Chapter 18 (7)
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
Reserve Currencies in the World Monetary System
The Mechanics of a Reserve Currency Standard
The Asymmetric Position of the Reserve Center
108 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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 (7): Equilibrium in the Foreign-Exchange Market
with Imperfect Asset Substitutability
Demand
Supply
Equilibrium
APPENDIX 2 TO CHAPTER 18 (7): 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 aggressive exchange-rate management, and the irrevocably fixed rates among countries that use
the euro (a topic addressed in depth in Chapter 20 [9]).
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(4) 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(6) 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.
Chapter 18 (7) Fixed Exchange Rates and Foreign Exchange Intervention 109
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
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
accounts is most easily understood by recalling how the fall in foreign reserves comes about. After
the central bank buys domestic assets with money, there is initially an excess supply of money. The
2. An increase in government spending raises income and also money demand. The central bank
prevents the initial excess money demand from appreciating the domestic currency by purchasing
foreign assets from the domestic public. Central bank foreign assets rise, as do the central bank’s
110 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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
assets with domestic currency, a step that raises the central bank’s liabilities (and the home money
A more subtle issue is the following: When the price of foreign currency is raised, the value of the
initial stock of foreign reserves rises when measured in terms of domestic currency. This capital gain
in itself raises central bank foreign assets (which were measured in domestic currency units in our
analysis)—so where is the corresponding increase in liabilities? Does the central bank inject more
4. As shown in Figure 18(7)-1, a devaluation causes the AA curve to shift to AA, which reflects an
expansion in both output and the money supply in the economy. Figure 18(7)-1 also contains an XX
curve along which the current account is in balance. The initial equilibrium, at point 0, was on the XX
curve, reflecting the fact that the current account was in balance there. After the devaluation,
Figure 18(7)-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
currency risk can remove a significant barrier to international trade and investment. Finally, policy
Chapter 18 (7) Fixed Exchange Rates and Foreign Exchange Intervention 111
6. By raising output, fiscal expansion raises imports and thus worsens the current account balance.
The immediate fall in the current account is smaller than underfloating, however, because the
currency does not appreciate and crowd out net exports.
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
permanent policy does. The AA curve shifts with a change in the expected exchange rate. In terms
of the diagram, a permanent fiscal expansion causes the AA curve to shift down and to the left
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,
implying an increase in public saving. We have assumed investment to be constant in the main text. If
9. An import tariff raises the price of imports to domestic consumers and shifts consumption from
imports to domestically produced goods. This causes an outward shift in the DD curve, increasing
output and appreciating the currency. Because the central bank cannot allow exchange rates to
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
112 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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
reserves, according to our model. Even if another devaluation were to occur in the near future,
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
depletes its stock of foreign reserves, it is no longer able to keep its exchange rate from depreciating
in response to pressures arising from a balance of payments deficit. Simply put, a central bank can
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
an exchange of one type of bond for another, there is no change in the money supply, and thus,
Chapter 18 (7) Fixed Exchange Rates and Foreign Exchange Intervention 113
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,
it can purchase domestic assets and increase the money supply. In order to sterilize this intervention,
15.
Assets
Liabilities
FA: 900
Deposits held by banks: 400
DA: 1500
Currency: 2000
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 percent, the home currency
depreciates 1 percent, setting an expected appreciation of the home currency back to the middle of the
band, thus offsetting the 1 percent lower interest rate. On a shorter maturity, one could—in theory—
114 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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
money supply) to keep gold from leaving their country. The consequence may be that all central
banks reduce their DA holdings and still hold the same amount of gold. Put differently, if France tries
to sell domestic assets for gold and all other central banks do the same thing, the net effect is that
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 currency. If a country revalues, this will lead to local currency losses. These potential
valuation gains and losses will affect the costs of reserves. A country receiving a lower interest rate
on U.S. Treasury bills than it pays on its own debt is experiencing a cost of holding reserves, but if
uncovered interest parity holds, this interest rate gap loss should be exactly offset by exchange rate
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
attempt to depreciate the currency through an expansion in the money supply will leave the exchange
rate unchanged because interest rates cannot be negative. A temporary increase in the money supply
Chapter 18 (7) Fixed Exchange Rates and Foreign Exchange Intervention 115
If, however, the central bank committed to a permanent increase in the money supply and permanent
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
below, the expected exchange rate rises from
1
e
E
to
2.
e
E
This shifts the AA curve up and to the right
21. As Switzerland is in a liquidity trap, the AA and DD curve are intersecting along the flat portion of
the AA curve. As a result, any increase in the Swiss money supply due to the SNB buying up foreign
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
euro) in order for interest rate parity to hold. If the Swiss franc is expected to appreciate by more than