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Money, Banking, and Financial Markets
: Econ. 212
Stephen G. Cecchetti: Chapter 19
Exchange-Rate Policy and the Central Bank
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Linking Exchange-Rate Policy with Domestic Monetary Policy

Inflation and the Long-Run Implications of Purchasing Power Parity

The law of one price says that identical goods should sell for
the same price regardless of where they are sold. The
concept of purchasing power parity extends the logic of the
law of one price to a basket of goods and services.

The implication of this is that when prices change in one
country, but not in another, the exchange rate will adjust to
reflect the change. In the long run, changes in the exchange
rate are tied to differences in inflation.

If a country wants to fix its exchange rate with another
country, it must therefore conduct its monetary policy so
that the two countries’ inflation rates match.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

The central bank must choose between a fixed exchange rate
and an independent inflation policy; it cannot have both.

Deviations from purchasing power parity occur, and can last
for years.

Interest Rates and the Short-Run Implications of Capital
Market Arbitrage
In the short run, a country’s exchange rate is determined by
supply and demand. The exchange value of a currency
depends on the preferences of the country’s citizens for
foreign assets and the preferences of foreign investors for the
country’s assets.


In the short run, investors can move large quantities of
currency across international borders, assuming that
governments allow the free movement of funds.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

International capital mobility results in capital market
arbitrage across nations. Two bonds that are equally risky,
with the same maturity and same coupon rate will sell for
the same price and have the same interest rate; this is true
even if the bonds are denominated in different currencies.

If interest rates differ in two countries and their exchange
rate is fixed, investors will move back and forth, wiping out
the difference.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


Capital Controls and the Policymakers’ Choice
If capital cannot flow freely between countries, there is no
mechanism to equate interest rates in the two countries.

So long as capital can flow freely, monetary policymakers
must choose between fixing their exchange rate and fixing
their interest rate. A country cannot be open to capital flows,
control its domestic interest rate, and fix its exchange rate.
Policymakers must choose two of these three.

Different countries make different choices; if a country is
willing to forgo participation in international capital
markets it can impose capital controls, fix its exchange rate,
and still use monetary policy to pursue domestic objectives.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Capital controls go against the grain of modern economic
thinking. Internationally integrated capital markets ensure
that capital goes to its most efficient uses.

The free flow of capital across borders enhances
competition, improves opportunities for diversification, and
equalizes rates of return (adjusted for risk).

For a developing country, openness comes with the risk of
large movements of funds out of the country, driving the
interest rate up and the value of the currency down.

It is tempting for governments to try to avoid such crises by
restricting the ability to move capital in and out of a country
(inflow controls and outflow controls).
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University



Mechanics of Exchange Rate Management
The Central Bank’s Balance Sheet
If all policymakers want to do is fix the exchange rate they
can offer to buy and sell their country’s currency at a fixed
rate.

However, these interventions have an impact on interest
rates and on the quantity of money in the economy: buying
foreign currency or selling dollars increases reserves,
putting downward pressure on interest rates and expanding
the quantity of money.

In effect, the decision to control the exchange rate means
giving up control of the size of reserves, so that the market
determines the interest rate.

A foreign exchange intervention has the same impact on
reserves as a domestic open market operation.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

A foreign exchange intervention affects the value of a
country’s currency by changing domestic interest rates. In
general any central bank policy that influences the domestic
interest rate will affect the exchange rate.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


Sterilized Intervention
In a sterilized intervention, a change in foreign exchange
reserves alters the asset side of the central bank’s balance
sheet, but the domestic monetary base remains unaffected.

A sterilized intervention is actually a combination of two
transactions, the purchase (or sale) or foreign currency
reserves and an open market operation of exactly the same
size, designed to offset the impact of the first transaction on
the monetary base.

The intervention changes the composition of the asset side of
the central bank’s balance sheet but not its size.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


The Costs, Benefits, and Risks of Fixed Exchange Rates
Assessing the Costs and Benefits

Fixed exchange rates simplify operations for businesses
that trade internationally and reduce the risk that
investors face when they hold foreign stocks and bonds
as well.

A fixed exchange rate ties policymakers’ hands, and in
countries that are prone to bouts of high inflation, a
fixed exchange rate may be the only way to establish a
credible low-inflation policy. Moreover, An exchange
rate target enforces low-inflation discipline on both
central banks and politicians and enhances
transparency and accountability.

There is one serious drawback to a fixed exchange rate;
it means importing monetary policy.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Fixing our currency to that of another country means
adopting the interest rate policy of the other country,
which can be a real problem if the two countries have
different macroeconomic fluctuations.

In order to fix the rate, the central bank must have
ample reserves because it will need to buy (and sell) its
currency at the fixed rate; such reserves may be
difficult to obtain and expensive to keep.

Fixing the exchange rate also means reducing the
domestic economy’s natural ability to respond to
macroeconomic shocks. The stabilization mechanism of
interest rates is shut down.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


The Danger of Speculative Attacks
Fixed exchange rates are fragile and are prone to a type of
crisis called a speculative attack.

If traders believe that the reserves at the central bank are
insufficient they can launch an attack and, in effect, drain
those reserves.

Speculative attacks are caused by traders not believing that
officials can maintain the exchange rate at its fixed level
(perhaps due to expectations of inflation) but can also arise
spontaneously (and can be contagious).


Summarizing the Case for a Fixed Exchange Rate
A country will be better off fixing its exchange rate if it has a
poor reputation for controlling inflation on its own, an
economy that is well integrated with the one to whose
currency the rate is fixed, and a high level of foreign
exchange reserves.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Regardless of how closely a country meets these criteria, fixed
exchange rates are still risky to adopt and difficult to maintain.


Fixed Exchange-Rate Regimes
Exchange-Rate Pegs and the Bretton Woods System

The Bretton Woods System, which lasted from 1945 to 1971, was a
system of fixed exchange rates that offered more flexibility over
the short term than had been possible under the gold standard.

Each country maintained an agreed-upon exchange rate with the
U.S. dollar (currencies were pegged to the dollar). Every country
held dollar reserves and stood ready to exchange its own currency
for the dollar at the fixed rate.

Countries had to intervene regularly to maintain the fixed rates at
the peg.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

The International Monetary Fund (IMF) was created to
manage the system by making loans to countries in need of
short-term financing to pay for an excess of imports over
exports.

As capital markets opened up the system came under
increasing strain, because with a fixed exchange rate and the
free movements of capital, countries could no longer have
independent monetary policies.

When U.S. inflation began to rise in the late 1960s many
countries balked; they didn’t want to match the rise in
inflation.

By 1971 the system had completely fallen apart, and
American officials have allowed the dollar to float freely
ever since. Europeans took the different approach of
maintaining various fixed exchange rate mechanisms, up to
the introduction of the euro.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

Hard Pegs: Currency Boards and Dollarization

Under a hard-peg system the central bank implements an
institutional mechanism that ensures its ability to convert a
domestic currency into the foreign currency to which it is pegged.

Only two exchange-rate regimes can be considered hard pegs: a
currency board (whereby the central bank commits to holding
enough foreign currency assets to back domestic currency liabilities
at a fixed rate) and dollarization (whereby the country formally
adopts the currency of another country for use in all its financial
transactions).

Currency Boards and the Argentinean Experience

Somewhere between 10 and 20 currency boards operate in the
world today, the best known of which is the Hong Kong Monetary
Authority.

With a currency board, the central bank’s only job is to maintain
the exchange rate.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

While that means that policymakers cannot adjust monetary
policy in response to domestic economic shocks, the system
does have its advantages.

Prime among the advantages is the control of inflation. But
currency boards do have their problems, including the fact
that the central bank loses its role as the lender of last resort
to the domestic banking system.


Dollarization in Ecuador
In January of 2000, Ecuador officially gave up its currency,
and almost immediately interest rates dropped, the banking
system reestablished itself, inflation fell dramatically and
growth resumed.

A year later El Salvador followed suit. Panama has been
dollarized since 1904.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University

A country might choose dollarization because with no
exchange rate there is no risk of an exchange-rate crisis, it
helps the country become integrated into world markets, and
it can reduce their risk premium (associated with inflation
risk).

The benefits of dollarization are balanced against the loss of
revenue from issuing currency (called seigniorage), the loss of
the central bank’s role as lender of last resort, the loss of
autonomous monetary or exchange rate policy, and the
importing of U.S. monetary policy (like it or not).

Dollarization is not the same as monetary union, because
dollarized countries have no “vote” in the monetary policy
chosen by the FOMC. A monetary union is shared
governance; dollarization is not.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
 Appendix: What You Really Need to Know about the Balance
of Payments
 To understand the international financial system you need to
know three important terms connected with the international
balance of payments: (1) current account balance; (2) capital
account balance; and (3) the official settlements balance.
 The current account tracks the flow of payments across
national boundaries; the balance on the account is the
difference between a country’s exports and imports of goods
and services (also included are transfers and investment
income).
 The capital account tracks the purchase and sale of assets, and
the balance is the difference between a country’s capital inflows
and outflows.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
 The official settlements balance is the change in a country’s
official reserve holdings; it shows the change in the central
bank’s foreign exchange reserves (or gold reserves).
 The three must sum to zero. A country running a current
account deficit can pay for it by running a capital account
surplus or it can draw down its foreign exchange reserves.
 Countries with current account deficits would lose reserves and
those with surpluses would gain them.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Lessons of Chapter 19



When capital flows freely across a country's borders, fixing the exchange rate
means giving up domestic monetary policy.

Purchasing power parity implies that, in the long run, exchange rates are tied
to inflation differentials across countries.

Capital market arbitrage means that, in the short run, the exchange rate is
tied to differences in interest rates.

Monetary policymakers must choose two of the following three options: open
capital markets, control of domestic interest rates, and a fixed exchange rate.

Countries that impose controls on capital flowing in and/or out can fix the
exchange rate without giving up their domestic monetary policy.
Central banks can intervene in foreign exchange markets.

When they do, it affects their balance sheet in the same way as an open
market operation.

Foreign exchange intervention affects the exchange rate by changing domestic
interest rates. This is called unsterilized intervention.

A sterilized intervention is a purchase or sale of foreign exchange reserves that
leaves the central bank’s liabilities unchanged. It has no impact on the
exchange rate.
The decision to fix the exchange rate has costs, benefits, and risks.

Both corporations and investors benefit from predictable exchange rates.

Fixed exchange rates can reduce domestic inflation by importing the
monetary policy of a country with low inflation.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University


Fixed exchange rate regimes are fragile and leave countries open to
speculative attacks.

The right conditions for choosing to fix the exchange rate include:
•
a poor reputation for inflation control.
•
an economy that is well integrated with the one to whose currency the rate
is fixed.
•
a high level of foreign exchange reserves.
There are a number of examples of exchange-rate systems.

The Bretton Woods System, set up after World War II, pegged exchange rates
to the U.S. dollar, but collapsed in 1971 after U.S. inflation began to rise.

Most fixed exchange rate regimes are no longer thought to be viable.

Two that may work are currency boards and dollarization.

With a currency board, the central bank holds enough foreign currency
reserves to exchange the entire monetary base at the promised exchange rate.

Argentina's currency board collapsed when the regional governments began
printing their own money.

Dollarization is the total conversion of an economy from its own currency to
the currency of another country.

Several Latin American countries have adopted the dollar recently, with good
results over the short run.
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University
Key Terms
•Bretton Woods System
capital controls
•capital inflow controls
capital outflow controls
•currency board
dollarization
•foreign exchange intervention
gold standard
•hard peg
reserve currency
•speculative attack
sterilized intervention
•unsterilized intervention
Economics of International Finance
Prof. M. El-Sakka
CBA. Kuwait University