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1、Fixed Exchange Rates and Foreign Exchange Intervention,WONG Ka Fu 15 March 2000,Central bank balance sheet,Assets,Liabilities,Foreign Assets,$1000,Domestic assets,$1500,Deposits held by private banks,$500,Currency in circulation,$2000,Open-market operations,Purchase or sale of domestic assets A purc
2、hase of assets increases money supply A sale of assets decreases money supply FOMC: Federal Open Market Committee The FOMC holds eight regularly scheduled meetings per year to direct the conduct of open market operations by the Federal Reserve Bank of New York in a manner designed to foster the long
3、-run objectives of price stability and sustainable economic growth. The FOMC also establishes policy relating to System operations in the foreign exchange markets. (http:/www.bog.frb.fed.us/fomc/),CBs balance sheet after $100 foreign asset sale (buyer pays with currency),Assets,Liabilities,Foreign A
4、ssets,$900,Domestic assets,$1500,Deposits held by private banks,$500,Currency in circulation,$1900,Note: CB = Central Bank,CBs balance sheet after $100 foreign asset sale (buyer pays with a check),Assets,Liabilities,Foreign Assets,$900,Domestic assets,$1500,Deposits held by private banks,$400,Curren
5、cy in circulation,$2000,Note: CB = Central Bank,Sterilization,CB carries out equal foreign and domestic asset transactions in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply,CBs balance sheet after sterilized $100 foreign asset sale,Assets,
6、Liabilities,Foreign Assets,$900,Domestic assets,$1600,Deposits held by private banks,$500,Currency in circulation,$2000,Liabilities unchanged after an foreign asset sale.,Balance of payment,The sum of current account and the non-reserve component of the capital account I.e., the international paymen
7、ts gap that central banks must finance through their reserve transactions.,Balance of payment surplus without sterilization,Balance of payment surplus,Home central banks foreign assets,Home money supply,Balance of payment surplus with sterilization,Balance of payment surplus,Home central banks forei
8、gn assets,Home money supply,How the CB fixes the exchange rate (assuming free capital flow),CB must be willing to trade currencies at the fixed exchange rate - with the private sector in the foreign exchange market,Foreign exchange market equilibrium under fixed exchange rate,Uncovered interest pari
9、ty: RH,t = EH/F,t+1e - EH/F,t / EH/F,t + RF,t EH/F,t+1e = EH/F,t under a purely fixed exchange rate RH,t = RF,t I.e., a central bank must hold RH,t = RF,t,Rate of return (in home currency),Expected return on foreign deposit,Return on home deposit,HD/FD exchange rate,0,(MsH/PH)1,L(RH,YH),1,1,EH/F0,Re
10、al money holdings,Relationship between Exchange rate and money supply,RF,Rate of return (in home currency),Expected return on foreign deposit,Return on home deposit,HD/FD exchange rate,0,M1H/PH,L(RH,YH1),1,1,EH/F0,Real money holdings,An increase in output,L(RH,YH2),RF,2,3,3,Rate of return (in home c
11、urrency),Expected return on foreign deposit,Return on home deposit,HD/FD exchange rate,0,M1H/PH,L(RH,YH1),1,1,EH/F0,Real money holdings,Maintaining a fixed exchange rate after an increase in output,L(RH,YH2),RF,2,3,3,M2H/PH,Output, Y,Exchange Rate, E,DD,AA,Y1,E1,Short-run equilibrium: The intersecti
12、on of DD and AA,1,Output, Y,Exchange Rate, E,DD1,AA1,Y1,E1,Can we use temporary monetary policy to affect short-run equilibrium output?,1,AA2,Output, Y,Exchange Rate, E,DD1,AA1,Y1,E1,Can we use temporary monetary policy to affect short-run equilibrium output?,1,AA2,Decrease in money supply in order
13、to counter the depreciation,Tradeoff between fixed exchange rate regime and monetary policy autonomy,Under fixed exchange rate regime, a country cannot use monetary policy to affect output Monetary policy, if any, serves to fix the exchange rate In other words, for fixed exchange rate regime, we sac
14、rifice monetary policy as a tool to affect the economy Currency board system is one form of fixed exchange rate regime.,Output, Y,Exchange Rate, E,DD,AA,Y1,E1,A temporary decrease in aggregate demand, say by a reduction of government expenditure,1,Output, Y,Exchange Rate, E,DD,AA,Y1,E1,A temporary d
15、ecrease in aggregate demand, say by a reduction of government expenditure,1,Decrease in money supply in order to counter the depreciation,Effect of aggregate demand shock,Under fixed exchange rate regime, a shock in aggregate demand has a larger effect on output than under a flexible exchange rate r
16、egime. Example of aggregate demand shock: changes of government expenditure, autonomous consumption, export demand,Variability of short-run equilibrium output,Suppose there are continuous shocks to the economy such that DD shifts left or right around a given DD, variability of short-run equilibrium output is larger under fixed than flexible exchange rate regime.,Output, Y,
