Download Fixed exchange rate

Monetary Policy and the Choice
of an Exchange Rate Regime
ÉCOLE DES HAUTES ÉTUDES COMMERCIALES
MBA PROGRAM
NOVEMBER 2001
The monetary transmission mechanism
• By the monetary transmission mechanism we mean the
process by which a change in the instrument of monetary
policy (usually the discount rate) changes the level of an
intermediate target (usually aggregate demand) so as to
reach the final target (usually the rate of inflation).
• In a closed economy, a stylized representation of the
monetary transmission mechanism could be the
following:
•  i   SB and  Credit   AD    (given  AS)
– The central bank changes its discount rate and this affects the
economy’s level of short-run interest rates ( i =  r at the initial
level of the inflation rate), the change in credit conditions affects
the rate at which changed settlement balances and credit expand
( SB and  Credit) , aggregate demand responds ( AD) and
this ultimately influences the inflation rate ( ).
The monetary transmission mechanism
• In the open economy, things do not stop there:
• Caeteris paribus, a change in the level of domestic interest
rates changes the interest rate differential between the
country and the rest of the world
–  (i -i*)
• If capital inflows respond to  (i -i*), this affects the
overall balance of payments and, depending on the
exchange rate regime, this will have additional effects.
• In order to understand why, we have to go back to the
balance of payments and discuss the capital and financial
account
The balance of payments and the capital
and financial account
• When we first introduced the balance of payments, we
made the distinction between current account transactions
(transactions with the non-residents which generate
income and expenditure) and capital and financial account
transactions (transactions with the non-residents implying
a sale or a purchase of real or financial assets).
• When we sell assets to non-residents, we obtain financial
resources that can be used to finance our expenditures.
– We receive financing from the non-residents: capital inflows (CI)
•
When we buy assets from the non-residents, we provide
them with financial resources that they can use to finance
their expenditures.
–
We finance the non-residents: capital outflows (CO)
• The capital and financial account (CFA) is equal to the
difference between capital inflows and outflows:
– CFA = CI - CO
The balance of payments and the capital
and financial account
• Now, suppose we measure both the current account (CA)
and the capital and financial account (CFA) in foreign
currency.
• Let us interpret the sum of the current account and capital
account (CA + CFA):
– What does it mean to have CA + CFA = 0 ?
– What does it mean to have CA + CFA > 0 ?
– What does it mean to have CA + CFA < 0 ?
• If we omit the “errors and omissions” term of the balance
of payments, this sum tells us by how much our current
inflows of foreign currency (supply) exceed our needs
(demand). When foreign currency is in excess supply, its
price tends to go down unless the central bank decides to
buy up the excess supply. When foreign currency is in
excess demand, its price tends to go up unless the central
bank decides to supply the market with its own reserves of
foreign currency.
The balance of payments and the capital
and financial account
• Note that this means:
– CA + CFA =  R
– Or stated differently: CA + CFA -  R = 0
• Note that by definition CA + CFA -  R is the balance of payments.
• In conclusion, balance of payments equilibrium implies:
–  R = 0 when CA + CFA = 0
–  R > 0 when CA + CFA > 0
–  R < 0 when CA + CFA < 0
• We now build on this to explain how the exchange rate is
determined.
The foreign exchange market
Price of foreign
currency (ex. $US)
E
S0
E0
D0
Quantity of foreign
currency (ex. $US)
• The supply of
foreign currency is a
function of the value
of exports and other
sources of foreign
income. It is also a
function of the value
of capital inflows.
•The demand for
foreign currency is a
function of the value
of imports and other
sources of external
spending. It is also a
function of capital
outflows.
•S = D means CA +
CFA and  R = 0.
•There is no pressure
on the exchange rate
and E remains at E0
The foreign exchange market
E
S = f (X$+…, NCI)
E0
D = f (M$+…)
Quantity of foreign
currency (ex.$US)
• To simplify the
diagrammatic
representation of the
foreign exchange
market, we will lump
capital inflows and
outflows into the
supply curve
•Net supply S now
depends upon net
capital inflows (NCI).
•S = f (value of X plus
other income, NCI)
•D = f(value of M plus
other external
spending)
The impact of a decrease in net capital inflows
• A decrease in net
S1
E
S0
E1
E0
D0
R  0
Quantity of foreign
currency (ex.: $US)
capital inflows
contracts the net supply
of foreign currency in
the domestic economy.
•At the initial level of
the exchange rate, there
is an excess demand for
foreign currency.
•In order to keep the
exchange rate constant,
the central bank would
have to supply the
market with its own
reserves (R < 0)
•If the central bank
does not supply the
market with its
reserves, the market
clearing exchange rate
will move up to E1.
The monetary transmission mechanism
under fixed and flexible exchange rates
• Let’s go back to the first step of our stylized monetary
transmission mechanism:
– i
• We must now add:
–  i   (i -i*)  either  R (fixed exchange rate) or  E (freely
floating exchange rate)
• It turns out that the final impact on aggregate demand and
on the rate of inflation will be quite different depending on
the exchange rate regime.
• Suppose the central bank wants to slow down aggregate
demand in order to keep inflation in check.
The monetary transmission mechanism
under fixed and flexible exchange rates
• Normally, this would lead to:
– i
• and
–   ( i - i* )
• This should be expected to increase short-run capital
inflows
• The important conclusion we then reach is:
– In a fixed exchange rate regime, the central bank will be induced
to act in a way that will restore the previous interest rate i. Its
restrictive monetary policy will be undone.
– In a floating rate regime, the exchange rate will go down. This
will provide a second channel through which a restrictive
monetary policy contracts aggregate demand.
An independent monetary tightening: fixed versus
floating exchange rates
• As i-i* goes up, net
short-run capital
inflows are stimulated.
E
S0
•The net supply of
foreign currency goes
up and there is an
initial excess supply
of foreign currency.
S1
E0
E1
D0
R > 0
Quantity of foreign
currency (ex.: $US)
•If the central bank
wants to keep the
exchange rate constant
at E0, it must purchase
the excess supply (R
> 0)
•If the central bank
does not buy the
excess supply the
exchange rate drops to
E1
Fixed exchange rate: The central bank
buys the excess supply of foreign
currency
ASSETS
LIABILITIES + CAPITAL
• Domestic money market instruments • Government deposits
• Domestic bonds
• Deposits of the domestic financial
institutions
• Net advances to the government
• Domestic notes and coins
• Net advances to the domestic
• Capital
financial institutions
• Foreign exchange reserves
The central bank first increased its discount rate in order to slow the expansion of settlement
balances and credit in the financial system. In a fixed exchange rate regime, domestic
financial institutions can avoid paying the higher bank rate by selling the excess supply of
foreign exchange to the central bank. The restrictive monetary policy does not work.
In a fixed exchange rate regime, restrictive
monetary policy does not work...
Normally, the banks would have to pay more for their
settlement balances...
Inter-bank
overnight rate
SB SB’
SB’
The Central bank raises its
discount rate which raises the
target rate of the operating band
by exactly the same amount...
New discount rate
Initial discount rate
D’
D
Settlement
But in a fixed exchange rate regime, capital inflows would lead to
balances
an excess supply of foreign currency and the banks would obtain
settlement balances by selling the excess supply to the central bank
What about an expansionary
monetary policy ? Try it under
both a flexible and a fixed
exchange rate regime.
The monetary transmission mechanism
under fixed and flexible exchange rates
• Let’s summarize:
• Fixed exchange rate
– When the national central bank acts alone in increasing its key
interest rate, this stimulates net capital inflows. These capital
inflows must be purchased by the central bank in order to keep the
exchange rate constant. The central bank cannot slow the
expansion of settlement balances. In the end neither i nor E
change. The central bank cannot conduct a nationally
independent monetary policy.
• Flexible exchange rate
– The central bank does not buy the excess supply of foreign
currency and the exchange rate falls. In addition to the rise in i,
this is a second reason why aggregate demand is affected
downward. The central bank can conduct a nationally
independent monetary policy.
– The monetary transmission mechanism is then:
–  i   E and  SB and  Credit   AD   
Fixed and flexible exchange rates: some
additional issues
• Of course, in a floating regime, the exchange rate may
respond to a variety of shocks which have nothing to do
with monetary policy.
• A good example of this would be a terms of trade shock.
• Let’s suppose that an economy experiences a deterioration
in its terms of trade.
• We already saw that this should affect negatively
aggregate demand.
• We will now see that it also affects the foreign exchange
market.
• To make the example particularly relevant, let’s suppose
that the deterioration in the terms of trade occurs at a time
when the inflation rate is below the target level.
The impact of a deterioration in the terms of trade (ex.:
PX falls while PM remains constant)
E
•A fall in PX reduces
the value of the
country’s exports.
•The net supply of
foreign exchange
contracts.
S1
S0
E1
E0
D0
R < 0
Quantity of $US
•If the exchange rate
was flexible, E would
rise. This would
provide a cushion to
absorb the negative
impact of the terms of
trade shock.
•If the exchange rate
was fixed, the central
bank would have to
sell its reserves and as
we saw, this implies a
restrictive monetary
policy
Fixed and flexible exchange rates: some
additional issues
• When the terms of trade deteriorate, the central bank is
forced to respond with a restrictive monetary policy under
a fixed exchange rate regime.
• If inflation was already below target, this restrictive
monetary policy is totally untimely.
• In fact, an expansionary monetary policy would be
welcome.
• In a floating regime, the rising exchange rate does just that
because it stimulates in itself aggregate demand and partly
compensate for falling absorption.
• A country may prefer to have some exchange rate
flexibility when its terms of trade are subject to frequent
and important shocks. This is the Bank of Canada’s main
argument in favor of a flexible exchange rate.
Fixed and flexible exchange rates: some
additional issues
• Another important class of shocks to consider in a shock
to capital inflows, that is the amount of capital inflows
could change for exogenous reasons from the point of
view of the domestic economy.
• Emerging markets are particularly affected by this type of
shocks since world capital markets often tend to look upon
these markets as if they were all alike.
• A financial crisis in one particular emerging market may
lead to a drastic fall in capital inflows to all emerging
markets.
• An example: the financial crisis in Brazil in 1999 led to a
drastic fall in capital flows to Argentina .
The impact of an exogenous fall in capital inflows
• A fall in CI leads to a
E
S1
S0
E1
E0
D0
R < 0
Quantity of $US
reduction in the net
supply of foreign
currency. With less
foreign financing (lower
credit availability),
aggregate demand will
tend to fall.
•If the exchange rate was
flexible, E would rise.
This would provide a
cushion to absorb the
negative impact of the
reduction in capital
inflows.
•If the exchange rate was
fixed, the central bank
would have to sell its
reserves and this implies
would imply a restrictive
monetary policy. The
negative consequences
of the fall in CI would be
magnified.
Fixed exchange rates: Are there
advantages to tying one’s hands ?
• The previous discussion may have seemed to tilt the
balance in favor of flexible exchange rates.
• One of the main advantage of a flexible exchange rate is
that it permits the central bank to conduct an independent
monetary policy.
• The benefits for a country to have its own independent
monetary policy depend very much on what it does with
this independence.
• The decision to fix the exchange rate is sometimes seen as
the most efficient way to discipline the central bank and
the rest of the public sector.
Choosing a strategy for inflation
stabilization
• You will have understood from our previous
discussion that there is one key to inflation
stabilization:
– Only a very small part of the government deficit (if any) should be
financed by money creation.
• This way, the central bank can be given the effective
powers to bring down the inflation rate with the usual tools
of monetary policy.
• But this may not sufficient in the short run:
– The public has to be convinced that the monetary financing of the
government deficit has gone for ever.
– The only way to do that is to implement a bold fiscal reform that
will reduce the deficit to what can voluntarily be financed in the
financial markets.
– The public also has to be convinced that the central bank will carry
its job with competence, efficiency and consistency
Choosing a strategy for inflation
stabilization
• There is no quick fix for inflation stabilization:
– Inflation stabilization requires solid and competent public
institutions capable of:
• Establishing priorities
• Collecting in an efficient way the (non-prohibitive)
taxes required to finance these priorities
• Concentrating on achieving the targets set by these
priorities in a cost efficient way.
• Saying no to the demands that fall outside these
priorities or would imply prohibitive levels of taxation
or an unacceptably high budget deficit.
• As you can see, inflation stabilization requires some solid
efforts at institutions building, in other words, it requires
political and institutional convergence to the standards of the
most stable countries.
• In certain countries, a drastic course to political and
institutional convergence has been chosen: Tying the hands
of the state.
Choosing a strategy for inflation
stabilization
• In Argentina, was adopted in 1991 a monetary system
which they name “convertibility”.
• Under the convertibility law, the central bank is strictly
forbidden to provide credit to the government.
• Moreover, at least two thirds of the central banks assets
must be foreign reserves assets.
• These two things make it virtually impossible for the
national treasury to obtain financing (directly or indirectly)
from the central bank.
• Under this self-imposed discipline, the government had no
choice but implement a bold fiscal reform aiming at
enlarging the tax base and combat tax evasion.
Choosing a strategy for inflation
stabilization
• The other part of the strategy was to fix the value of the
peso in dollar “for ever” .
• This, in addition to the foreign exchange reserves
requirement, transformed the central bank into a virtual
currency board.
• The strategy worked as inflation rapidly fell. Argentina
lived in a 200 % per month inflation environment in the
middle of 1989. Today, Argentina lives in a zero inflation
environment and even in the last two years, a deflationary
environment.
Simplified balance sheet
of the argentine currency board
ASSETS
• Domestic bonds and money market
instruments (at most 1/3)
• Net assets in foreign currency (at
least 2/3)
LIABILITIES + CAPITAL
• Government deposits
• Domestic financial institutions
deposits
• Domestic notes and coins
• Capital
Given the fixed exchange rate, this basically
means that  SB = R = CA + CFA
The inflation rate in Argentina
3500
%
3000
2500
2000
1500
1000
500
0
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
1957
1954
1951
1948
1945
Fixed exchange rates may work
for inflation stabilization but…
• Click here to read a polemical essay about
Argentina’s current financial crisis.
• Click here to read about a possible way out.
• And here is my own analysis for those of you who
read French (optional).
Monetary Policy and the Choice
of an Exchange Rate Regime
ÉCOLE DES HAUTES ÉTUDES COMMERCIALES
MBA PROGRAM
NOVEMBER 2001