M18_Krugman_46657_09_IE_C18_F_GE

Copyright©2012PearsonEducation.Allrightsreserved.Chapter18FixedExchangeRatesandForeignExchangeInterventionCopyright©2012PearsonEducation.Allrightsreserved.18-2Preview•Balancesheetsofcentralbanks•Interventionintheforeignexchangemarketsandthemoneysupply•Howthecentralbankfixestheexchangerate•Monetaryandfiscalpoliciesunderfixedexchangerates•Financialmarketcrisesandcapitalflight•Typesoffixedexchangerates:reservecurrencyandgoldstandardsystemsCopyright©2012PearsonEducation.Allrightsreserved.18-3Introduction•Manycountriestrytofixor“peg”theirexchangeratetoacurrencyorgroupofcurrenciesbyinterveningintheforeignexchangemarkets.•Manywithaflexibleor“floating”exchangerateinfactpracticeamanagedfloatingexchangerate.–Thecentralbank“manages”theexchangeratefromtimetotimebybuyingandsellingcurrencyandassets,especiallyinperiodsofexchangeratevolatility.•Howdocentralbanksinterveneintheforeignexchangemarkets?Copyright©2012PearsonEducation.Allrightsreserved.18-4CentralBankInterventionandtheMoneySupply•Tostudytheeffectsofcentralbankinterventionintheforeignexchangemarkets,firstconstructasimplifiedbalancesheetforthecentralbank.–Thisrecordstheassetsandliabilitiesofacentralbank.–Balancesheetsusedouble-entrybookkeeping:eachtransactionentersthebalancesheettwice.Copyright©2012PearsonEducation.Allrightsreserved.18-5CentralBank’sBalanceSheet•Assets–Foreigngovernmentbonds(officialinternationalreserves)–Gold(officialinternationalreserves)–Domesticgovernmentbonds–Loanstodomesticbanks(calleddiscountloansinUS)•Liabilities–Depositsofdomesticbanks–Currencyincirculation(previouslycentralbankshadtogiveupgoldwhencitizensbroughtcurrencytoexchange)Copyright©2012PearsonEducation.Allrightsreserved.18-6CentralBank’sBalanceSheet(cont.)•Assets=Liabilities+NetWorth–Ifweassumethatnetworthisconstant,then•Anincreaseinassetsleadstoanequalincreaseinliabilities.•Adecreaseinassetsleadstoanequaldecreaseinliabilities.•Changesinthecentralbank’sbalancesheetleadtochangesincurrencyincirculationorchangesindepositsofbanks,whichleadtochangesinthemoneysupply.–Iftheirdepositsatthecentralbankincrease,banksaretypicallyabletousetheseadditionalfundstolendtocustomers,sothattheamountofmoneyincirculationincreases.Copyright©2012PearsonEducation.Allrightsreserved.18-7Assets,Liabilities,andtheMoneySupply•Apurchaseofanyassetbythecentralbankwillbepaidforwithcurrencyoracheckwrittenfromthecentralbank,–bothofwhicharedenominatedindomesticcurrency,and–bothofwhichincreasethesupplyofmoneyincirculation.–Thetransactionleadstoequalincreasesofassetsandliabilities.•Whenthecentralbankbuysdomesticbondsorforeignbonds,thedomesticmoneysupplyincreases.Copyright©2012PearsonEducation.Allrightsreserved.18-8Assets,Liabilities,andtheMoneySupply(cont.)•Asaleofanyassetbythecentralbankwillbepaidforwithcurrencyoracheckwrittentothecentralbank,–bothofwhicharedenominatedindomesticcurrency.–Thecentralbankputsthecurrencyintoitsvaultorreducestheamountofdepositsofbanks,–causingthesupplyofmoneyincirculationtoshrink.–Thetransactionleadstoequaldecreasesofassetsandliabilities.•Whenthecentralbanksellsdomesticbondsorforeignbonds,thedomesticmoneysupplydecreases.Copyright©2012PearsonEducation.Allrightsreserved.18-9Table18-1:Effectsofa$100ForeignExchangeIntervention:SummaryCopyright©2012PearsonEducation.Allrightsreserved.18-10ForeignExchangeMarkets•Centralbankstradeforeigngovernmentbondsintheforeignexchangemarkets.–Foreigncurrencydepositsandforeigngovernmentbondsareoftensubstitutes:botharefairlyliquidassetsdenominatedinforeigncurrency.–Quantitiesofbothforeigncurrencydepositsandforeigngovernmentbondsthatareboughtandsoldinfluencetheexchangerate.Copyright©2012PearsonEducation.Allrightsreserved.18-11Sterilization•Becausebuyingandsellingofforeignbondsintheforeignexchangemarketsaffectsthedomesticmoneysupply,acentralbankmaywanttooffsetthiseffect.•Thisoffsettingeffectiscalledsterilization.•Ifthecentralbanksellsforeignbondsintheforeignexchangemarkets,itcanbuydomesticgovernmentbondsinbondmarkets—hopingtoleavetheamountofmoneyincirculationunchanged.Copyright©2012PearsonEducation.Allrightsreserved.18-12FixedExchangeRates•Tofixtheexchangerate,acentralbankinfluencesthequantitiessuppliedanddemandedofcurrencybytradingdomesticandforeignassets,sothattheexchangerate(thepriceofforeigncurrencyintermsofdomesticcurrency)staysconstant.•ForeignexchangemarketsareinequilibriumwhenR=R*+(Ee–E)/E•WhentheexchangerateisfixedatsomelevelE0andthemarketexpectsittostayfixedatthatlevel,thenR=R*Copyright©2012PearsonEducation.Allrightsreserved.18-13FixedExchangeRates(cont.)•Tofixtheexchangerate,thecentralbankmusttradeforeignanddomesticassetsintheforeignexchangemarketuntilR=R*.•Alternatively,wecansaythatitadjuststhequantityofmonetaryassetsinthemoneymarketuntilthedomesticinterestrateequalstheforeigninterestrate,giventhelevelofaveragepricesandrealoutput:Ms/P=L(R*,Y)Copyright©2012PearsonEducation.Allrightsreserved.18-14FixedExchangeRates(cont.)•SupposethatthecentralbankhasfixedtheexchangerateatE0butthelevelofoutputrises,raisingthedemandofrealmonetaryassets.•Thisispredictedtoput