Download Chapter 19 Exchange Rate Policy and the Central Bank

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Chapter Nineteen
Exchange-Rate Policy and the Central
Bank
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
• We need to examine the mechanics of how a
central bank manages its country’s exchange
rate.
• Both the U.S. and Europe are huge and largely
self-contained economies.
• For the most part, these economies produce
what they consume and invest.
• They can focus on domestic economy and let their
exchange rates take care of themselves.
19-2
Introduction
• In small countries, however, imports and
exports are sometimes more than 50 percent of
GDP.
• Central banks in these countries do not have the
luxury of leaving their exchange rates to take care
of themselves.
• These countries are more exposed to what goes
on in the rest of the world.
• Change in their exchange rates can have dramatic
impact on them.
19-3
Introduction
•
If exchange-rate policy is inseparable from
interest-rate policy, we have left something
out of our analysis.
1. Why is a country’s exchange rate linked to its
domestic monetary policy?
2. Are there circumstances when exchange-rate
stabilization becomes the overriding objective of
central bankers?
3. Should central bankers try to fix their exchange
rate?
4. Should a country consider giving up its currency
entirely?
19-4
Linking Exchange-Rate Policy with
Domestic Monetary Policy
• Exchange-rate policy is integral to any
monetary policy regime.
• When capital flows freely across a country’s
borders, a fixed exchange rate means giving up
domestic monetary policy.
19-5
Linking Exchange-Rate Policy with
Domestic Monetary Policy
•
There are two ways to see the connection
between exchange rates and monetary policy.
1. We can think about the market for goods and
purchasing power parity.
2. Capital market arbitrage shows us how shortrun movements in exchange rates are tied to
the supply and demand in the currency
markets.
19-6
Inflation and the Long-Run Implications
of Purchasing Power Parity
• In Chapter 10 we discussed the law of one
price:
• Ignoring transportation costs, this says that identical
goods should sell for the same price regardless of
where they are sold.
• The concept of purchasing power parity (PPP)
extends the logic of the law of one price to a
basket of goods and services.
19-7
Inflation and the Long-Run Implications
of Purchasing Power Parity
• As long as goods can move freely across
international boundaries, one unit of domestic
currency should buy the same basket of goods
anywhere in the world.
• 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.
19-8
Inflation and the Long-Run Implications
of Purchasing Power Parity
• PPP has immediate implications for monetary
policy.
• If Mexico’s central bank wants to fix its
exchange rate, then Mexican monetary policy
must be conducted so that Mexican inflation
matches U.S. inflation.
• The central bank must choose between a fixed
exchange rate and an independent inflation
policy; it cannot have both.
19-9
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.
• Investors play a crucial role, because they are the
ones who can move large quantities of currency
across international borders.
• When the bonds have different yields, the
prices will be bid up or down until the returns
are equal.
• Arbitrage in the capital market ensures that two
equally risky bonds have the same expected return.
19-10
Interest Rates and the Short-Run
Implications of Capital Market Arbitrage
• Consider a hypothetical case where the Bank of
England fixes the exchange rate at $1.50 per
pound.
• Say a U.S. investor is considering how to
invest $1500 over the next year.
• Buy a one-year Chicago bond with interest rate, i.
• Buy a one-year London bond with interest rate, if.
• Investing in the London bond requires
converting dollars to pounds and then pounds to
dollars at the end of the year.
19-11
Interest Rates and the Short-Run
Implications of Capital Market Arbitrage
• At a fixed exchange rate of $1.50 per pound,
$1500 becomes £1000.
• After one year, this amount becomes
£1000(1 + if) or $1500(1 + if) after conversion.
• If has invested in Chicago bond, then would
have $1500(1 + i) at the end of the year.
• Arbitrage equates the two returns, so under a
fixed exchange rate:
$1500(1 + if) = $1500(1 + i)
if = i
19-12
Interest Rates and the Short-Run
Implications of Capital Market Arbitrage
• Investors will be indifferent between investing
in a dollar-denominated bond or a pounddenominated bond only when the interest rates
in the two cities are the same.
• If interest rates differ in Chicago and London,
and the dollar-pound exchange rate is fixed,
investors will move funds back and forth,
wiping out the difference.
19-13
• Diversification reduces risk.
• Investing overseas is diversification: You
should hold equity from emerging markets.
• But, should you worry about crises?
• If you are diversified and in long term
investments, then they are not likely to affect
you.
19-14
Capital Controls and the
Policymaker’s Choice
• If capital cannot flow freely between London
and Chicago, there is no mechanism to equate
interest rates in the two countries.
• So long as capital can flow freely between
countries, monetary policymakers must choose
between fixing their exchange rate and fixing
their interest rate.
19-15
Capital Controls and the
Policymaker’s Choice
• A country cannot:
• Be open to international capital flows,
• Control its domestic interest rate, and
• Fix its exchange rate.
• Policymakers must choose two of these three
options.
• 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 its domestic
objectives.
19-16
Capital Controls and the
Policymaker’s Choice
• However, this goes against the grain of modern
economic thinking.
• Internationally integrated capital markets
ensure that capital goes to its most efficient
uses.
• As this view took hold in the late 20th century,
countries removed the restrictions on the flow
of capital that had been initiated earlier in the
century.
19-17
Capital Controls and the
Policymaker’s Choice
• The benefits of open capital markets are easy to
see.
• On the downside, disturbances in one country’s
financial market can be quickly transmitted to
markets and institutions in other countries.
• For emerging-market countries, greater
openness of capital markets poses other risks,
too.
• Capital that flows in can also flow out, and can do
so quickly.
19-18
Capital Controls and the
Policymaker’s Choice
• That means that countries with open capital
markets are vulnerable to sudden changes in
investor sentiment.
• Investors may decide to sell a country's bonds.
• Prices are driven down.
• Interest rates are driven up.
• The value of the domestic currency is driven down.
• The result is similar to a bank run.
• All investors leave at once, precipitating a financial
collapse.
19-19
Capital Controls and the
Policymaker’s Choice
• It is tempting for government officials to
implement capital controls to avert such a
crisis.
• Inflow controls restrict the ability of foreigners
to invest in a country.
• Outflow controls place obstacles in the way of
selling investments and taking funds out.
• Outflow controls include restrictions on the
ability of domestic residents to purchase
foreign assets, and often include prohibitions
on removing currency from the country.
19-20
• In 1997, financial crises in many emerging
markets caused investors to pull out.
• Typical response would be for these countries to
borrow from the IMF.
• Malaysia decided instead to implement strict
capital controls.
• By placing severe limits on investor's ability to
remove money from the country, they ensured that
foreign investment would remain.
• They could then fix their currency and lower
domestic interest rates.
19-21
• Malaysia’s recovery took only two years,
compared to five years for Thailand and
Indonesia.
• But, if countries start instituting capital
controls every time there is a whiff of crisis,
they will dramatically increase the risk of
investing in emerging markets.
• Investors will become wary of putting money into
foreign countries if they aren’t sure they will be
able to take it out when they want.
19-22
Mechanics of Exchange-Rate
Management
• If either the Fed or the ECB chose to, it could
give up controlling interest rates and target the
exchange rate.
• How would they do that?
• We will begin with the central bank’s balance
sheet.
• We can look more closely at what large central
banks like the Fed and ECB actually do.
19-23
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.
• As the Fed works to maintain a fixed dollareuro exchange rate, its balance sheet shifts.
• When it buy euros, it increases its dollar liabilities.
• When it sells euros, it reduces its dollar liabilities.
• These interventions have an impact on interest
rates and the quantity of money in the
economy.
19-24
The Central Bank’s Balance Sheet
• Buying euros or selling dollars increases the
supply of reserves to the banking system.
• This puts downward pressure on interest rates and
expands the quantity of money.
• Controlling the exchange rate means giving up
control of the size of reserves so that the
market determines the interest rate.
19-25
The Central Bank’s Balance Sheet
• In September 2000, the world’s largest central
banks intervened to bolster the value of the
euro.
• The Fed purchased €1.5 billion in exchange for
$1.34 billion.
• They did this by purchasing German government
bonds.
• The Fed increased its euro-denominated
foreign exchange assets by $1.34 billion.
• On the liabilities side, commercial bank
reserves have increase by the same amount.
19-26
The Central Bank’s Balance Sheet
19-27
The Central Bank’s Balance Sheet
• This T-account is identical to a purchase of
U.S. Treasury bonds.
• A foreign exchange intervention has the same
impact on reserves as a domestic open market
operation.
• The Fed did supply dollars to the market
through its intervention, but more importantly,
the interest rate has fallen.
19-28
The Central Bank’s Balance Sheet
• The U.S. interest rate will fall while European
interest rates remain the same.
• Foreign investors will want to buy fewer U.S.
bonds, and they will need fewer dollars to do it.
• The demand for dollars in the foreign exchange
market falls.
• U.S. investors will want to buy more foreign
bonds.
• The supply of dollars will increase.
19-29
The Central Bank’s Balance Sheet
19-30
The Central Bank’s Balance Sheet
• The demand and supply shifts together drive
the value of the dollar down and the value of
the euro up.
• But the reason that the exchange rate moved
was that the domestic interest rate changed.
• A foreign exchange intervention affects the
value of a country's currency by changing
domestic interest rates.
19-31
The Central Bank’s Balance Sheet
• Any central bank policy that influences the
domestic interest rate will affect the exchange
rate.
• An open market purchase or sale works the
same way as an exchange-rate intervention.
• This would have been exactly the same result if
the Fed had purchased U.S. Treasury bonds.
• There is nothing special about a foreign exchange
intervention.
19-32
Sterilized Intervention
• When all these countries intervened to buy
euros, none of them changed their domestic
interest-rate targets.
• No wonder the value of the euro didn’t change.
• We assumed that when the Fed bought euros, it
increased commercial bank reserves, which
would reduce the interest rate in the absence of
any other action.
19-33
Sterilized Intervention
• This is an example of an unsterilized foreign
exchange intervention:
• One that changes central bank liabilities.
• In large countries, central banks don’t operate
that way.
• They engage in sterilized foreign exchange
interventions:
• A change in foreign exchange reserves alters the
asset side of the central bank’s balance sheet but the
domestic monetary base remains unaffected.
19-34
Sterilized Intervention
•
A sterilized intervention is a combination of
two transactions:
1. There is the purchase or sale of foreign
currency reserves, which changes the central
bank’s liabilities.
2. Then an immediate open market operation, of
exactly the same size, designed to offset the
impact of the first transaction on the monetary
base.
19-35
Sterilized Intervention
• For example, the Fed’s purchase of a German
government bond, is offset by the sale of a U.S.
Treasury bond.
• These two actions leave the level of reserves
unchanged.
• This intervention is sterilized with respect to its
effect on the monetary base, or the size of the
central bank’s balance sheet.
• An intervention is unsterilized if it changes the
monetary base and sterilized if it does not
change the monetary base.
19-36
Sterilized Intervention
• When the Fed purchased the German
government bonds, the level of reserves in the
banking system increased.
• But the FOMC had not changed the target
federal funds rate, so the job of the Open
Market Trading Desk had not changed.
• The foreign exchange desk had purchase bonds
issued by a euro-area government, paying for them
with reserves, and the Open Market Desk had sold
U.S. Treasury bonds to reverse the potential impact.
19-37
Sterilized Intervention
19-38
Sterilized Intervention
•
From Figure 19.3 we see the result on the
Fed’s balance sheet.
1. Commercial bank reserves remain unchanged
following a sterilized intervention, so
domestic monetary policy does not change.
2. The intervention changes the composition of
the asset side of the central bank’s balance
sheet.
• The sterilized intervention in support of the
euro in 2000 had no sustained effect.
19-39
Sterilized Intervention
•
However, change in the composition of a
central bank balance sheet can alter the
relative prices of assets if:
1. Markets are thin or functioning poorly, and
2. The policy shift is large compared to the level
of market transactions.
19-40
The Costs, Benefits, and Risks of
Fixed Exchange Rates
• Many countries allow their exchange rates to
float freely.
• But others, especially small, emerging-market
countries, fix their exchange rates.
• Fixing the exchange rate has costs and benefits.
• We will discuss the trade-offs.
19-41
Assessing the Costs and Benefits
• Capital crosses international borders like goods
and services do.
• Fixed exchange rates not only simplify
operations for businesses that trade
internationally, they also reduce the risk that
investors face when they hold foreign stocks
and bonds.
19-42
Assessing the Costs and Benefits
• Another potential benefit is that a fixed
exchange rate ties policymakers’ hands.
• 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.
• It forces low-inflation discipline on both central
bankers and politicians, and
• An exchange rate target enhances transparency and
accountability.
19-43
Assessing the Costs and Benefits
• One serious drawback to a fixed exchange rate,
however, is that it imports monetary policy.
• You must adopt the other country’s interest-rate
policy.
• A fixed exchange rate policy makes the most
sense when the two countries involved have
similar macroeconomic fluctuations.
• Otherwise, the country with the flexible exchange
rate that is in control of monetary policy might be
raising interest rates at the same time the other
country in going into a recession.
19-44
Assessing the Costs and Benefits
•
Policymakers should consider several
additional matters.
1. When a country fixes its exchange rate, the
central bank is offering to buy and sell its
own currency at a fixed rate.
•
Monetary policymakers will need ample currency
reserves.
2. Fixing the exchange rate means reducing the
domestic economy’s natural ability to respond
to macroeconomic shocks.
19-45
The Danger of Speculative Attacks
• Fixed exchange rates have benefits, but they
are fragile and prone to a type of crisis called a
speculative attack.
• Suppose for some reason, financial market
participants come to believe that the
government will need to devalue its currency in
the near future.
• Investors will attack the currency and force an
immediate devaluation.
19-46
Assessing the Costs and Benefits
• Through the mid-1990’s, the Bank of Thailand
was committed to maintaining a fixed
exchange rate.
• They had to make sure foreign currency traders
believed that the Bank of Thailand had enough
dollars on hand to buy however many baht the
traders wanted to sell.
• In summer 1997, financial market participants
began to question whether the reserves at the
central bank really were big enough.
19-47
Assessing the Costs and Benefits
• Speculators borrowed baht at domestic Thai
interest rates,
• Took them to the central bank to convert them
to dollars at a rate of 25 to one, and
• Then invested the dollars in short-term,
interest-bearing securities in the U.S.
• This action drained the Bank of Thailand's
dollar reserves.
• The more baht speculators borrowed to convert into
dollars, the further the reserves fell.
19-48
Assessing the Costs and Benefits
• After the baht depreciated, speculators were
able to repay the loan with much fewer dollars.
• There was an instant profit for the speculators.
• International currency sponsors have very deep
pockets, so they can quickly drain billions of
dollars from a central bank.
19-49
Assessing the Costs and Benefits
What causes a speculative attack?
1. Fiscal policy:
•
If investors begin to think that at current levels,
government spending must ultimately increase
inflation, they will stop believing that officials can
maintain the exchange rate at its fixed level.
2. Financial instability:
•
If a country’s banking system is insufficiently
capitalized or otherwise unsound, a central bank
may face pressure to relax monetary policy to
avoid or contain a financial crisis.
19-50
Assessing the Costs and Benefits
•
If investors doubt that the central bank will keep
interest rates high enough for a sufficient time to
defend the currency peg, an attack may follow.
3. Spontaneously:
•
•
If enough currency speculators simply decide that
a central bank cannot maintain its exchange rate,
they will attack.
• Spontaneous speculative attacks are like bank
runs; they can be contagious.
Many observers suspect that in today’s world,
no central bank has the resources to withstand
such an attack.
19-51
• The gold standard obligates the central bank to
fix the price of something we don’t really care
about - gold.
• Instead of stabilizing the price of goods, we
stabilize the price of gold.
• Any political disruption in parts of the world
where gold is mined could have dramatic
monetary policy effects.
• The promise to convert dollars into gold means
that international transactions must be settled in
gold.
19-52
• Under a gold standard, countries running
current account deficient will be forced into
deflation.
• Economic historians believe that gold flows
played a central role in spreading the Great
Depression of the 1930’s throughout the world.
• The sooner a country left the gold standard and
regained control of its monetary policy, the
faster its economy recovered.
19-53
• Some financial advisors advocate holding gold
as an investment.
• They argue that it reduces inflation risk.
• However, gold doesn’t pay interest and its price is
highly volatile.
• If you are worried about inflation risk, aren’t
you better off with short-term bonds?
• They are both cheaper and easier than buying gold.
19-54
Summarizing the Case for a Fixed
Exchange Rate
• We can list the conditions under which
adopting a fixed exchange rate makes sense.
• 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.
• A high level of foreign exchange reserves.
• Fixed exchange rates are still risky to adopt and
difficult to maintain.
19-55
Fixed Exchange Rate Regimes
• We will study some examples of fixed
exchange-rate regimes, to see how they work.
• We will look at:
• Managed exchange-rate pegs,
• Currency boards, and
• Dollarization.
19-56
Exchange-Rate Pegs and the Bretton
Woods System
• In 1944, a group of 44 countries agreed to form
the Bretton Woods system.
• It was a system of fixed exchange rates that offered
more policy flexibility over the short term than had
been possible under the gold standard.
• The system lasted from 1945 to 1971.
• Each country maintained an agreed-upon
exchange rate with the U.S. dollar.
• It pegged its exchange rate to the dollar.
19-57
Exchange-Rate Pegs and the Bretton
Woods System
•
The dollar was what is knows as a reserve
currency.
•
•
It was convertible into gold at a rate of $35 per
ounce.
The choice of the dollar was based on the
facts that:
1. The U.S. was the biggest of the Allies in WWII,
both economically and militarily, and
2. Dollars were relatively abundant.
19-58
Exchange-Rate Pegs and the Bretton
Woods System
• Because other countries did not want to adopt
U.S. monetary policy, their fixed exchange
rates required complex capital controls.
• Countries had to intervene regularly to maintain
their exchange rates at the peg.
• Adjustments were made to the exchange-rate
pegs, but only in response to perceived longterm imbalances.
19-59
Exchange-Rate Pegs and the Bretton
Woods System
• The system had some flexibility because of the
International Monetary Fund (IMF).
• They were created to manage the Bretton Woods
System by making loans to countries in need of
short-term financing to pay for an excess of imports
over exports.
• With a fixed exchange rate and the free
movement of capital, countries could not have
independent monetary policies.
19-60
Exchange-Rate Pegs and the Bretton
Woods System
• Because their exchange rate was fixed to the
dollar, participating countries were forced to
adopt policies that resulted in the same amount
of inflation as in the US.
• When U.S. inflation began to rise in the late
1960s, many countries were unhappy.
• By 1971, the system had completely fallen apart.
19-61
Exchange-Rate Pegs and the Bretton
Woods System
• The response of American officials has been to
allow the dollar to float freely ever since.
• Europeans took a different tack:
• For much of the time from the collapse of the
Bretton Woods system to the adoption of the euro in
1999, they maintained various fixed exchange-rate
mechanisms.
• Because capital flowed freely among these
countries, that meant giving up their ability to set
interest rates.
19-62
• In March 2010, the amount of foreign
exchange reserves held by China’s central bank
surpassed $2.4 trillion.
• About 30% of all currency reserves in the world.
• The increase of reserves reflects China’s
astonishing, sustained current account
surpluses - the excess of exports over imports.
• China’s fixed exchange-rate regime supports
these enormous export surpluses.
19-63
• China has promoted export-led growth by
pegging their currency, the Yuan, to the U.S.
dollar.
• Although policy makers have adjusted the
dollar peg repeatedly, the appreciation has been
too modest to offset China’s rapid gains in
international competitiveness.
• When a country runs a current account surplus,
it also runs a capital account deficit.
• It is either making loans to foreigners or buying
their assets.
19-64
• In June 2009, China owned about $1.2 trillion
of Treasury and agency debt.
• Chinese firms have also increased their direct
investment abroad.
• China will probably face large currency losses
on its foreign assets when the Yuan eventually
rises to reflect the country's trade
competitiveness.
• If China tries to avert these projected losses by
lowering its dollar holdings, the risk is that the
Yuan will rise sooner against the dollar,
undermining the fixed exchange rate and hurting
exports.
19-65
• China’s leaders can slow the rate of reserve
accumulation by promoting domestic
consumption, but this process is likely to take
place gradually over many years.
• A rise of trade protectionism in other countries
could change this picture more abruptly.
19-66
Hard Pegs: Currency Boards and
Dollarization
• In a hard-peg system, the central bank
guarantees convertibility of domestic currency
into the foreign currency to which it is pegged.
• Only two exchange-rate regimes can be
considered hard pegs:
• Currency boards, and
• Dollarization.
19-67
Hard Pegs: Currency Boards and
Dollarization
• With a currency board, the central bank
commits to holding enough foreign currency
assets to back domestic currency liabilities at a
fixed rate.
• With dollarization, one country formally adopts
the currency of another country for use in all its
financial transactions.
19-68
Currency Boards and the Argentinean
Experience
• Somewhere between 10 and 20 currency
boards operate in the world today.
• The Hong Kong Monetary Authority (HKMA)
operates a system whose sole objective is to
maintain a fixed exchange rate of 7.8 Hong
Kong dollars to one U.S dollar.
• The rules of the currency board provide that the
HKMA can increase the size of Hong Kong’s
monetary base only if it can accumulate additional
dollar reserves.
19-69
Currency Boards and the Argentinean
Experience
• With a currency board, the central bank’s only
job is to maintain the exchange rate.
• While that means that policymakers cannot
adjust monetary policy in response to domestic
economic shocks, the system does have it
advantages.
• It controls inflation.
19-70
Currency Boards and the Argentinean
Experience
• Currency boards do have their problems.
• The central bank loses its role as the lender of
last resort to the domestic banking system.
• The Banco Central de la Republica Argentina
solved this problems by establishing standby letters
of credit from large U.S. banks.
• However, their lending was limited to the amount of
dollar credit that foreign banks were willing to
extend.
19-71
Currency Boards and the Argentinean
Experience
•
In 2001, the Argentinean currency board
collapsed and authorities were forced to allow
the peso to float.
• What caused the collapse?
1. The peso was pegged to the U.S. dollar, even
though Argentina’s economy doesn’t have
much to do with the U.S. economy.
•
•
When the dollar appreciated, the peso appreciated.
The overvalued peso priced Argentinean exporters
out of their markets severely damaging their
economy.
19-72
Currency Boards and the Argentinean
Experience
2. Fiscal policy was the other problem.
•
•
•
While the Argentinean economy grew at a healthy
rate through much of the 1990’s, government
spending rose even faster.
The more the government borrowed, the more
wary lenders became of continuing to lend.
Politicians spent until they simply ran out of
money.
19-73
Currency Boards and the Argentinean
Experience
• When politicians began printing their own
money, the claim that Argentinean inflation
would roughly mirror U.S. inflation was no
longer credible and the currency board
collapsed.
• Irresponsible politicians can undermine any
monetary policy regime.
19-74
Dollarization in Ecuador
• Some countries just give up and adopt the
currency of another country for all their
transactions, completely eliminating their own
monetary policy.
• In 1865, Monaco adopted the French franc and
uses the euro today.
19-75
Dollarization in Ecuador
• In 1999, Ecuador experienced severe financial
crisis.
• In 2000, Ecuador officially gave up its currency.
• Within 6 months, the central bank had bought back
all the sucres in circulation.
• Almost immediately,
•
•
•
•
Interest rates dropped,
The banking system reestablished itself,
Inflation fell dramatically, and
Growth resumed.
19-76
Dollarization in Ecuador
• Ecuador’s move to dollarization was successful
enough that a year later El Salvador followed
suit.
• Panama has been dollarized since 1904.
• Why would a country choose to give up its
currency?
19-77
Dollarization in Ecuador
•
In a small emerging-market country, there are
a host of reasons.
1. With no exchange rate, there is no risk of an
exchange-rate crisis.
2. Using dollars or euros or yen can help a country to
become integrated into world market, increasing
trade and investment.
3. By rejecting the possibility of inflationary finance,
a country can reduce the risk premium it must pay
on loans and generally strengthen its financial
institutions.
19-78
Dollarization in Ecuador
•
It does, however, need to find a way to get the
dollars it will need to keep the monetary base
growing, which can prove to be challenging.
• There are costs to dollarization as well.
1. There is a loss of revenue that comes from
issuing currency:
•
What is called seignorage.
2. Dollarization effectively eliminates the
central bank as the lender of last resort as they
cannot print their own money.
19-79
Dollarization in Ecuador
3. There is a loss of autonomous monetary or
exchange-rate policy.
4. Any country that adopts the dollar as its
currency gets U.S. monetary policy, like it or
not.
19-80
Dollarization in Ecuador
• Dollarization is not the same as a monetary union.
• The decision by European countries to adopt a
common currency, the euro, was fundamentally
different from a country's decision to adopt the dollar.
• When the FOMC makes its decisions, the affairs of
Ecuador and El Salvador carry no weight.
• All European countries participating in the monetary
union take part in monetary policy decisions.
• A monetary union is shared governance; dollarization
is not.
19-81
• Monetary policy is one of several important
determinants of the exchange rate.
• In the past, poor fiscal prospects in an
emerging-market economy frequently led to a
loss of confidence in its currency.
• In the financial crisis of 2007-2009, industrial
countries also developed fiscal problems that
could weaken their currencies.
• Even for the international reserve currency, the
U.S. dollar, confidence depends in part on
whether the fiscal path of the U.S. government
will be seen as healthy.
19-82
Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
End of
Chapter Nineteen
Exchange-Rate Policy and the Central
Bank
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.