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Fixed Exchange Rates and Foreign Exchange Intervention (Reference: Chapter 17 and IMF http://www.imf.org/external/np/mfd/er/index.asp 2004) Chapter Organization Introduction Exchange rate regimes Why Study Fixed Exchange Rates? Central Bank Intervention and the Money Supply How the Central Bank Fixes the Exchange Rates Stabilization Policies with a Fixed Exchange Rate Balance of Payments Crises and Capital Flight Managed Floating and Sterilized Intervention Reserve Currencies in the World Monetary System The Gold Standard Summary Slide 17-2 Copyright © 2009 Pearson Education, Inc. Introduction In reality, the assumption of complete exchange rate flexibility is rarely accurate. Industrialized countries operate under a hybrid system of managed floating exchange rates. A system in which governments attempt to moderate exchange rate movements without keeping exchange rates rigidly fixed. A number of developing countries have retained some form of government exchange rate fixing. How do central banks intervene in the foreign exchange market? Slide 17-3 Copyright © 2009 Pearson Education, Inc. EXCHANGE RATE REGIMES 1. 2. 3. 4. 5. 6. 7. 8. Exchange arrangements with no separate legal tender Currency boards Conventional fixed peg Pegged exchange rates within horizontal bands Crawling pegs Exchange rates within crawling bands Managed floating with no predetermined path for the exchange rate Independently floating Copyright © 2009 Pearson Education, Inc. 4 EXCHANGE ARRANGEMENTS WITH NO SEPARATE LEGAL TENDER • Currency of another country circulates as the sole legal tender (formal dollarization) • Or membership of a monetary or currency union that shares same legal tender • Implies the complete surrender of the monetary authorities' control over domestic monetary policy Copyright © 2009 Pearson Education, Inc. 5 CURRENCY BOARD ARRANGEMENTS • Explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate • There are restrictions on the issuing authority to ensure the fulfillment of its legal obligation. • Implies that domestic currency will be issued only against foreign exchange • Domestic currency remains fully backed by foreign assets • leaves little scope for discretionary monetary policy and eliminates traditional central bank functions • Some flexibility may still be afforded, depending on how strict the banking rules of the currency board arrangement are Copyright © 2009 Pearson Education, Inc. 6 CONVENTIONAL FIXED PEG ARRANGEMENTS • The domestic currency is pegged within margins of ±1 percent or less against another currency or a basket of currencies • There is no commitment to keep the parity irrevocably • May fluctuate within margins of less than ±1 percent around a central rate- or the maximum and minimum value of the ER may remain within a margin of 2 percent- for at least three months • fixed parity is maintained through direct or indirect intervention • Flexibility of MP limited but greater than currency boards or no separate legal tender arrangements Copyright © 2009 Pearson Education, Inc. 7 PEGGED E.R.s WITHIN HORIZONTAL BANDS • Currency is maintained within certain margins of fluctuation of more than ±1 percent around a fixed central rate • Or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent • Reference may be made to a single currency, a cooperative arrangement, or a currency composite • Limited degree of monetary policy discretion, depending on the band width Copyright © 2009 Pearson Education, Inc. 8 CRAWLING PEGS Currency adjusted periodically in small amounts at a fixed rate Could be set in terms of a single currency or basket of currencies Monetary authorities may announce in advance when they will change the exchange rate and by how much or may make public the formula they will use to make the adjustment e.g. inflation rates differential or in response to changes in selective quantitative indicators • Imposes constraints on monetary policy in a manner similar to a fixed peg system Copyright © 2009 Pearson Education, Inc. 9 EXCHANGE RATES WITHIN CRAWLING BANDS • • • • • Currency is maintained within certain fluctuation margins of at least ±1 percent around a central rate or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent and the central rate or margins are adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators The degree of exchange rate flexibility is a function of the band width Types of bands 1. 2. • symmetric around a crawling central parity or widen gradually with an asymmetric choice of the crawl of upper and lower bands Imposes constraints on monetary policy Copyright © 2009 Pearson Education, Inc. 10 MANAGED FLOATING EXCHANGE RATE • Monetary Authority attempts to influence the E.R. without having a specific E.R. path or target • Indicators for managing the rate are broadly judgmental (e.g. BOP position, international reserves, parallel market dev’ts) • Adjustments may not be automatic • Intervention may be direct or indirect. Copyright © 2009 Pearson Education, Inc. 11 INDEPENDENTLY FLOATING EXCHANGE RATE Exchange rate is market-determined Official foreign exchange market intervention is aimed at moderating the rate of change and preventing undue fluctuations Copyright © 2009 Pearson Education, Inc. 12 FEATURES OF EXCHANGE RATE REGIMES Exchange Rate Regime No Separate Legal Tender Currency Boards Conventional Fixed Peg Pegged E.R.s with Horizontal Bands Crawling pegs Exchange rates within crawling bands Managed floating Independently floating Fixed or Flexible Fixed or Flexible Fixed Fixed Semi Fixed Semi-fixed semi-fixed flexible flexible Own Currency or adopts another currency Adopts Own Own Own Own Own Own Own Domestic currency will be issued only against foreign exchange and will remain fully backed by foreign assets Method of determining the exchange rate level domestic currency pegged +/-1% vs. Currency is maintained another currency, within a margin of more Currency is adjusted periodically in cooperative than +/-1% around a fixed small amounts at a fixed rate arrangement or a basket rate of currencies currency is maintained within certain fluctuation margins of at least ±1 percent around a central rate maximum and minimum Margin between the Adjustment is in response to value of E.R may maximum and minimum of changes in selective quantitative remain within a margin the E.R. exceeds 2% indicators of 2% Margin between the maximum and minimum value of the exchange rate exceeds 2 percent Reference may be made to indicators such as past inflation No commitment to keep a single currency, a differentials vis-à-vis major trading parity irrevocably cooperative arrangement, partners or a currency composite central rate or margins are adjusted periodically at a fixed rate or in response to changes in selective quantitative indicators Requires explicit legislative Fixed parity maintained commitment to exchange through direct or indirect domestic currency for intervention foreign currency The monetary authority attempts to influence the exchange rate is exchange rate market-determined without having a specific exchange rate path or target market intervention is aimed at moderating Indicators for the rate of change and managing the rate preventing undue are broadly fluctuations in the judgmental exchange rate, rather than at establishing a level for it Intervention may be direct or indirect differentials between the inflation target and expected inflation in major trading partners The rate of crawl can be set to adjust for measured inflation or other indicators or set at a preannounced fixed rate and/or below the projected inflation differentials (forward looking) Membership of Monetary Sometimes but not required or Currency Union Degree of Flexibility of Domestic Monetary Policy Example None Not required Not required Not required Not required Not required commitment to maintain the exchange rate within little, eliminates most CB Flexibility of MP limited the band imposes functions some flexibility Limited degree of monetary Imposes constraints on monetary but greater than CBs or constraints on monetary depending on how strict the policy discretion, depending policy in a manner similar to a fixed no separate legal tender policy, with the degree of banking rules of the CB on the band width peg system arrangements policy independence arrangement are being a function of the band width Ecuador, Panama Hong Kong to USD; Bosnia Angola, Bahrain, Saudi with USD to EUR pegged to USD Slovak Rep to EUR China to USD Botswana to Composite Currency Not required Not required Flexible Flexible Ghana, Romania, Egypt U.K, Canada, Brazil 13 Why Study Fixed Exchange Rates? Four reasons to study fixed exchange rates: Managed floating Regional currency arrangements Developing countries and countries in transition Lessons of the past for the future Slide 17-14 Copyright © 2009 Pearson Education, Inc. IMF CLASSIFICATION OF EXCHANGE RATE REGIMES AND MONETARY POLICY FRAMEWORKS (As at April 2008) Monetary Policy Framework Exchange rate arrangement (Number of countries) Exchange rate anchor (115) U.S. dollar (66) Exchange arrangement with no Ecuador separate legal tender (10) El Salvador Marshall Islands Micronesia Currency board arrangement Antigua and Barbuda2 (13) Djibouti Monetary aggregate Inflation targeting target (22) framework (44) Other1 (11) Euro (27) Palau Composite Other(7) (15) Montenegro Kiribati Panama San Marino Timor-Leste St. Lucia2 Bosnia and Herzegovina Brunei Darussalam St. Vincent Bulgaria and the Grenadines 2 Dominica2 Grenada2 Hong Kong SAR St. Kitts and Nevis2 Estonia3 Lithuania3 Copyright © 2009 Pearson Education, Inc. IMF CLASSIFICATION OF EXCHANGE RATE REGIMES AND MONETARY POLICY FRAMEWORKS Monetary Policy Framework Exchange rate arrangement (Number of countries) Other conventional fixed peg arrangement (68) Exchange rate anchor (115) U.S. dollar (66) Angola Argentina Aruba Bahamas, The Bahrain Bangladesh Barbados Belarus Belize Eritrea Guyana Honduras Jordan Kazakhstan Lebanon Malawi Maldives Mongolia Netherlands Antilles Seychell es Sierra Leone Solomon Islands Sri Lanka Euro (27) Composit e (15) Fiji Benin4 Other(7) Monetary Inflation aggregate target targeting (22) framework (44) Bhutan Argentina Burkina Faso 4 Cameroo n5 Cape Verde Suriname Central African Rep. 5 Tajikistan Chad 5 Kuwait Lesotho Malawi Libya Namibia Rwanda Morocco Nepal Sierra Leone Russian Federatio n Samoa Swaziland Trinidad and Tobago Turkmeni stan United Arab Emirates Venezuel a, Rep. Bolivaria na de Vietnam Tunisia Comoros Congo, Rep. of 5 Côte d'Ivoire 4 Croatia Denmark3 Yemen, Equatorial Rep. of Guinea 5 Zimbabw Gabon 5 e GuineaBissau4 Latvia3 Macedoni a, FYR Mali4 Niger4 Senegal4 Copyright © 2009 Pearson Education, Inc. IMF CLASSIFICATION OF EXCHANGE RATE REGIMES AND MONETARY POLICY FRAMEWORKS Monetary Policy Framework Exchange rate arrangement (Number of countries) Exchange rate anchor (115) U.S. dollar (66) Slovak Rep.3 Pegged exchange rate within horizontal bands (3) Crawling peg (8) Euro (27) Bolivia China Monetary aggregate Inflation targeting target (22) framework (44) Other1 (11) Composite Other(7) (15) Syria. Tonga Botswana Iran, I.R. of. Ethiopia Iraq Nicaragua Uzbekistan Crawling band (2) Costa Rica Azerbaijan Copyright © 2009 Pearson Education, Inc. IMF CLASSIFICATION OF EXCHANGE RATE REGIMES AND MONETARY POLICY FRAMEWORKS Monetary Policy Framework Exchange rate arrangement (Number of countries) Exchange rate anchor (115) U.S. dollar (66) Managed floating with no pre- Cambodia determined path for the Kyrgyz Rep. exchange rate (44) Lao P.D.R. Liberia Mauritania Mauritius Myanmar Ukraine Euro (27) Composite Other(7) (15) Algeria Monetary aggregate Inflation targeting target (22) framework (44) Afghanistan, I.R. of Armenia6 Burundi Gambia, The Georgia Colombia Guinea Haiti Jamaica Kenya Indonesia Peru Romania Madagascar Moldova Mozambique Nigeria Papua New Guinea São Tomé and Sudan Tanzania Uganda Ghana Guatemala 6 Serbia Thailand Uruguay Copyright © 2009 Pearson Education, Inc. IMF CLASSIFICATION OF EXCHANGE RATE REGIMES AND MONETARY POLICY FRAMEWORKS Monetary Policy Framework Exchange rate arrangement (Number of countries) Exchange rate anchor (115) U.S. dollar (66) Independently floating (40) Euro (27) Other1 (11) Monetary aggregate Inflation targeting target (22) framework (44) Composite (15) Other(7) Zambia Albania Australia 7 Austria 7 Belgium Brazil Canada Chile Cyprus7 Czech Rep. 7 Finland 7 France Germany7 Greece7 Hungary Iceland Luxembo Congo, 7 Dem. Rep. urg of 7 Japan Malta 8 Mexico Somalia Netherlan Switzerland ds7 New United Zealand States Norway Philippine s Poland Portugal7 7 Slovenia South Africa Spain7 Sweden Turkey United Kingdom Ireland7 Israel Italy7 Korea, Rep. of Copyright © 2009 Pearson Education, Inc. EXCHANGE RATE REGIME AND MONETARY POLICY FRAMEWORK OF GHANA • Managed Floating (According to IMF, using Data as of April 31, 2008) • Independently Floating (According to BOG) • Inflation Targeting Copyright © 2009 Pearson Education, Inc. Central Bank Intervention and the Money Supply The Central Bank Balance Sheet and the Money Supply Central bank balance sheet It records the assets held by the central bank and its liabilities. It is organized according to the principles of double-entry bookkeeping. Any acquisition of an asset by the central bank results in a + change on the assets side of the balance sheet. Any increase in the bank’s liabilities results in a + change on the balance sheet’s liabilities side. Slide 17-21 Copyright © 2009 Pearson Education, Inc. Central Bank Intervention and the Money Supply The assets side of a balance sheet lists two types of assets: Foreign assets Mainly foreign currency bonds owned by the central bank (its official international reserves) Domestic assets Central bank holdings of claims to future payments by its own citizens and domestic institutions The liabilities side of a balance sheet lists as liabilities: Deposits of private banks Currency in circulation Total assets = total liabilities + net worth Slide 17-22 Copyright © 2009 Pearson Education, Inc. Central Bank Intervention and the Money Supply Net worth is constant. The changes in central bank assets cause equal changes in central bank liabilities. Any central bank purchase of assets automatically results in an increase in the domestic money supply. Any central bank sale of assets automatically causes the money supply to decline. Slide 17-23 Copyright © 2009 Pearson Education, Inc. Central Bank Intervention and the Money Supply Foreign Exchange Intervention and the Money Supply The central bank balance sheet shows how foreign exchange intervention affects the money supply because the central bank’s liabilities are the base of the domestic money supply process. The central bank can negate the money supply effect of intervention though sterilization. Slide 17-24 Copyright © 2009 Pearson Education, Inc. Central Bank Intervention and the Money Supply Sterilization Sterilized foreign exchange intervention Central banks sometimes carry out equal foreign and domestic asset transactions in opposite directions to nullify the impact of their foreign exchange operations on the domestic money supply. With no sterilization, there is a link between the balance of payments and national money supplies that depends on how central banks share the burden of financing payments gaps. Slide 17-25 Copyright © 2009 Pearson Education, Inc. Central Bank Intervention and the Money Supply Table 17-2: Effects of a $100 Foreign Exchange Intervention: Summary Slide 17-26 Central Bank Intervention and the Money Supply The Balance of Payments and the Money Supply If central banks are not sterilizing and the home country has a balance of payments surplus: An increase in the home central bank’s foreign assets implies an increased home money supply. A decrease in a foreign central bank’s claims on the home country implies a decreased foreign money supply. Slide 17-27 Copyright © 2009 Pearson Education, Inc. How the Central Bank Fixes the Exchange Rate Foreign Exchange Market Equilibrium Under a Fixed Exchange Rate The foreign exchange market is in equilibrium when: R = R* + (Ee – E)/E When the central bank fixes E at E0, the expected rate of domestic currency depreciation is zero. The interest parity condition implies that E0 is today’s equilibrium exchange rate only if: R = R*. Slide 17-28 Copyright © 2009 Pearson Education, Inc. How the Central Bank Fixes the Exchange Rate Money Market Equilibrium Under a Fixed Exchange Rate To hold the domestic interest rate at R*, the central bank’s foreign exchange intervention must adjust the money supply so that: MS/P = L(R*, Y) Example: Suppose the central bank has been fixing E at E0 and that asset markets are in equilibrium. An increase in output would raise the money demand and thus lead to a higher interest rate and an appreciation of the home currency. Slide 17-29 Copyright © 2009 Pearson Education, Inc. How the Central Bank Fixes the Exchange Rate The central bank must intervene in the foreign exchange market by buying foreign assets in order to prevent this appreciation. If the central bank does not purchase foreign assets when output increases but instead holds the money stock constant, it cannot keep the exchange rate fixed at E0. Slide 17-30 Copyright © 2009 Pearson Education, Inc. How the Central Bank Fixes the Exchange Rate A Diagrammatic Analysis To hold the exchange rate fixed at E0 when output rises, the central bank must purchase foreign assets and thereby raise the money supply. Slide 17-31 Copyright © 2009 Pearson Education, Inc. How the Central Bank Fixes the Exchange Rate Figure 17-1: Asset Market Equilibrium with a Fixed Exchange Rate, E0 Exchange rate, E E0 0 M1 P M2 P Real domestic money holdings Slide 17-32 1' 3' R* 1 2 3 Domestic-currency return on foreign-currency deposits, R* + (E0 – E)/E Domestic Interest rate, R Real money demand, L(R, Y1) Real money supply Stabilization Policies With a Fixed Exchange Rate Monetary Policy Under a fixed exchange rate, central bank monetary policy tools are powerless to affect the economy’s money supply or its output. Figure 17-2 shows the economy’s short-run equilibrium as point 1 when the central bank fixes the exchange rate at the level E0. Slide 17-33 Copyright © 2009 Pearson Education, Inc. Stabilization Policies With a Fixed Exchange Rate Figure 17-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate Exchange rate, E DD 2 E2 1 E0 AA2 AA1 Y1 Slide 17-34 Y2 Output, Y Stabilization Policies With a Fixed Exchange Rate Fiscal Policy How does the central bank intervention hold the exchange rate fixed after the fiscal expansion? The rise in output due to expansionary fiscal policy raises money demand. To prevent an increase in the home interest rate and an appreciation of the currency, the central bank must buy foreign assets with money (i.e., increasing the money supply). The effects of expansionary fiscal policy when the economy’s initial equilibrium is at point 1 are illustrated in Figure 17-3. Slide 17-35 Copyright Copyright © © 2009 2003 Pearson Pearson Education, Education, Inc. Inc. Stabilization Policies With a Fixed Exchange Rate Figure 17-3: Fiscal Expansion Under a Fixed Exchange Rate Exchange rate, E DD1 DD2 3 1 E0 2 E2 AA2 AA1 Y1 Slide 17-36 Y2 Y3 Output, Y Stabilization Policies With a Fixed Exchange Rate Changes in the Exchange Rate Devaluation It occurs when the central bank raises the domestic currency price of foreign currency, E. It causes: A rise in output A rise in official reserves An expansion of the money supply It is chosen by governments to: Fight domestic unemployment Improve the current account Affect the central bank's foreign reserves Slide 17-37 Copyright © 2009 Pearson Education, Inc. Stabilization Policies With a Fixed Exchange Rate Revaluation It occurs when the central bank lowers E. In order to devalue or revalue, the central bank has to announce its willingness to trade domestic against foreign currency, in unlimited amounts, at the new exchange rate. Slide 17-38 Copyright Copyright © © 2009 2003 Pearson Pearson Education, Education, Inc. Inc. Stabilization Policies With a Fixed Exchange Rate Figure 17-4: Effects of a Currency Devaluation Exchange rate, E DD 2 E1 1 E0 AA2 AA1 Y1 Slide 17-39 Y2 Output, Y Copyright © 2003 Pearson Education, Inc. Stabilization Policies With a Fixed Exchange Rate Adjustment to Fiscal Policy and Exchange Rate Changes Fiscal expansion causes P to rise. There is no real appreciation in the short-run There is real appreciation in the long-run Devaluation is neutral in the long-run. Slide 17-40 Copyright © 2009 Pearson Education, Inc. Balance of Payments Crises and Capital Flight Balance of payments crisis It is a sharp change in official foreign reserves sparked by a change in expectations about the future exchange rate. Slide 17-41 Copyright © 2009 Pearson Education, Inc. Balance of Payments Crises and Capital Flight Figure 17-7: Capital Flight, the Money Supply, and the Interest Rate Exchange rate, E 1' E0 2' R* + (E1– E)/E 0 R* M2 P M1 P 1 Real domestic money holdings Slide 17-42 R* + (E0 – E)/E R* + (E1 – E0)/E0 Domestic Interest rate, R 2 Real money supply Copyright © 2003 Pearson Education, Inc. Balance of Payments Crises and Capital Flight The expectation of a future devaluation causes: A balance of payments crisis marked by a sharp fall in reserves A rise in the home interest rate above the world interest rate An expected revaluation causes the opposite effects of an expected devaluation. Slide 17-43 Copyright © 2009 Pearson Education, Inc. Balance of Payments Crises and Capital Flight Capital flight The reserve loss accompanying a devaluation scare The associated debit in the balance of payments accounts is a private capital outflow. Self-fulfilling currency crises It occurs when an economy is vulnerable to speculation. The government may be responsible for such crises by creating or tolerating domestic economic weaknesses that invite speculators to attack the currency. Slide 17-44 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention Under managed floating, monetary policy is influenced by exchange rate change. Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention When a central bank carries out a sterilized foreign exchange intervention, its transactions leave the domestic money supply unchanged. Slide 17-45 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention Perfect asset substitutability The foreign exchange market is in equilibrium only when the expected return on domestic and foreign currency bonds are the same. Central banks cannot control the money supply and the exchange rate through sterilized foreign exchange intervention. Slide 17-46 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention Imperfect asset substitutability Assets’ expected returns can differ in equilibrium. Risk is the main factor that may lead to imperfect asset substitutability in foreign exchange markets. Central banks may be able to control both the money supply and the exchange rate through sterilized foreign exchange intervention. Slide 17-47 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention Foreign Exchange Market Equilibrium Under Imperfect Asset Substitutability When domestic and foreign currency bonds are perfect substitutes, the foreign exchange market is in equilibrium only if the interest parity condition holds: R = R* + (Ee – E)/E (17-1) This condition does not hold when domestic and foreign currency bonds are imperfect substitutes. Slide 17-48 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention Equilibrium in the foreign exchange market requires that: R = R* + (Ee – E)/E + (17-2) where: is a risk premium that reflects the difference between the riskiness of domestic and foreign bonds The risk premium depends positively on the stock of domestic government debt: = (B – A) (17-3) where: B is the stock of domestic government debt A is domestic assets of the central bank Slide 17-49 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention The Effects of Sterilized Intervention with Imperfect Asset Substitutability A sterilized purchase of foreign assets leaves the money supply unchanged but raises the risk adjusted return that domestic currency deposits must offer in equilibrium. Figure 17-8 illustrates the effects of a sterilized purchase of foreign assets by the central bank. The purchase of foreign assets is matched by a sale of domestic assets (from A1 to A2). Slide 17-50 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention Figure 17-8: Effect of a Sterilized Central Bank Purchase of Foreign Assets Under Imperfect Asset Substitutability Exchange rate, E E2 E1 Sterilized purchase 2' of foreign assets Risk-adjusted domesticcurrency return on foreign currency deposits, 1' R* + (Ee– E)/E + (B –A2) R* + (Ee – E)/E + (B –A1) 0 Ms P Slide 17-51 Real domestic money holdings R1 Domestic Interest rate, R Real money supply 1 Managed Floating and Sterilized Intervention Evidence on the Effects of Sterilized Intervention Empirical evidence provides little support for the idea that sterilized intervention has a significant direct effect on exchange rates. Slide 17-52 Copyright © 2009 Pearson Education, Inc. Managed Floating and Sterilized Intervention The Signaling Effect of Intervention Signaling effect of foreign exchange intervention An important complicating factor in econometric efforts to study the effects of sterilization Sterilized intervention may give an indication of where the central bank expects (or desires) the exchange rate to move. This signal can change market views of future policies even when domestic and foreign bonds are perfect substitutes. Slide 17-53 Copyright © 2009 Pearson Education, Inc. Reserve Currencies in the World Monetary System Two possible systems for fixing the exchange rates: Reserve currency standard Central banks peg the prices of their currencies in terms of a reserve currency. The currency central banks hold in their international reserves. Gold standard Central banks peg the prices of their currencies in terms of gold. Slide 17-54 Copyright © 2009 Pearson Education, Inc. Reserve Currencies in the World Monetary System The two systems have very different implications about: How countries share the burden of balance of payments financing The growth and control of national money supplies Slide 17-55 Copyright © 2009 Pearson Education, Inc. Reserve Currencies in the World Monetary System The Mechanics of a Reserve Currency Standard The workings of a reserve currency system can be illustrated by the system based on the U.S. dollar set up at the end of World War II. Every central bank fixed the dollar exchange rate of its currency through foreign exchange market trades of domestic currency for dollar assets. Exchange rates between any two currencies were fixed. Slide 17-56 Copyright © 2009 Pearson Education, Inc. Reserve Currencies in the World Monetary System The Asymmetric Position of the Reserve Center The reserve-issuing country can use its monetary policy for macroeconomic stabilization even though it has fixed exchange rates. The purchase of domestic assets by the central bank of the reverse currency country leads to: Excess demand for foreign currencies in the foreign exchange market Expansionary monetary policies by all other central banks Higher world output Slide 17-57 Copyright © 2009 Pearson Education, Inc. The Gold Standard Each country fixes the price of its currency in terms of gold. No single country occupies a privileged position within the system. The Mechanics of a Gold Standard Exchange rates between any two currencies were fixed. Example: If the dollar price of gold is pegged at $35 per ounce by the Federal Reserve while the pound price of gold is pegged at £14.58 per ounce by the Bank of England, the dollar/pound exchange rate must be constant at $2.40 per pound. Slide 17-58 Copyright © 2009 Pearson Education, Inc. The Gold Standard Symmetric Monetary Adjustment Under a Gold Standard Whenever a country is losing reserves and its money supply shrinks as a consequence, foreign countries are gaining reserves and their money supplies expand. Benefits and Drawbacks of the Gold Standard Benefits: It avoids the asymmetry inherent in a reserve currency standard. It places constraints on the growth of countries’ money supplies. Slide 17-59 Copyright © 2009 Pearson Education, Inc. The Gold Standard Drawbacks: It places undesirable constraints on the use of monetary policy to fight unemployment. It ensures a stable overall price level only if the relative price of gold and other goods and services is stable. It makes central banks compete for reserves and bring about world unemployment. It could give gold producing countries (like Russia and South Africa) too much power. Slide 17-60 Copyright © 2009 Pearson Education, Inc. The Gold Standard Bimetallic standard The currency was based on both silver and gold. The U.S. was bimetallic from 1837 until the Civil War. In a bimetallic system, a country’s mint will coin specified amounts of gold or silver into the national currency unit. Example: 371.25 grains of silver or 23.22 grains of gold could be turned into a silver or a gold dollar. This made gold worth 371.25/23.22 = 16 times as much as silver. It might reduce the price-level instability resulting from use of one of the metals alone. Slide 17-61 Copyright © 2009 Pearson Education, Inc. The Gold Standard The Gold Exchange Standard Central banks’ reserves consist of gold and currencies whose prices in terms of gold are fixed. Each central bank fixes its exchange rate to a currency with a fixed gold price. It can operate like a gold standard in restraining excessive monetary growth throughout the world, but it allows more flexibility in the growth of international reserves. Slide 17-62 Copyright © 2009 Pearson Education, Inc. Summary There is a direct link between central bank intervention in the foreign exchange market and the domestic money supply. When a country’s central bank purchases (sells) foreign assets, the country's money supply automatically increases (decreases). The central bank balance sheet shows how foreign exchange intervention affects the money supply. The central bank can negate the money supply effect of intervention through sterilization. Slide 17-63 Copyright © 2009 Pearson Education, Inc. Summary A central bank can fix the exchange rate of its currency against foreign currency if it trades unlimited amounts of domestic money against foreign assets at that rate. A commitment to fix the exchange rate forces the central bank to sacrifice its ability to use monetary policy for stabilization. Fiscal policy has a more powerful effect on output under fixed exchange rates than under floating rates. Balance of payments crises occur when market participants expect the central bank to change the exchange rate from its current level. Slide 17-64 Copyright © 2009 Pearson Education, Inc. Summary Self-fulfilling currency crises can occur when an economy is vulnerable to speculation. A system of managed floating allows the central bank to retain some ability to control the domestic money supply. A world system of fixed exchange rates in which countries peg the prices of their currencies in terms of a reserve currency involves a striking asymmetry. A gold standard avoids the asymmetry inherent in a reserve currency standard. A related arrangement was the bimetallic standard based on both silver and gold. Slide 17-65 Copyright © 2009 Pearson Education, Inc.