Transcript Factors influencing ER - Warsaw School of Economics

Fixed exchange rates
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Lecture outline
 Interventions on the FX market
 Equilibrium on the FX market in a fixed ER regime
 Adjustment mechanisms
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Why analyze fixed ER?
 Managed floating
 Regional monetary agreements
 Monetary unions and currency boards
 ERR in developing countries
 Conclusions from the past
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Central bank interventions
 Money supply management
 The influence of CB transations on money
supply
 The CB balance sheet
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The CB balance sheet
 CB assets and liabilities
 Foreign and national assets
 Foreign assets- e.g. bonds denominated in
foreign currency
 National assets- CB claims concerning future
payments from national market participants
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Foreign assets
 Foreign assets are a part of CB reserves
 CB interventions- reserves shifts
 Reserves- liabilities of foreign market
participants and other commonly accepted
monetary values
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CB liabilities
 Private banks’ deposits
 Money in circulation
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The CB balance sheet
 The CB assets equal the liabilities plus
the net value of the balance
 The net value e.g reinvested profits from
interest from assets- modest share in the
balance
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The CB balance sheet
 Shifts in assets automatically imply shifts
in liabilities
 Example:
 CB buys assets --> money supply increases
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CB payments and money supply
 Payment in cash
 Payment by cheque
 CB liabilities increase BC due to the payment
for assets  money supply increase
 Selling assets cheque or cash withdrawal
from the circulation  money supply decreases
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Monetary multiplicator effect
 Each time the CB buys assets the money
supply increases automatically while each
time it sells assets it causes it’s decrease
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Monetary multiplicator effect
 the ratio of commercial bank and central
bank money
 the impact of raising the money supply on
commercial bank money
 MM=1/ reserves requirements
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CB interventions
 CB sells foreign bonds at the FX market  foreign
reserves decrease  CB asstes decrease
 Payment to the CB decreases it’s liabilities
 Payment in national currency  cash withdrawal from
the circulation  CB balance changes, both sides of the
balance decrease by the value of money in circulation
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CB interventions
 CB sells foreign bonds at the FX market 
foreign reserves increase  CB asstes increase
 Payment of the CB increases it’s liabilities
 Payment in national currency  cash
introduction to the circulation  CB balance
changes, both sides of the balance increase by
the value of money in circulation
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CB interventions- sterilisation
 contrary transactions at the foreign at national assets
market  neutralising the influence of FX market
transactions on national money supply operacji
walutowych na krajową podaż pieniądza
 Example:
 CB sells foreign asstes to a commercial bank and at same time it
buys national governement bonds
 Influence on the balance- national assets increase, foreign
assets decrease, money supply does not change
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Sterilized vs. not sterilized
interventions
Influence on
national
money supply
Influence on
national assets
of the CB
Influence on
foreign assets
of the CB
CB's action
Not sterilized purchase
of foreign assets
"+100"
0 "+100"
Sterilized purchase of
foreign assets
Not sterilized sell of
foreign assets
0 "-100"
"-100"
"+100"
0 "-100"
Sterilized sell of foreign
assets
0 "+100"
Source: Krugman, Obstfeld, 2009.
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"-100"
CB interventions and the balance
of payments
 Financing a part of the current account balance,
which has not been equilibrated by the financial
account balance except foreign reserves
 Absorbing the part of the surplus of the current
account which has not been equilibrated buy the
net outflow from the financial account except
foreign reserves
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CB interventions and the balance
of payments
 If CB does not conduct sterilized
interventions while a country has a BP
deficit/surplus than each
decrease/increase of foreign assetes
related to that situation
decreases/increases the national money
supply
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CB interventions and the balance
of payments
 The influence of the BP gap on the money
supply- hard to predict
 BP adjustments born by several CB
 Sterilization
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The equilibrium on the FX market
in a fixed ERR
 The mechanism of fixing the ER
 The necessity to exchange currencies at a fixed ER
 Eliminating demand and supply surpluses at the FX
market
 CB transactions must insure constant equilibrium on
the assets market
 Equilibrium on the FX market and on the money market
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The equilibrium on the FX market
in a fixed ERR
 Interest rate parity
rUSD=rEUR+ (EReEUR-EeUSD)/EUSD/EUR
 Fixed ER expected ER changes=0
 rUSD=rEUR
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The equilibrium on the FX market
in a fixed ERR
 The necessity to keep the interest rate at r 
the necessity of CB interventions aiming at
stabilizing money supply
 r must equalize the real national demand for
money and the real national money supply
M/P=L(r, Y)
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The equilibrium on the FX market
in a fixed ERR
 The equilibrium condition defines the
money supply by fixed ER, which
equilibrates the asset market by a given
level of the foreign interest rate
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The equilibrium on the FX market
in a fixed ERR
 CB interventions aimed at maintaining the
ER  the necessity to adjust the money
supply in order to maintain the equilibrium
on the money market
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The equilibrium on the FX market
in a fixed ERR
 Example:
 ER fixed at E0
 Assets market in equilibrium
 Production increase  pressure on the assets market +
expectations that the ER will be maintained at E0
 Endavour to apply monetary policy measures- the necessity to
decrease money demand in order to counteract appreciation of the
currency  CB buys foreign assets  national money supply
increases  the equilibrium reinstated ???
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Adjustment mechanisms in fixed
ERR
 Monetary policy
 Fiscal policy
 ER policy
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Monetary policy
 ER fixed at E0
 Equilibrium on the money market
 Endeavour to raise production money supply
increase  unequilibrium on the assets market
 pressure on depreciation  the necessity for
the CB to sell foreign assets money supply
decrease
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Monetary policy
Source: Own elaboration based on Krugman, Obstfeld, op. cit.
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Monetary policy
 In fixed ERR monetary policy does not
influence neither the money supply nor the
production level
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Fiscal policy
 Expansionary fiscal policy  increase of demand on the
products market production increase  pressure for
appreciation  CB interventions
 CB buys foreign assets  ER maintained at E0
 Effect:
 Production growth,
 Maintained ER
 Foreign reserves increase and money supply increase
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Fiscal policy
Source: Own elaboration based on Krugman, Obstfeld, op. cit.
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ER policy
 Excessive deficit of the current account
balance  decrease of foreign reserves 
necessity to devalue the ER
 Currency exchange at a new ER
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ER policy
 devaluation  decrease of relative national
prices  production increase  excessive
money demand  CB buys foreign assets in
order to increase money supply
 Effect:
 Production increase
 Foreign reserves increase
 Money supply increase
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ER policy
Source: Own elaboration based on Krugman, Obstfeld, op. cit
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Adjustment mechanisms in the long
term
 Full employment
 Expansionary fiscal policy  production
increase  price increase  real
appreciation  the necessity of CB
interventions in order to increase money
supply
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Adjustment mechanisms in the long
term
 Devaluation does not increase neither the
demand nor the supply on the product
market
 The only effect is the increase of prices
and money supply
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Adjustment mechanisms in the long
term
 devaluation may trigger demand shifts
within countries characterized by different
economic cycles
 the wages-prices interdependence 
potential inflationary pressures
Balance of payments reactions to
devaluation/ revaluation
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Fixed ER and expectations
 Changing economic conditions 
speculation on ER changes
 The balance of payment crisis
 Immediate capital outflow
 Foreign reserves decrease
 Monetary crisis
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Intermediate ER regimes
 Aimed at mainataining the internal and external
eqilibrium at the same time
Contradictory economic policy measures
Example:
 Money supply increase in order to fight
unemployment and selling foreign assets at the
same time in order to counteract depreciation 
counteracting the monetary expansion
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Intermediate ER regimes
 Sterilisation by intermediate ERR is
inefficient
 The role of expectations
 Vanishing of intermediate ERR
Example:
 Crawling peg- inflationary pressures
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Summing up
 The CB balance sheet construction
 CB interventions
 Sterilization
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Summing up
 Monetary policy tools are inefficient by
fixed ERR
 Fiscal policy tools are efficient by fixed
ERR
 ER policy may be efficient in the short
term, but it does not work in the long term
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References
 P. Krugman, M.Obstfeld, International economics: theory and policy.
Part II, Pearson, Addison Wesley, Boston 2009
 F. Mishkin, The economics of money banking and financial markets,
Addison-Wesley, Longman, Boston 2001
 P. De Grauwe, Economics of monetary union, Oxford University
Press, 2007.
 L. Sarno, M. Taylor, Official intervention in the foreign exchange
market: is it effective and if so, how does it work?, Journal of
Economic Literature, 2001
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