Overview of Fixed Exchange Rates

Learning Objective
1. Preview the discussion about fixed exchange rate systems, their varieties, and their mechanisms. This chapter begins by defining several types of fixed exchange rate systems, including the gold standard, the reserve currency standard, and the gold exchange standard. The price-specie flow mechanism is described for the gold standard. It continues with other modern fixed exchange variations such as fixing a currency to a basket of several other currencies, crawling pegs, fixing within a band or range of exchange rates, currency boards, and finally the most extreme way to fix a currency: adopting another countrys currency as your own, as is done with dollarization or euroization. The chapter proceeds with the basic mechanics of a reserve currency standard in which a country fixes its currency to anothers. In general, a countrys central bank must intervene in the foreign exchange (Forex) markets, buying foreign currency whenever there is excess supply (resulting in a balance of payments surplus) and selling foreign currency whenever there is excess demand (resulting in a balance of payments deficit). These actions will achieve the fixed exchange rate version of the interest parity condition in which interest rates are equalized across countries. However, to make central bank actions possible, a country will need to hold a stock of foreign exchange reserves. If a countrys central bank does not intervene in the Forex in a fixed exchange system, black markets are shown to be a likely consequence.

Results

Gold standard rules: (1) fix currency to a weight of gold; (2) central bank freely exchanges gold for currency with public. Adjustment under a gold standard involves the flow of gold between countries, resulting in equalization of prices satisfying purchasing power parity (PPP) and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate. Reserve currency rules: (1) fix currency to another currency, known as the reserve currency; (2) central bank must hold a stock of foreign exchange reserves to facilitate Forex interventions. Gold-exchange standard rules: (1) reserve country fixes its currency to a weight of gold, (2) all other countries fix their currencies to the reserve, (3) reserve central bank freely exchanges gold for currency with other central banks, (4) nonreserve countries hold a stock of the reserve currency to facilitate intervention in the Forex. The postWorld War II fixed exchange rate system, known as the Bretton Woods system, was a gold exchange standard. Some countries fix their currencies to a weighted average of several other currencies, called a basket of currencies. Some countries implement a crawling peg in which the fixed exchange rate is adjusted regularly.

Some countries set a central exchange rate and allow free floating within a predefined range or band. Some countries implement currency boards to legally mandate Forex interventions. Some countries simply adopt another countrys currency, as with dollarization, or choose a brand-new currency, as with the euro. The interest rate parity condition becomes the equalization of interest rates between two countries in a fixed exchange rate system. A balance of payments surplus (deficit) arises when the central bank buys (sells) foreign reserves on the Forex in exchange for its own currency. A black market in currency trade arises when there is unsatisfied excess demand or supply of foreign currency in exchange for domestic currency on the Forex.

Fixed Exchange Rate Systems

Learning Objectives
1. Recognize the varieties of ways that exchange rates can be fixed to a particular value. 2. Understand the basic operation and the adjustment mechanism of a gold standard. There are two basic systems that can be used to determine the exchange rate between one countrys currency and anothers: a floating exchange rate system and a fixed exchange rate system. Under a floating exchange rate system, the value of a countrys currency is determined by the supply and demand for that currency in exchange for another in a private market operated by major international banks. In contrast, in a fixed exchange rate system, a countrys government announces (or decrees) what its currency will be worth in terms of something else and also sets up the rules of exchange. The something else to which a currency value is set and the rules of exchange determine the type of fixed exchange rate system, of which there are many. For example, if the government sets its currency value in terms of a fixed weight of gold, then we have a gold standard. If the currency value is set to a fixed amount of another countrys currency, then it is a reserve currency standard. As we review several ways in which a fixed exchange rate system can work, we will highlight some of the advantages and disadvantages of the system. In anticipation, it is worth noting that one key advantage of fixed exchange rates is the intention to eliminate exchange rate risk, which can greatly enhance international trade and investment. A second key advantage is the discipline a fixed exchange rate system imposes on a countrys monetary authority, with the intention of inducing a much lower inflation rate.

The Gold Standard

Most people are aware that at one time the world operated under something called a gold standard. Some people today, reflecting back on the periods of rapid growth and prosperity that

occurred when the world was on a gold standard, have suggested that the world abandon its current mixture of fixed and floating exchange rate systems and return to this system. (For a discussion of some pros and cons see Alan Greenspans remarks on this from the early 1980s.[9] See Murray Rothbards article for an argument in favor of a return to the gold standard.[10]) Whether or not countries seriously consider this in the future, it is instructive to understand the workings of a gold standard, especially since, historically, it is the first major international system of fixed exchange rates. Most of the world maintained a pure gold standard during the late 1800s and early 1900s, with a major interruption during World War I. Before the enactment of a gold standard, countries were generally using a Bimetallic standard consisting of both gold and silver.[11] The earliest establishment of a gold standard was in Great Britain in 1821, followed by Australia in 1852 and Canada in 1853. The United States established its gold standard system with the Coinage Act of 1873, sometimes known as The Crime of 73.[12] The gold standard was abandoned in the early days of the Great Depression. Britain dropped the standard in 1931, the United States in 1933. The rules of a gold standard are quite simple. First, a countrys government declares that its issued currency (it may be coin or paper currency) will exchange for a weight in gold. For example, in the United States during the late 1800s and early 1900s, the government set the dollar exchange rate to gold at the rate $20.67 per troy ounce. During the same period, Great Britain set its currency at the rate 4.24 per troy ounce. Second, in a pure gold standard, a countrys government declares that it will freely exchange currency for actual gold at the designated exchange rate. This rule of exchange means that anyone can go to the central bank with coin or currency and walk out with pure gold. Conversely, one could also walk in with pure gold and walk out with the equivalent in coin or currency. Because the government bank must always be prepared to give out gold in exchange for coin and currency on demand, it must maintain a storehouse of gold. That store of gold is referred to as gold reserves. That is, the central bank maintains a reserve of gold so that it can always fulfill its promise of exchange. As discussed in Chapter 11, Fixed Exchange Rates, the section called Central Bank Intervention with Fixed Exchange Rates, a well-functioning system will require that the central bank always have an adequate amount of reserves. The two simple rules, when maintained, guarantee that the exchange rate between dollars and pounds remains constant. Heres why. First, the dollar/pound exchange rate is defined as the ratio of the two-currency-gold exchange rates. Thus

E$/=20.67 $/oz4.24 /oz=4.875$ozoz=4.875$.

Next, suppose an individual wants to exchange $4.875 for one pound. Following the exchange rules, this person can enter the central bank in the United States and exchange dollars for gold to get

$4.87520.67 $/oz=0.23585 oz of gold.

This person can then take the gold into the central bank in the United Kingdom, and assuming no costs of transportation, can exchange the gold into pounds as follows:

0.23585 oz4.24oz=1.00.
Hence, the $4.875 converts to precisely 1 and this will remain the fixed exchange rate between the two currencies, as long as the simple exchange rules are followed. If many countries define the value of their own currency in terms of a weight of gold and agree to exchange gold freely at that rate with all who desire to exchange, then all these countries will have fixed currency exchange rates with respect to each other.

Price-Specie Flow Mechanism

The price-specie flow mechanism is a description about how adjustments to shocks or changes are handled within a pure gold standard system. Although there is some disagreement whether the gold standard functioned as described by this mechanism, the mechanism does fix the basic principles of how a gold standard is supposed to work. Consider the United States and United Kingdom operating under a pure gold standard. Suppose there is a gold discovery in the United States. This will represent a shock to the system. Under a gold standard, a gold discovery is like digging up money, which is precisely what inspired so many people to rush to California after 1848 to strike it rich. Once the gold is unearthed, the prospectors bring it into town and proceed to the national bank where it can be exchanged for coin and currency at the prevailing dollar/gold exchange rate. The new currency in circulation represents an increase in the domestic money supply. Indeed, it is this very transaction that explains the origins of the gold and silver standards in the first place. The original purpose of banks was to store individuals precious metal wealth and to provide exchangeable notes that were backed by the gold holdings in the vault. Thus rather than carrying around heavy gold, one could carry lightweight paper money. Before national or central banks were founded, individual commercial banks issued their own currencies, which circulated together with many other bank currencies. However, it was also common for governments to issue coins that were made directly from gold or silver. Now, once the money supply increases following the gold discovery, it can have two effects: operating through the goods market and financial market. The price-specie flow mechanism describes the adjustment through goods markets. First, lets assume that the money increase occurs in an economy that is not growingthat is, with a fixed level of GDP. Also assume that both purchasing power parity (PPP) and interest rate parity (IRP) holds. PPP implies an equalization of the cost of a market basket of goods between the United States and the United Kingdom at the current fixed exchange rate. IRP implies an equalization of the rates of return on comparable assets in the two countries.

As discussed in Chapter 7, Interest Rate Determination, the section called Money Supply and Long-Run Prices, when the U.S. money supply increases, and when there is no subsequent increase in output, the prices of goods and services will begin to rise. This inflationary effect occurs because more money is chasing (i.e., demanding) the same amount of goods and services. As the price level rises in an economy open to international trade, domestic goods become more expensive relative to foreign goods. This will induce domestic residents to increase demand for foreign goods; hence import demand will rise. Foreign consumers will also find domestic goods more expensive, so export supply will fall. The result is a demand for a current account deficit. To make these transactions possible in a gold standard, currency exchange will take place as follows. U.S. residents wishing to buy cheaper British goods will first exchange dollars for gold at the U.S. central bank. Then they will ship that gold to the United Kingdom to exchange for the pounds that can be used to buy UK goods. As gold moves from the United States to the United Kingdom, the money supply in the United States falls while the money supply in the United Kingdom rises. Less money in the United States will eventually reduce prices, while more money in the United Kingdom will raise prices. This means that the prices of goods will move together until purchasing power parity holds again. Once PPP holds, there is no further incentive for money to move between countries. There will continue to be demand for UK goods by U.S. residents, but this will balance with the United Kingdom demands for similarly priced U.S. goods. Hence, the trade balance reverts to zero. The adjustment process in the financial market under a gold standard will work through changes in interest rates. When the U.S. money supply rises after the gold discovery, average interest rates will begin to fall. Lower U.S. interest rates will make British assets temporarily more attractive, and U.S. investors will seek to move investments to the United Kingdom. The adjustment under a gold standard is the same as with goods. Investors trade dollars for gold in the United States and move that gold to the United Kingdom where it is exchanged for pounds and used to purchase UK assets. Thus the U.S. money supply will begin to fall, causing an increase in U.S. interest rates, while the UK money supply rises, leading to a decrease in UK interest rates. The interest rates will move together until interest rate parity again holds. In summary, adjustment under a gold standard involves the flow of gold between countries, resulting in equalization of prices satisfying purchasing power parity (PPP) and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate. The only requirement for the government to maintain this type of fixed exchange rate system is to maintain the fixed price of its currency in terms of gold and to freely and readily exchange currency for gold on demand.

Reserve Currency Standard

In a reserve currency system, another countrys currency takes the role that gold played in a gold standard. In other words a country fixes its own currency value to a unit of another countrys currency. For example, suppose Britain decided to fix its currency to the dollar at the exchange rate E$/ = 1.50. To maintain this fixed exchange rate, the Bank of England would stand ready to exchange pounds for dollars (or dollars for pounds) on demand at the specified exchange rate. To

accomplish this, the Bank of England would need to hold dollars on reserve in case there was ever any excess demand for dollars in exchange for pounds on the Forex. In the gold standard, the central bank held gold to exchange for its own currency; with a reserve currency standard, it must hold a stock of the reserve currency. Always, the reserve currency is the currency to which the country fixes. A reserve currency standard is the typical method for fixing a currency today. Most countries that fix its exchange rate will fix to a currency that either is prominently used in international transactions or is the currency of a major trading partner. Thus many countries fixing their exchange rate today fix to the U.S. dollar because it is the most widely traded currency internationally. Alternatively, fourteen African countries that were former French colonies had established the CFA franc zone and fixed the CFA franc (current currency used by these African countries) to the French franc. Since 1999, the CFA franc has been fixed to the euro. Namibia, Lesotho, and Swaziland are all a part of the common monetary area (CMA) and fix their currency to the South African rand.

Gold Exchange Standard

A gold exchange standard is a mixed system consisting of a cross between a reserve currency standard and a gold standard. In general, it includes the following two rules: 1. A reserve currency is chosen. All nonreserve countries agree to fix their exchange rates to the reserve at some announced rate. To maintain the fixity, these nonreserve countries will hold a stockpile of reserve currency assets. 2. The reserve currency country agrees to fix its currency value to a weight in gold. Finally, the reserve country agrees to exchange gold for its own currency with other central banks within the system on demand. One key difference in this system from a gold standard is that the reserve country does not agree to exchange gold for currency with the general public, only with other central banks. The system works exactly like a reserve currency system from the perspective of the nonreserve countries. However, if over time the nonreserve countries accumulate the reserve currency, they can demand exchange for gold from the reserve country central bank. In this case, gold reserves will flow away from the reserve currency country. The fixed exchange rate system set up after World War II was a gold exchange standard, as was the system that prevailed between 1920 and the early 1930s. The postWorld War II system was agreed to by the allied countries at a conference in Bretton Woods, New Hampshire, in the United States in June 1944. As a result, the exchange rate system after the war also became known as the Bretton Woods system. Also proposed at Bretton Woods was the establishment of an international institution to help regulate the fixed exchange rate system. This institution was the International Monetary Fund (IMF). The IMFs main mission was to help maintain the stability of the Bretton Woods fixed exchange rate system.

Other Fixed Exchange Rate Variations

Basket of Currencies

Countries that have several important trading partners, or who fear that one currency may be too volatile over an extended period, have chosen to fix their currency to a basket of several other currencies. This means fixing to a weighted average of several currencies. This method is best understood by considering the creation of a composite currency. Consider the following hypothetical example: a new unit of money consisting of 1 euro, 100 Japanese yen, and one U.S. dollar. Call this new unit a Eur-yen-dol. A country could now fix its currency to one Eur-yendol. The country would then need to maintain reserves in one or more of the three currencies to satisfy excess demand or supply of its currency on the Forex. A better example of a composite currency is found in the SDR. SDR stands for special drawing rights. It is a composite currency created by the International Monetary Fund (IMF). One SDR now consists of a fixed quantity of U.S. dollars, euros, Japanese yen, and British pounds. For more info on the SDR see the IMF factsheet.[13] Now Saudi Arabia officially fixes its currency to the SDR. Botswana fixes to a basket consisting of the SDR and the South African rand.
Crawling Pegs

A crawling peg refers to a system in which a country fixes its exchange rate but also changes the fixed rate at periodic or regular intervals. Central bank interventions in the Forex may occur to maintain the temporary fixed rate. However, central banks can avoid interventions and save reserves by adjusting the fixed rate instead. Since crawling pegs are adjusted gradually, they can help eliminate some exchange rate volatility without fully constraining the central bank with a fixed rate. In 2010 Bolivia, China, Ethiopia, and Nicaragua were among several countries maintaining a crawling peg.
Pegged within a Band

In this system, a country specifies a central exchange rate together with a percentage allowable deviation, expressed as plus or minus some percentage. For example, Denmark, an EU member country, does not yet use the euro but participates in the Exchange Rate Mechanism (ERM2). Under this system, Denmark sets its central exchange rate to 7.46038 krona per euro and allows fluctuations of the exchange rate within a 2.25 percent band. This means the krona can fluctuate from a low of 7.63 kr/ to a high of 7.29 kr/. (Recall that the krona is at a high with the smaller exchange rate value since the kr/euro rate represents the euro value.) If the market determined floating exchange rate rises above or falls below the bands, the Danish central bank must intervene in the Forex. Otherwise, the exchange rate is allowed to fluctuate freely. As of 2010, Slovenia, Syria, and Tonga were fixing their currencies within a band.

Currency Boards

A currency board is a legislated method to provide greater assurances that an exchange rate fixed to a reserve currency will indeed remain fixed. In this system, the government requires that domestic currency is always exchangeable for the specific reserve at the fixed exchange rate. The central bank authorities are stripped of all discretion in the Forex interventions in this system. As a result, they must maintain sufficient foreign reserves to keep the system intact. In 2010 Bulgaria, Hong Kong, Estonia, and Lithuania were among the countries using a currency board arrangement. Argentina used a currency board system from 1991 until 2002. The currency board was very effective in reducing inflation in Argentina during the 1990s. However, the collapse of the exchange rate system and the economy in 2002 demonstrated that currency boards are not a panacea.
Dollarization/Euroization

The most extreme and convincing method for a country to fix its exchange rate is to give up ones national currency and adopt the currency of another country. In creating the euro-zone among twelve of the European Union (EU) countries, these European nations have given up their own national currencies and have adopted the currency issued by the European Central Bank. This is a case of euroization. Since all twelve countries now share the euro as a common currency, their exchange rates are effectively fixed to each other at a 1:1 ratio. As other countries in the EU join the common currency, they too will be forever fixing their exchange rate to the euro. (Note, however, that although all countries that use the euro are fixed to each other, the euro itself floats with respect to external currencies such as the U.S. dollar.) Other examples of adopting another currency as ones own are the countries of Panama, Ecuador, and El Salvador. These countries have all chosen to adopt the U.S. dollar as their national currency of circulation. Thus they have chosen the most extreme method of assuring a fixed exchange rate. These are examples of dollarization.

Key Takeaways

In a gold standard, a countrys government declares that its issued currency will exchange for a weight in gold and that it will freely exchange currency for actual gold at the designated exchange rate. Adjustment under a gold standard involves the flow of gold between countries, resulting in equalization of prices satisfying purchasing power parity (PPP) and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate. In a reserve currency system, a country fixes its own currency value to a unit of another countrys currency. The other country is called the reserve currency country. A gold exchange standard is a mixed system consisting of a cross between a reserve currency standard and a gold standard. First, a reserve currency is chosen. Second, the reserve currency country agrees to fix its currency value to a weight in gold. Finally, the

reserve country agrees to exchange gold for its own currency with other central banks within the system on demand. The postWorld War II Bretton Woods system was a gold exchange currency standard. Other fixed exchange rate choices include fixing to a market basket, fixing in a nonrigid way by implementing a crawling peg or an exchange rate band, implementing a currency board, or adopting another countrys currency.

Overview of Policy with Floating Exchange Rates

Learning Objective
1. Preview the comparative statics results from the AA-DD model with floating exchange rates. This chapter uses the AA-DD model to describe the effects of fiscal and monetary policy under a system of floating exchange rates. Fiscal and monetary policies are the primary tools governments use to guide the macroeconomy. In introductory macroeconomics courses, students learn how fiscal and monetary policy levers can be used to influence the level of gross national product (GNP), the inflation rate, the unemployment rate, and interest rates. In this chapter, that analysis is expanded to an open economy (i.e., one open to trade) and to the effects on exchange rates and current account balances.

Results
Using the AA-DD model, several important relationships between key economic variables are shown:

Expansionary monetary policy (MS) causes an increase in GNP and a depreciation of the domestic currency in a floating exchange rate system in the short run. Contractionary monetary policy (MS) causes a decrease in GNP and an appreciation of the domestic currency in a floating exchange rate system in the short run. Expansionary fiscal policy (G, TR, or T) causes an increase in GNP and an appreciation of the domestic currency in a floating exchange rate system. Contractionary fiscal policy (G, TR, or T) causes a decrease in GNP and a depreciation of the domestic currency in a floating exchange rate system. In the long run, once inflation effects are included, expansionary monetary policy (MS) in a full employment economy causes no long-term change in GNP and a depreciation of the domestic currency in a floating exchange rate system. In the transition, the exchange rate overshoots its long-run target and GNP rises then falls. A sterilized foreign exchange intervention will have no effect on GNP or the exchange rate in the AA-DD model, unless international investors adjust their expected future exchange rate in response. A central bank can influence the exchange rate with direct Forex interventions (buying or selling domestic currency in exchange for foreign currency). To sell foreign currency and buy domestic currency, the central bank must have a stockpile of foreign currency reserves.

A central bank can also influence the exchange rate with indirect open market operations (buying or selling domestic treasury bonds). These transactions work through money supply changes and their effect on interest rates. Purchases (sales) of foreign currency on the Forex will raise (lower) the domestic money supply and cause a secondary indirect effect upon the exchange rate.

Connections
The AA-DD model was developed to describe the interrelationships of macroeconomic variables within an open economy. Since some of these macroeconomic variables are controlled by the government, we can use the model to understand the likely effects of government policy changes. The two main levers the government controls are monetary policy (changes in the money supply) and fiscal policy (changes in the government budget). In this chapter, the AA-DD model is applied to understand government policy effects in the context of a floating exchange rate system. In Chapter 12, Policy Effects with Fixed Exchange Rates, well revisit these same government policies in the context of a fixed exchange rate system. It is important to recognize that these results are what would happen under the full set of assumptions that describe the AA-DD model. These effects may or may not happen in reality. Despite this problem, the model surely captures some of the simple cause-and-effect relationships and therefore helps us to understand the broader implications of policy changes. Thus even if in reality many more elements not described in the model may act to influence the key endogenous variables, the AA-DD model at least gives a more complete picture of some of the expected tendencies.

Key Takeaways

The main objective of the AA-DD model is to assess the effects of monetary and fiscal policy changes. It is important to recognize that these results are what would happen under the full set of assumptions that describes the AA-DD model; they may or may not accurately describe actual outcomes in actual economies.

Monetary Policy with Floating Exchange Rates

Learning Objectives
1. Learn how changes in monetary policy affect GNP, the value of the exchange rate, and the current account balance in a floating exchange rate system in the context of the AADD model. 2. Understand the adjustment process in the money market, the foreign exchange market, and the G&S market. In this section, we use the AA-DD model to assess the effects of monetary policy in a floating exchange rate system. Recall from Chapter 7, Interest Rate Determination that the money supply is effectively controlled by a countrys central bank. In the case of the United States, this is the Federal Reserve Board, or the Fed for short. When the money supply increases due to action taken by the central bank, we refer to it as expansionary monetary policy. If the central bank acts to reduce the money supply, it is referred to as contractionary monetary policy. Methods that can be used to change the money supply are discussed in Chapter 7, Interest Rate Determination, the section called Controlling the Money Supply.

Expansionary Monetary Policy

Suppose the economy is originally at a superequilibrium shown as point F in Figure 10.1, Expansionary Monetary Policy in the AA-DD Model with Floating Exchange Rates. The original GNP level is Y1 and the exchange rate is E$/1. Next, suppose the U.S. central bank (or the Fed) decides to expand the money supply. As shown in Chapter 9, The AA-DD Model, the section called Shifting the AA Curve, money supply changes cause a shift in the AA curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., MS is an AA up-shifter). This is depicted in the diagram as a shift from the red AA to the blue AA line. Figure 10.1. Expansionary Monetary Policy in the AA-DD Model with Floating Exchange Rates

There are several different levels of detail that can be provided to describe the effects of this policy. Below, we present three descriptions with increasing degrees of completeness. First the quick result, then the quick result with the transition process described, and finally the complete adjustment story.

Quick Result
The increase in AA causes a shift in the superequilibrium point from F to H. In adjusting to the new equilibrium at H, GNP rises from Y1 to Y2 and the exchange rate increases from E$/1 to E$/2. The increase in the exchange rate represents an increase in the British pound value and a decrease in the U.S. dollar value. In other words, it is an appreciation of the pound and a depreciation of the dollar. Since the final equilibrium point H is above the initial iso-CAB line CC, the current account balance increases. (See Chapter 9, The AA-DD Model, the section called AA-DD and the Current Account Balance for a description of CC.) If the CAB were in surplus at F, then the surplus increases; if the CAB were in deficit, then the deficit falls. Thus U.S. expansionary monetary policy causes an increase in GNP, a depreciation of the U.S. dollar, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.

Transition Description

Consider the upward shift of the AA curve due to the increase in the money supply. Since exchange rates adjust much more rapidly than GNP, the economy will initially adjust back to the new AA curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from E$/1 to E$/1, representing a depreciation of the U.S. dollar. Now at point G, the economy lies to the left of the DD curve. Thus GNP will begin to rise to get back to goods and services (G&S) market equilibrium on the DD curve. However, as GNP rises, the economy moves to the right above the AA curve, which forces a downward readjustment of the exchange rate to get back to AA. In the end, the economy will adjust in a stepwise fashion from point G to point H, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the AA curve. This process will continue until the economy reaches the superequilibrium at point H. Notice that in the transition the exchange rate first rises to E$/1. Above the rate it will ultimately reach E$/2 before settling back to superequilibrium value. This is an example of exchange rate overshooting. In the transition, the exchange rate overshoots its ultimate long-run value. Exchange rate overshooting is used as one explanation for the volatility of exchange rates in floating markets. If many small changes occur frequently in an economy, the economy may always be in transition moving to a superequilibrium. Because of the more rapid adjustment of exchange rates, it is possible that many episodes of overshootingboth upward and downward can occur in a relatively short period.

Complete Adjustment Story

Step 1: When the money supply increases, real money supply will exceed real money demand in the economy. Since households and businesses hold more money than they would like, at current interest rates, they begin to convert liquid money assets into less-liquid nonmoney assets. This raises the supply of long-term deposits and the amount of funds available for banks to loan. More money to lend will lower average U.S. interest rates, which in turn will result in a lower U.S. rate of return in the Forex market. Since RoR$ < ROR now, there will be an immediate increase in the demand for foreign British currency, thus causing an appreciation of the pound and a depreciation of the U.S. dollar. Thus the exchange rate (E$/) rises. This change is represented by the movement from point F to G on the AA-DD diagram. The AA curve has shifted up to reflect the new set of asset market equilbria corresponding to the higher U.S. money supply. Since the money market and foreign exchange (Forex) markets adjust very swiftly to the money supply change, the economy will not remain off the new AA curve for very long. Step 2: Now that the exchange rate has risen to E$/1, the real exchange has also increased. This implies foreign goods and services are relatively more expensive while U.S. G&S are relatively cheaper. This will raise demand for U.S. exports, curtail demand for U.S. imports, and result in an increase in current account and, thereby, aggregate demand. Because aggregate demand exceeds aggregate supply, inventories will begin to fall, stimulating an increase in production and thus GNP. This is represented by a rightward shift from point G.

Step 3: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom, and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)that is, a decrease in the exchange rate (E$/). This moves the economy downward, back to the AA curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point G in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the AA curve, as shown in the figure. Step 4: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point H in the diagram. Step 5: The equilibrium at H lies to the northeast of F along the original DD curve. As shown in Chapter 9, The AA-DD Model, the section called AA-DD and the Current Account Balance, the equilibrium at H lies above the original iso-CAB line. Therefore, the current account balance will rise.

Contractionary Monetary Policy

Contractionary monetary policy corresponds to a decrease in the money supply. In the AA-DD model, a decrease in the money supply shifts the AA curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise. The quick effects, however, are as follows. U.S. contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate, E$/, implying an appreciation of the U.S. dollar and a decrease in the current account balance.

Key Takeaways

The U.S. expansionary monetary policy causes an increase in GNP, a depreciation of the U.S. dollar, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model. Contractionary monetary policy will cause a reduction in GNP and a reduction in the exchange rate (E$/), implying an appreciation of the U.S. dollar and a decrease in the current account balance.

Fiscal Policy with Floating Exchange Rates

Learning Objectives
1. Learn how changes in fiscal policy affect GNP, the value of the exchange rate, and the current account balance in a floating exchange rate system in the context of the AA-DD model. 2. Understand the adjustment process in the money market, the Forex market, and the G&S market. In this section, we use the AA-DD model to assess the effects of fiscal policy in a floating exchange rate system. Recall that fiscal policy refers to any change in expenditures or revenues within any branch of the government. This means any change in government spendingtransfer payments, or taxes, by either federal, state, or local governmentsrepresents a fiscal policy change. Since changes in expenditures or revenues will often affect a government budget balance, we can also say that a change in the government surplus or deficit represents a change in fiscal policy. When government spending or transfer payments increase, or tax revenues decrease, we refer to it as expansionary fiscal policy. These actions would also be associated with an increase in the government budget deficit or a decrease in its budget surplus. If the government acts to reduce government spending or transfer payments, or increase tax revenues, it is referred to as contractionary fiscal policy. These actions would also be associated with a decrease in the government budget deficit, or an increase in its budget surplus.

Expansionary Fiscal Policy

Suppose the economy is originally at a superequilibrium shown as point J in Figure 10.2, Expansionary Fiscal Policy in the AA-DD Model with Floating Exchange Rates. The original gross national product (GNP) level is Y1 and the exchange rate is E$/1. Next, suppose the government decides to increase government spending (or increase transfer payments or decrease taxes). As shown in Chapter 9, The AA-DD Model, the section called Shifting the DD Curve, fiscal policy changes cause a shift in the DD curve. More specifically, an increase in government spending (or an increase in transfer payments or a decrease in taxes) will cause DD to shift rightward (i.e., G, TR, and T all are DD right-shifters). This is depicted in the diagram as a shift from the red DD to the blue DD line. Figure 10.2. Expansionary Fiscal Policy in the AA-DD Model with Floating Exchange Rates

There are several different levels of detail that can be provided to describe the effects of this policy. Below, we present three descriptions with increasing degrees of completeness: first the quick result, then the quick result with the transition process described, and finally the complete adjustment story.

Quick Result
The increase in DD causes a shift in the superequilibrium point from J to K. In adjusting to the new equilibrium at K, GNP rises from Y1 to Y2 and the exchange rate decreases from E$/1 to E$/2. The decrease in the exchange represents a decrease in the British pound value and an increase in the U.S. dollar value. In other words, it is a depreciation of the pound and an appreciation of the dollar. Since the final equilibrium point K is below the initial iso-CAB line CC, the current account balance decreases. (Caveat: this will be true for all fiscal expansions, but the iso-CAB line can only be used with an increase in G; see Chapter 9, The AA-DD Model, the section called AA-DD and the Current Account Balance for an explanation.) If the CAB were in surplus at J, then the surplus decreases; if the CAB were in deficit, then the deficit rises. Thus the U.S. expansionary fiscal policy causes an increase in the U.S. GNP, an appreciation of the U.S. dollar, and a decrease in the current account balance in a floating exchange rate system according to the AA-DD model.

Transition Description

If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for goods and services (G&S) will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase, leading to an increase in consumption demand. In either case aggregate demand increases, and this causes the rightward shift in the DD curve. Immediately after aggregate demand increases, but before any adjustment has occurred at point J, the economy lies to the left of the new DD curve. Thus GNP will begin to rise to get back to G&S market equilibrium on the DD curve. However, as GNP rises, the economy will move above the AA curve, forcing a downward readjustment of the exchange rate to get back to asset market equilibrium on the AA curve. In the end, the economy will adjust in a stepwise fashion from point J to point K, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the AA curve. This process will continue until the economy reaches the superequilibrium at point K.

Complete Adjustment Story

Step 1: If the expansionary fiscal policy occurs because of an increase in government spending, then government demand for G&S will increase. If the expansionary fiscal policy occurs due to an increase in transfer payments or a decrease in taxes, then disposable income will increase, leading to an increase in consumption demand. In either case aggregate demand increases. Before any adjustment occurs, the increase in aggregate demand implies aggregate demand exceeds aggregate supply, which will lead to a decline in inventories. To prevent this decline, retailers (or government suppliers) will signal firms to produce more. As supply increases so does the GNP, and the economy moves to the right of point J. Step 2: As GNP rises, so does real money demand, causing an increase in U.S. interest rates. With higher interest rates, the rate of return on U.S. assets rises above that in the United Kingdom and international investors shift funds back to the United States, resulting in a dollar appreciation (pound depreciation)that is, a decrease in the exchange rate E$/. This moves the economy downward, back to the AA curve. The adjustment in the asset market will occur quickly after the change in interest rates. Thus the rightward shift from point J in the diagram results in quick downward adjustment to regain equilibrium in the asset market on the AA curve, as shown. Step 3: Continuing increases in GNP caused by excess aggregate demand, results in continuing increases in U.S. interest rates and rates of return, repeating the stepwise process above until the new equilibrium is reached at point K in the diagram. Step 4: The equilibrium at K lies to the southeast of J along the original AA curve. As shown in Chapter 9, The AA-DD Model, the section called AA-DD and the Current Account Balance, the current account balance must be lower at K since both an increase in GNP and a dollar appreciation cause decreases in current account demand. Thus the equilibrium at K lies below the original iso-CAB line. However, this is only assured if the fiscal expansion occurred due to an increase in G.

If transfer payments increased or taxes were reduced, these would both increase disposable income and lead to a further decline in the current account balance. Thus also with these types of fiscal expansions, the current account balance is reduced; however, one cannot use the iso-CAB line to show it.

Contractionary Fiscal Policy

Contractionary fiscal policy corresponds to a decrease in government spending, a decrease in transfer payments, or an increase in taxes. It would also be represented by a decrease in the government budget deficit or an increase in the budget surplus. In the AA-DD model, a contractionary fiscal policy shifts the DD curve leftward. The effects will be the opposite of those described above for expansionary fiscal policy. A complete description is left for the reader as an exercise. The quick effects, however, are as follows. U.S. contractionary fiscal policy will cause a reduction in GNP and an increase in the exchange rate (E$/), implying a depreciation of the U.S. dollar.

Key Takeaways

Expansionary fiscal policy causes an increase in GNP, an appreciation of the currency, and a decrease in the current account balance in a floating exchange rate system according to the AA-DD model. Contractionary fiscal policy will cause a reduction in GNP, a depreciation of the currency, and an increase in the current account balance in a floating exchange rate system according to the AA-DD model.

Expansionary Monetary Policy with Floating Exchange Rates in the Long Run
Learning Objectives
1. Learn how changes in monetary policy affect GNP and the value of the exchange rate in a floating exchange rate system in the context of the AA-DD model in the long run. 2. Understand the adjustment process in the money market, the Forex market, and the G&S market. If expansionary monetary policy occurs when the economy is operating at full employment output, then the money supply increase will eventually put upward pressure on prices. Thus we say that eventually, or in the long run, the aggregate price level will rise and the economy will experience an episode of inflation in the transition. See Chapter 7, Interest Rate Determination, the section called Money Supply and Long-Run Prices for a complete description of this process. Here, we will describe the long-run effects of an increase in the money supply using the AA-DD model. We break up the effects into short-run and long-run components. In the short run, the initial money supply effects are felt and investor anticipations about future effects are implemented. In the long run, we allow the price level to rise. Suppose the economy is originally at a superequilibrium, shown as point F in Figure 10.3, Expansionary Monetary Policy in the Long Run. The original GNP level is YF, and the exchange rate is E1. YF represents the full-employment level of output, which also implies that the natural rate of unemployment prevails. Any movement of the economy to the right of YF will cause an eventual increase in the aggregate price level. Any movement to the left of YF causes an eventual decrease in the price level. Figure 10.3. Expansionary Monetary Policy in the Long Run

Next, suppose the U.S. central bank (or the Fed) decides to expand the money supply. As shown in Chapter 9, The AA-DD Model, the section called Shifting the AA Curve, money supply changes cause a shift in the AA curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., MS is an AA up-shifter). This is depicted in the diagram as a shift from the AA line to the red AA line. In the long-run adjustment story, several different changes in exogenous variables will occur sequentially, thus it is difficult to describe the quick final result, so we will only describe the transition process in partial detail.

Partial Detail
The increase in the money supply causes the first upward shift of the AA curve, shown as step 1 in the diagram. Since exchange rates adjust much more rapidly than gross national product (GNP), the economy will quickly adjust to the new AA curve before any change in GNP occurs. That means the first adjustment will be from point F to point G directly above. The exchange rate will increase from E1 to E2, representing a depreciation of the U.S. dollar. The second effect is caused by changes in investor expectations. Investors generally track important changes in the economy, including money supply changes, because these changes can

have important implications for the returns on their investments. Investors who see an increase in money supply in an economy at full employment are likely to expect inflation to occur in the future. When investors expect future U.S. inflation, and when they consider both domestic and foreign investments, they will respond today with an increase in their expected future exchange rate (E$/e). There are two reasons to expect this immediate effect:
1. Investors are very likely to understand the story we are in the process of explaining now.

As we will see below, the long-run effect of a money supply increase for an economy (initially, at full employment) is an increase in the exchange rate (E$/)that is, a depreciation of the dollar. If investors believe the exchange rate will be higher next year due to todays action by the Fed, then it makes sense for them to raise their expected future exchange rate in anticipation of that effect. Thus the average E$/e will rise among investors who participate in the foreign exchange (Forex) markets. 2. Investors may look to the purchasing power parity (PPP) theory for guidance. PPP is generally interpreted as a long-run theory of exchange rate trends. If PPP holds in the long run, then E$/ = P$/P. In other words, the exchange rate will equal the ratio of the two countries price levels. If P$ is expected to rise due to inflation, then PPP predicts that the exchange rate (E$/) will also rise and the dollar will depreciate. The timing of the change in E$/e will depend on how quickly investors recognize the money supply change, compute its likely effect, and incorporate it into their investment plans. Since investors are typically very quick to adapt to market changes, the expectations effect should take place in the short run, perhaps long before the inflation ever occurs. In some cases, the expectations change may even occur before the Fed increases the money supply, if investors anticipate the Feds action. The increase in the expected exchange rate (this means a decrease in the expected future dollar value) causes a second upward shift of the AA curve, shown as step 2 in the diagram. Again, rapid exchange rate adjustment implies the economy will quickly adjust to the new AA curve at point H directly above. The exchange rate will now increase from E2 to E3, representing a further depreciation of the U.S. dollar. Once at point H, aggregate demand, which is on the DD curve to the right of H, exceeds aggregate supply, which is still at YF. Thus GNP will begin to rise to get back to G&S market equilibrium on the DD curve. However, as GNP rises, the economy moves above the AA curve that forces a downward readjustment of the exchange rate to get back to asset market equilibrium on AA. In the end, the economy will adjust in a stepwise fashion from point H to point I, with each rightward movement in GNP followed by a quick reduction in the exchange rate to remain on the AA curve. This process will continue until the economy reaches the temporary superequilibrium at point I. The next effect occurs because GNP, now at Y2 at point I, has risen above the full employment level at YF. This causes an increase in U.S. prices, meaning that P$ (the U.S. price level) begins to rise. The increase in U.S. prices has two effects as shown in Figure 10.4, Expansionary Monetary Policy in the Long Run, Continued. An increase in P$ is both a DD left-shifter and an AA down-shifter.

Figure 10.4. Expansionary Monetary Policy in the Long Run, Continued

In step 3, we depict a leftward shift of DD to DD. DD shifts left because higher U.S. prices will reduce the real exchange rate. This makes U.S. G&S relatively more expensive compared with foreign G&S, thus reducing export demand, increasing import demand, and thereby reducing aggregate demand. In step 4, we depict a downward shift of AA to AA. AA shifts down because a higher U.S. price level reduces real money supply. As the real money supply falls, U.S. interest rates rise, leading to an increase in the rate of return for U.S. assets as considered by international investors. This in turn raises the demand for U.S. dollars on the Forex, leading to a dollar appreciation. Since this effect occurs for any GNP level, the entire AA curve shifts downward. Steps 3 and 4 will both occur simultaneously, and since both are affected by the increase in the price level, it is impossible to know which curve will shift faster or precisely how far each curve will shift. However, we do know two things. First, the AA and DD shifting will continue as long as GNP remains above the full employment level. Once GNP falls to YF, there is no longer upward pressure on the price level and the shifting will cease. Second, the final equilibrium exchange rate must lie above the original exchange rate. This occurs because output will revert

back to its original level, the price level will be higher, and according to PPP, eventually the exchange rate will have to be higher as well. The final equilibrium will be at a point like J, which lies to the left of I. In this transition, the exchange rate will occasionally rise when DD shifts left and will occasionally fall when AA shifts down. Thus the economy will wiggle its way up and down, from point I to J. Once at point J, there is no reason for prices to rise further and no reason for a change in investor expectations. The economy will have reached its long-run equilibrium. Note that one cannot use the iso-CAB line to assess the long-run effect on the current account balance. In the final adjustment, although the final equilibrium lies above the original iso-CAB line, in the long run the P$ changes will raise the iso-CAB lines, making it impossible to use these to identify the final effect. However, in adjusting to the long-run equilibrium, the only two variables affecting the current account that will ultimately change are the exchange rate and the price level. If these two rise proportionally to each other, as they would if purchasing power parity held, then there will be no long-run effect on the current account balance. The final long-run effect of an increase in the U.S. money supply in a floating exchange rate system is a depreciation of the U.S. dollar and no change in real GNP. Along the way, GNP temporarily rises and unemployment falls below the natural rate. However, this spurs an increase in the price level, which reduces GNP to its full employment level and raises unemployment back to its natural rate. U.S. inflation occurs in the transition while the price level is increasing.

Key Takeaway

The final long-run effect of an increase in the money supply in a floating exchange rate system is a depreciation of the currency and no change in real GNP. In the transition process, there is an inflationary effect.

Foreign Exchange Interventions with Floating Exchange Rates

Learning Objectives
1. Learn how a countrys central bank can intervene to affect the value of the countrys currency in a floating exchange rate system. 2. Learn the mechanism and purpose of a central bank sterilized intervention in a Forex market. In a pure floating exchange rate system, the exchange rate is determined as the rate that equalizes private market demand for a currency with private market supply. The central bank has no necessary role to play in the determination of a pure floating exchange rate. Nonetheless, sometimes central banks desire or are pressured by external groups to take actions (i.e.,

intervene) to either raise or lower the exchange rate in a floating exchange system. When central banks do intervene on a semiregular basis, the system is sometimes referred to as a dirty float. There are several reasons such interventions occur. The first reason central banks intervene is to stabilize fluctuations in the exchange rate. International trade and investment decisions are much more difficult to make if the exchange rate value is changing rapidly. Whether a trade deal or international investment is good or bad often depends on the value of the exchange rate that will prevail at some point in the future. (See Chapter 4, Foreign Exchange Markets and Rates of Return, the section called Calculating Rate of Returns on International Investments for a discussion of how future exchange rates affect returns on international investments.) If the exchange rate changes rapidly, up or down, traders and investors will become more uncertain about the profitability of trades and investments and will likely reduce their international activities. As a consequence, international traders and investors tend to prefer more stable exchange rates and will often pressure governments and central banks to intervene in the foreign exchange (Forex) market whenever the exchange rate changes too rapidly. The second reason central banks intervene is to reverse the growth in the countrys trade deficit. Trade deficits (or current account deficits) can rise rapidly if a countrys exchange rate appreciates significantly. A higher currency value will make foreign goods and services (G&S) relatively cheaper, stimulating imports, while domestic goods will seem relatively more expensive to foreigners, thus reducing exports. This means a rising currency value can lead to a rising trade deficit. If that trade deficit is viewed as a problem for the economy, the central bank may be pressured to intervene to reduce the value of the currency in the Forex market and thereby reverse the rising trade deficit. There are two methods central banks can use to affect the exchange rate. The indirect method is to change the domestic money supply. The direct method is to intervene directly in the foreign exchange market by buying or selling currency.

Indirect Forex Intervention

The central bank can use an indirect method to raise or lower the exchange rate through domestic money supply changes. As was shown in Chapter 10, Policy Effects with Floating Exchange Rates, the section called Monetary Policy with Floating Exchange Rates, increases in the domestic U.S. money supply will cause an increase in E$/, or a dollar depreciation. Similarly, a decrease in the money supply will cause a dollar appreciation. Despite relatively quick adjustments in assets markets, this type of intervention must traverse from open market operations to changes in domestic money supply, domestic interest rates, and exchange rates due to new rates of returns. Thus this method may take several weeks or more for the effect on exchange rates to be realized. A second problem with this method is that to affect the exchange rate the central bank must change the domestic interest rate. Most of the time, central banks use interest rates to maintain stability in domestic markets. If the domestic economy is growing rapidly and inflation is

beginning to rise, the central bank may lower the money supply to raise interest rates and help slow down the economy. If the economy is growing too slowly, the central bank may raise the money supply to lower interest rates and help spur domestic expansion. Thus to change the exchange rate using the indirect method, the central bank may need to change interest rates away from what it views as appropriate for domestic concerns at the moment. (Below well discuss the method central banks use to avoid this dilemma.)

Direct Forex Intervention

The most obvious and direct way for central banks to intervene and affect the exchange rate is to enter the private Forex market directly by buying or selling domestic currency. There are two possible transactions. First, the central bank can sell domestic currency (lets use dollars) in exchange for a foreign currency (say, pounds). This transaction will raise the supply of dollars on the Forex (also raising the demand for pounds), causing a reduction in the value of the dollar and thus a dollar depreciation. Of course, when the dollar depreciates in value, the pound appreciates in value with respect to the dollar. Since the central bank is the ultimate source of all dollars (it can effectively print an unlimited amount), it can flood the Forex market with as many dollars as it desires. Thus the central banks power to reduce the dollar value by direct intervention in the Forex is virtually unlimited. If instead, the central bank wishes to raise the value of the dollar, it will have to reverse the transaction described above. Instead of selling dollars, it will need to buy dollars in exchange for pounds. The increased demand for dollars on the Forex by the central bank will raise the value of the dollar, thus causing a dollar appreciation. At the same time, the increased supply of pounds on the Forex explains why the pound will depreciate with respect to the dollar. The ability of a central bank to raise the value of its currency through direct Forex interventions is limited, however. In order for the U.S. Federal Reserve Bank (or the Fed) to buy dollars in exchange for pounds, it must have a stockpile of pound currency (or other pound assets) available to exchange. Such holdings of foreign assets by a central bank are called foreign exchange reserves. Foreign exchange reserves are typically accumulated over time and held in case an intervention is desired. In the end, the degree to which the Fed can raise the dollar value with respect to the pound through direct Forex intervention will depend on the size of its pound denominated foreign exchange reserves.
Indirect Effect of Direct Forex Intervention

There is a secondary indirect effect that occurs when a central bank intervenes in the Forex market. Suppose the Fed sells dollars in exchange for pounds in the private Forex. This transaction involves a purchase of foreign assets (pounds) in exchange for U.S. currency. Since the Fed is the ultimate source of dollar currency, these dollars used in the transaction will enter into circulation in the economy in precisely the same way as new dollars enter when the Fed buys a Treasury bill on the open market. The only difference is that with an open market operation, the Fed purchases a domestic asset, while in the Forex intervention it buys a foreign

asset. But both are assets all the same and both are paid for with newly created money. Thus when the Fed buys pounds and sells dollars on the Forex, there will be an increase in the U.S. money supply. The higher U.S. money supply will lower U.S. interest rates, reduce the rate of return on U.S. assets as viewed by international investors, and result in a depreciation of the dollar. The direction of this indirect effect is the same as the direct effect. In contrast, if the Fed were to buy dollars and sell pounds on the Forex, there will be a decrease in the U.S. money supply. The lower U.S. money supply will raise U.S. interest rates, increase the rate of return on U.S. assets as viewed by international investors, and result in an appreciation of the dollar. The only difference between the direct and indirect effects is the timing and sustainability. The direct effect will occur immediately with central bank intervention since the Fed will be affecting todays supply of dollars or pounds on the Forex. The indirect effect, working through money supply and interest rates, may take several days or weeks. The sustainability of the direct versus indirect effects is discussed next when we introduce the idea of a sterilized Forex intervention.

Sterilized Forex Interventions

There are many times in which a central bank either wants or is pressured to affect the exchange rate value by intervening directly in the foreign exchange market. However, as shown above, direct Forex interventions will change the domestic money supply. A change in the money supply will affect the average interest rate in the short run and the price level, and hence the inflation rate, in the long run. Because central banks are generally entrusted to maintain domestic price stability or to assist in maintaining appropriate interest rates, a low unemployment rate, and GDP growth, Forex intervention will often interfere with one or more of their other goals. For example, if the central bank believes that current interest rates should be raised slowly during the next several months to slow the growth of the economy and prevent a resurgence of inflation, then a Forex intervention to lower the value of the domestic currency would result in increases in the money supply and a decrease in interest rates, precisely the opposite of what the central bank wants to achieve. Conflicts such as this one are typical and usually result in a central bank choosing to sterilize its Forex interventions. The intended purpose of a sterilized intervention is to cause a change in the exchange rate while at the same time leaving the money supply and hence interest rates unaffected. As we will see, the intended purpose is unlikely to be realized in practice. A sterilized foreign exchange intervention occurs when a central bank counters direct intervention in the Forex with a simultaneous offsetting transaction in the domestic bond market. For example, suppose the U.S. Fed decides to intervene to lower the value of the U.S. dollar. This would require the Fed to sell dollars and buy foreign currency on the Forex. Sterilization, in this case, involves a Fed open market operation in which it sells Treasury bonds (T-bonds) at the same time and in the same value as the dollar sale in the Forex market. For example, if the Fed

intervenes and sells $10 million on the Forex, sterilization means it will also sell $10 million of Treasury bonds on the domestic open market at the same time. Consider the effects of a sterilized Forex intervention by the U.S. Fed shown in the adjoining AA-DD diagram, Figure 10.5, Sterilization in the AA-DD Model. Suppose the economy is initially in equilibrium at point F with GDP (Y1) and exchange rate (E$/1). Now, suppose the Fed intervenes in the Forex by selling dollars and buying British pounds. The direct effect on the exchange rate is not represented in the AA-DD diagram. The only way it can have an effect is through the increase in the money supply, which will shift the AA curve up from AA to AA. However, sterilization means the Fed will simultaneously conduct an offsetting open market operation, in this case selling Treasury bonds equal in value to the Forex sales. The sale of Tbonds will lower the U.S. money supply, causing an immediate shift of the AA curve back from AA to AA. In fact, because the two actions take place on the same day or within the same week at least, the AA curve does not really shift out at all. Instead, a sterilized Forex intervention maintains the U.S. money supply and thus achieves the Feds objective of maintaining interest rates. Figure 10.5. Sterilization in the AA-DD Model

However, because there is no shift in the AA or DD curves, the equilibrium in the economy will never move away from point F. This implies that a sterilized Forex intervention not only will not affect GNP, but also will not affect the exchange rate. This suggests the impossibility of the Feds overall objective to lower the dollar value while maintaining interest rates. Empirical studies of the effects of sterilized Forex interventions tend to support the results of this simple model. In other words, real-world sterilizations have generally been ineffective in achieving any lasting effect upon a countrys currency value. However, there are several reasons why sterilized interventions may be somewhat effective nonetheless. Temporary effects are certainly possible. If a central bank makes a substantial intervention in the Forex over a short period, this will certainly change the supply or demand of currency and have an immediate effect on the exchange rate on those days. A more lasting impact can occur if the intervention leads investors to change their expectations about the future. This could happen if investors are not sure whether the central bank is sterilizing its interventions. Knowing that sterilization is occurring would require a careful observation of several markets unless the Fed announces its policy. However, rather than announcing a sterilized intervention, a central bank that wants to affect expectations should announce the Forex intervention while hiding its offsetting open market operation. In this way, investors may be fooled into thinking that the Forex intervention will lower the future dollar value and thus may adjust their expectations. If investors are fooled, they will raise E$/e in anticipation of the future dollar depreciation. The increase in E$/e will shift the AA curve upward, resulting in an increase in GNP and a depreciation of the dollar. In this way, sterilized interventions may have a more lasting effect on the exchange rate. However, the magnitude of the exchange rate change in this caseif it occurs will certainly be less than that achieved with a nonsterilized intervention.

Key Takeaways

If the central bank sells domestic currency in exchange for a foreign currency on the Forex, it will cause a direct reduction in the value of the domestic currency, or a currency depreciation. If the Fed were to sell dollars on the Forex, there will be an increase in the U.S. money supply that will reduce U.S. interest rates, decrease the rate of return on U.S. assets, and lead to a depreciation of the dollar. A sterilized foreign exchange intervention occurs when a central bank counters direct intervention in the Forex with a simultaneous offsetting transaction in the domestic bond market. The intended purpose of a sterilized intervention is to cause a change in the exchange rate while at the same time leaving interest rates unaffected.

Which Is Better: Fixed or Floating Exchange Rates?

Learning Objective
1. Learn the pros and cons of both floating and fixed exchange rate systems. The exchange rate is one of the key international aggregate variables studied in an international finance course. It follows that the choice of exchange rate system is one of the key policy questions. Countries have been experimenting with different international payment and exchange systems for a very long time. In early history, all trade was barter exchange, meaning goods were traded for other goods. Eventually, especially scarce or precious commodities, for example gold and silver, were used as a medium of exchange and a method for storing value. This practice evolved into the metal standards that prevailed in the nineteenth and early twentieth centuries. By default, since gold and silver standards imply fixed exchange rates between countries, early experience with international monetary systems was exclusively with fixed systems. Fifty years ago, international textbooks dealt almost entirely with international adjustments under a fixed exchange rate system since the world had had few experiences with floating rates. That experience changed dramatically in 1973 with the collapse of the Bretton Woods fixed exchange rate system. At that time, most of the major developed economies allowed their currencies to float freely, with exchange values being determined in a private market based on supply and demand, rather than by government decree. Although when Bretton Woods collapsed, the participating countries intended to resurrect a new improved system of fixed

exchange rates, this never materialized. Instead, countries embarked on a series of experiments with different types of fixed and floating systems. For example, the European Economic Community (now the EU) implemented the exchange rate mechanism in 1979, which fixed each others currencies within an agreed band. These currencies continued to float with non-EU countries. By 2000, some of these countries in the EU created a single currency, the euro, which replaced the national currencies and effectively fixed the currencies to each other immutably. Some countries have fixed their currencies to a major trading partner, and others fix theirs to a basket of currencies comprising several major trading partners. Some have implemented a crawling peg, adjusting the exchange values regularly. Others have implemented a dirty float where the currency value is mostly determined by the market but periodically the central bank intervenes to push the currency value up or down depending on the circumstances. Lastly, some countries, like the United States, have allowed an almost pure float with central bank interventions only on rare occasions. Unfortunately, the results of these many experiments are mixed. Sometimes floating exchange rate systems have operated flawlessly. At other times, floating rates have changed at breakneck speed, leaving traders, investors, and governments scrambling to adjust to the volatility. Similarly, fixed rates have at times been a salvation to a country, helping to reduce persistent inflation. At other times, countries with fixed exchange rates have been forced to import excessive inflation from the reserve country. No one system has operated flawlessly in all circumstances. Hence, the best we can do is to highlight the pros and cons of each system and recommend that countries adopt that system that best suits its circumstances. Probably the best reason to adopt a fixed exchange rate system is to commit to a loss in monetary autonomy. This is necessary whenever a central bank has been independently unable to maintain prudent monetary policy, leading to a reasonably low inflation rate. In other words, when inflation cannot be controlled, adopting a fixed exchange rate system will tie the hands of the central bank and help force a reduction in inflation. Of course, in order for this to work, the country must credibly commit to that fixed rate and avoid pressures that lead to devaluations. Several methods to increase the credibility include the use of currency boards and complete adoption of the other countrys currency (i.e., dollarization or euroization). For many countries, for at least a period, fixed exchange rates have helped enormously to reduce inflationary pressures. Nonetheless, even when countries commit with credible systems in place, pressures on the system sometimes can lead to collapse. Argentina, for example, dismantled its currency board after ten years of operation and reverted to floating rates. In Europe, economic pressures have led to some talk about giving up the euro and returning to national currencies. The Bretton Woods system lasted for almost thirty years but eventually collapsed. Thus it has been difficult to maintain a credible fixed exchange rate system for a long period.

Floating exchange rate systems have had a similar colored past. Usually, floating rates are adopted when a fixed system collapses. At the time of a collapse, no one really knows what the market equilibrium exchange rate should be, and it makes some sense to let market forces (i.e., supply and demand) determine the equilibrium rate. One of the key advantages of floating rates is the autonomy over monetary policy that it affords a countrys central bank. When used wisely, monetary policy discretion can provide a useful mechanism for guiding a national economy. A central bank can inject money into the system when the economic growth slows or falls, or it can reduce money when excessively rapid growth leads to inflationary tendencies. Since monetary policy acts much more rapidly than fiscal policy, it is a much quicker policy lever to use to help control the economy.

Prudent Monetary and Fiscal Policies

Interestingly, monetary autonomy is both a negative trait for countries choosing fixed rates to rid themselves of inflation and a positive trait for countries wishing have more control over their domestic economies. It turns out that the key to success in both fixed and floating rates hinges on prudent monetary and fiscal policies. Fixed rates are chosen to force a more prudent monetary policy, while floating rates are a blessing for those countries that already have a prudent monetary policy. A prudent monetary policy is most likely to arise when two conditions are satisfied. First, the central bank, and the decisions it makes, must be independent of the national government that makes government-spending decisions. If it is not, governments have always been inclined to print money to finance government-spending projects. This has been the primary source of high inflation in most countries. The second condition is a clear guideline for the central banks objective. Ideally, that guideline should broadly convey a sense that monetary policy will satisfy the demands of a growing economy while maintaining sufficiently low inflation. When these conditions are satisfied, autonomy for a central bank and floating exchange rates will function well. Mandating fixed exchange rates can also work well, but only if the system can be maintained and if the country to which the other country fixes its currency has a prudent monetary policy. Both systems can experience great difficulties if prudent fiscal policies are not maintained. This requires governments to maintain a balanced budget over time. Balance over time does not mean balance in every period but rather that periodic budget deficits should be offset with periodic budget surpluses. In this way, government debt is managed and does not become excessive. It is also critical that governments do not overextend themselves in terms of international borrowing. International debt problems have become the bane of many countries. Unfortunately, most countries have been unable to accomplish this objective. Excessive government deficits and borrowing are the norm for both developing and developed countries. When excessive borrowing needs are coupled with a lack of central bank independence, tendencies to hyperinflations and exchange rate volatility are common. When excessive borrowing is coupled with an independent central bank and a floating exchange rate, exchange rate volatility is also common.

Stability of the international payments system then is less related to the type of exchange rate system chosen than it is to the internal policies of the individual countries. Prudent fiscal and monetary policies are the keys. With prudent domestic policies in place, a floating exchange rate system will operate flawlessly. Fixed exchange systems are most appropriate when a country needs to force itself to a more prudent monetary policy course.

Key Takeaways

Historically, no one system has operated flawlessly in all circumstances. Probably the best reason to adopt a fixed exchange rate system is whenever a central bank has been independently unable to maintain prudent monetary policy, leading to a reasonably low inflation rate. Probably the best reason to adopt a floating exchange rate system is whenever a country has more faith in the ability of its own central bank to maintain prudent monetary policy than any other countrys ability. The key to success in both fixed and floating rates hinges on prudent monetary and fiscal policies. Fixed rates are chosen to force a more prudent monetary policy; floating rates are a blessing for those countries that already have a prudent monetary policy.