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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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2003 Pearson
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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