for the gold standard grows less persuasive when we realize that
it is an exchange rate policy too. A country with a trade deficit would lose gold and be
forced into deflation (and the reverse for those with a surplus). Economic historians
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Chapter 19 – Exchange-Rate Policy and the Central Bank
believe that gold played a central role in spreading the Great Depression of the 1930s
throughout the world. It is hard to understand why anyone would want to bring it back.
Lessons from the Crisis: Oasis of Stability
In 2010 and 2011, investors fled to the Swiss franc as a safe haven as they worried that
the euro would break up, causing significant appreciation of the franc. The Swiss
National Bank had no conventional policy tools available to use, as interest rates were
already close to zero. Therefore, the bank issued a statement setting a minimum
exchange rate with the stated aim to protect the Swiss economy and stop the runaway
exchange rate. While this move was controversial, the central bank was resolute and
appears to maintain its credibility.
Applying the Concept: Implications of China’s Exchange Rate Regime
In 2013, the amount of foreign exchange reserves held by China’s central bank reached
$3.3 trillion. The increased reserves reflect China’s sustained current account surpluses.
Their fixed exchange rate regime supported these enormous export surpluses. When a
country runs a current account surplus, it also runs a capital account deficit. This means
that it is either making loans to foreigners or buying their assets. China buys mostly US
securities with its surpluses, making it the leading financier of US debt.
In the News: Phony Currency Wars
Officials from the world’s largest economies met to avert a currency war. America was
first accused of instigating a currency war in 2010 when the Fed bought large amounts of
bonds with newly created money. That made investors flood into emerging markets
seeking better returns and appreciating their currency. The “war” terminology implies
that these actions were intended to boost exports and suppress imports, but the US (and
Japan, who performed the same sort of action) was using an unconventional monetary
tool to stimulate domestic spending and investment.
Lessons of the Article: Global economic weakness puts policymakers on guard
against other countries’ efforts to gain a competitive edge by devaluing their
currencies. In the Great Depression, such “beggar thy neighbor” policies
triggered protectionism. Since the financial crisis, however, major central
banks emphasize that their stimulative policies aim to restore domestic
spending, with currency depreciation a side effect of monetary expansion.
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Chapter 19 – Exchange-Rate Policy and the Central Bank
Additional Teaching Tools
An February, 2010 article in Business Week entitled “Australia’s Stevens Waits for
World’s Central Banks” describes the unexpected move by Australia’s Central Bank
president to leave the overnight cash rate target the same, giving that economy a chance
to absorb a record number of increases in the rate and the rest of the world a chance to
catch up
(http://www.businessweek.com/globalbiz/content/feb2010/gb2010023_321423.htm). The
news decreased the value of Australia’s currency. The higher rates in Australia following
the increases in the overnight cash rate caused an increase in the demand for Australian
currency as investors sought higher yielding assets. Glen Stevens noted that other central
banks can take some time to determine when they would begin raising rates as economies
around the world began improving.
A December 27, 2013, article in the Wall Street Journal indicates that investors believe
that a reduction in the Fed’s easy money policies would appreciate the dollar over 2014.
http://online.wsj.com/news/articles/SB10001424052702304753504579282492121733158
?KEYWORDS=exchange+rates
Virtual Tools
Visit the IMF on the web at:
http://www.imf.org/
Who favors a return to the gold standard? Read this article by well-known economist
Paul Krugman:
http://web.mit.edu/krugman/www/goldbug.html
Here’s a great site with lots of links to more material on currency boards and
dollarization:
http://www.dollarization.org/
For More Discussion
What is more important to consumers, the exchange rate or the interest rate? Have
students assess the impact of each on their own spending and investments. Students may
be surprised to find out how much of what they purchase is imported.
Chapter Outline
I Linking Exchange-Rate Policy with Domestic Monetary Policy
A. Inflation and the Long-Run Implications of Purchasing Power Parity
1. The law of one price says that identical goods should sell for the same price
regardless of where they are sold.
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Chapter 19 – Exchange-Rate Policy and the Central Bank
2. The concept of purchasing power parity extends the logic of the law of one
price to a basket of goods and services.
3. The implication of this is that when prices change in one country, but not in
another, the exchange rate will adjust to reflect the change.
4. In the long run, changes in the exchange rate are tied to differences in
inflation.
5. If a country wants to fix its exchange rate with another country, it must
therefore conduct its monetary policy so that the two countries’ inflation rates
match.
6. The central bank must choose between a fixed exchange rate and an
independent inflation policy; it cannot have both.
7. Deviations from purchasing power parity occur, and can last for years.
B. Interest Rates and the Short-Run Implications of Capital Market Arbitrage
1. In the short run, a country’s exchange rate is determined by supply and
demand.
2. The exchange value of a currency depends on the preferences of the country’s
citizens for foreign assets and the preferences of foreign investors for the
country’s assets.
3. In the short run, investors can move large quantities of currency across
international borders, assuming that governments allow the free movement of
funds.
4. International capital mobility results in capital market arbitrage across nations.
Two bonds that are equally risky, with the same maturity and same coupon
rate will sell for the same price and have the same interest rate; this is true
even if the bonds are denominated in different currencies.
5. If interest rates differ in two countries and their exchange rate is fixed,
investors will move back and forth, wiping out the difference.
C. Capital Controls and the Policymakers’ Choice
1. If capital cannot flow freely between countries, there is no mechanism to
equate interest rates in the two countries.
2. So long as capital can flow freely, monetary policymakers must choose
between fixing their exchange rate and fixing their interest rate.
3. A country cannot be open to capital flows, control its domestic interest rate,
and fix its exchange rate. Policymakers must choose two of these three.
4. Different countries make different choices; if a country is willing to forgo
participation in international capital markets it can impose capital controls, fix
its exchange rate, and still use monetary policy to pursue domestic objectives.
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Chapter 19 – Exchange-Rate Policy and the Central Bank
5. Capital controls go against the grain of modern economic thinking.
Internationally integrated capital markets ensure that capital goes to its most
efficient uses.
6. The free flow of capital across borders enhances competition, improves
opportunities for diversification, and equalizes rates of return (adjusted for
risk). However, disturbances in one country’s financial market can be quickly
transmitted to others’ markets and institutions.
7. For a developing country, openness comes with the risk of large movements of
funds out of the country, driving the interest rate up and the value of the
currency down.
8. It is tempting for governments to try to avoid such crises by restricting the
ability to move capital in and out of a country (inflow controls and outflow
controls).
I. Mechanics of Exchange Rate Management
A. The Central Bank’s Balance Sheet
1. If all policymakers want to do is fix the exchange rate they can offer to buy
and sell their country’s currency at a fixed rate.
2. However, these interventions have an impact on interest rates and on the
quantity of money in the economy: buying foreign currency or selling dollars
increases reserves, putting downward pressure on interest rates and expanding
the quantity of money.
3. In effect, the decision to control the exchange rate means giving up control of
the size of reserves, so that the market determines the interest rate.
4. A foreign exchange intervention has the same impact on reserves as a
domestic open market operation.
5. A foreign exchange intervention affects the value of a country’s currency by
changing domestic interest rates.
6. Any central bank policy that influences the domestic interest rate will affect
the exchange rate.
B. Sterilized Intervention
1. In a sterilized intervention, a change in foreign exchange reserves alters the
asset side of the central bank’s balance sheet, but the domestic monetary base
remains unaffected.
2. A sterilized intervention is actually a combination of two transactions, the
purchase (or sale) or foreign currency reserves and an open market operation
of exactly the same size, designed to offset the impact of the first transaction
on the monetary base.
3. The intervention changes the composition of the asset side of the central
bank’s balance sheet but not its size.
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Chapter 19 – Exchange-Rate Policy and the Central Bank
4. In deep, well-functioning markets, small shifts in central banks’ assets are
dwarfed by the actions of private traders. But, changes in the composition of
a central banks’ balance sheet can alter the relative prices of assets if markets
are thin or if the policy shift is large relative to the market.
II. The Costs, Benefits, and Risks of Fixed Exchange Rates
A. Assessing the Costs and Benefits
1. Fixed exchange rates simplify operations for businesses that trade
internationally and reduce the risk that investors face when they hold foreign
stocks and bonds as well.
2. A fixed exchange rate ties policymakers’ hands, and in countries that are prone
to bouts of high inflation, a fixed exchange rate may be the only way to
establish a credible low-inflation policy.
3. An exchange rate target enforces low-inflation discipline on both central
banks and politicians and enhances transparency and accountability.
4. There is one serious drawback to a fixed exchange rate; it means importing
monetary policy.
5. Fixing your currency to that of another country means adopting the interest
rate policy of the other country, which can be a real problem if the two
countries have different macroeconomic fluctuations.
6. In order to fix the rate, the central bank must have ample reserves because it
will need to buy (and sell) its currency at the fixed rate; such reserves may be
difficult to obtain and expensive to keep.
7. Fixing the exchange rate also means reducing the domestic economy’s natural
ability to respond to macroeconomic shocks. The stabilization mechanism of
interest rates is shut down.
8. If the nominal exchange rate is fixed, a country may need its prices and wages
to decline to offset any loss of competitiveness in world markets.
9. To fix an exchange rate, a central bank may need to accommodate large
swings in reserve demand.
B. The Danger of Speculative Attacks
1. Fixed exchange rates are fragile and are prone to a type of crisis called a
speculative attack.
2. If traders believe that the reserves at the central bank are insufficient they can
launch an attack and, in effect, drain those reserves.
3. Speculative attacks are caused by traders not believing that officials can
maintain the exchange rate at its fixed level (perhaps due to expectations of
inflation), financial instability, or spontaneously (and can be contagious).
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Chapter 19 – Exchange-Rate Policy and the Central Bank
C. Summarizing the Case for a Fixed Exchange Rate
1. A country will be better off fixing its exchange rate if it has a poor reputation
for controlling inflation on its own, an economy that is well integrated with
the one to whose currency the rate is fixed, a high level of foreign exchange
reserves, a high degree of price and wage flexibility, and a robust banking
system.
2. Regardless of how closely a country meets these criteria, fixed exchange rates
are still risky to adopt and difficult to maintain.
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