Lecture 9

Fixed Exchange
Rates and Foreign
Exchange
Intervention

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Learning Objectives
18.1 Understand how a central bank must manage monetary
policy so as to fix its currency's value in the foreign
exchange market.
18.2 Describe and analyze the relationship among the central
bank’s foreign exchange reserves, its purchases and sales
in the foreign exchange market, and the money supply.
18.3 Explain how monetary, fiscal, and sterilized intervention
policies affect the economy under a fixed exchange rate.
18.4 Discuss causes and effects of balance of payments crises.
18.5 Describe how alternative multilateral systems for pegging
exchange rates work

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Preview
• Balance sheets of central banks
• Intervention in the foreign exchange markets and the
money supply
• How the central bank fixes the exchange rate
• Monetary and fiscal policies under fixed exchange rates
• Financial market crises and capital flight
• Types of fixed exchange rates: reserve currency and gold
standard systems

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Introduction
• Many countries try to fix or “peg” their exchange rate to
a currency or group of currencies by intervening in the
foreign exchange markets.
• Many with a flexible or “floating” exchange rate in fact
practice a managed floating exchange rate.
– The central bank “manages” the exchange rate from
time to time by buying and selling currency and
assets, especially in periods of exchange rate
volatility.
• How do central banks intervene in the foreign exchange
markets?

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Central Bank Intervention and the
Money Supply
• To study the effects of central bank intervention in the
foreign exchange markets, first construct a simplified
balance sheet for the central bank.
– This records the assets and liabilities of a central
bank.
– Balance sheets use double-entry bookkeeping:
each transaction enters the balance sheet twice.

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Central Bank’s Balance Sheet (1 of 2)
• Assets
– Foreign government bonds (official international
reserves)
– Gold (official international reserves)
– Domestic government bonds
– Loans to domestic banks (called discount loans in US)
• Liabilities
– Deposits of domestic banks
– Currency in circulation (previously central banks had to
give up gold when citizens brought currency to
exchange)
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Central Bank’s Balance Sheet (2 of 2)
• Assets = Liabilities + Net Worth
– If assume that net worth is constant, then
 An increase in assets leads to an equal increase in
liabilities.
 A decrease in assets leads to an equal decrease in
liabilities.
• Changes in the central bank's balance sheet lead to
changes in currency in circulation or changes in deposits of
banks, which lead to changes in the money supply.
– If their deposits at the central bank increase, banks are
usually able to use these additional funds to lend to
customers, so amount of money in circulation increases.
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Assets, Liabilities, and the Money
Supply (1 of 2)
• A purchase of any asset by the central bank will be paid for
with currency or a check written from the central bank,
– both of which are denominated in domestic currency,
and
– both of which increase the supply of money in
circulation.
– The transaction leads to equal increases of assets and
liabilities.
• When the central bank buys domestic bonds or foreign
bonds, the domestic money supply increases.

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Assets, Liabilities, and the Money
Supply (2 of 2)
• A sale of any asset by the central bank will be paid for
with currency or a check written to the central bank,
– both of which are denominated in domestic currency.
– The central bank puts the currency into its vault or
reduces the amount of deposits of banks,
– causing the supply of money in circulation to shrink.
– The transaction leads to equal decreases of assets
and liabilities.
• When the central bank sells domestic bonds or foreign
bonds, the domestic money supply decreases.

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Table 18.1 Effects of a $100 Foreign
Exchange Intervention: Summary
Effect on Effect on Central Effect on Central
Domestic Central
Domestic Money Bank’s Domestic Bank’s Foreign
Bank’s Action
Supply Assets Assets
Nonsterilized foreign +$100 0 +$100
exchange purchase

Sterilized foreign 0 −$100 +$100

exchange purchase

Nonsterilized foreign −$100 0 −$100

exchange sale

Sterilized foreign 0 +$100 −$100

exchange sale

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Foreign Exchange Markets
• Central banks trade foreign government bonds in the
foreign exchange markets.
– Foreign currency deposits and foreign government
bonds are often substitutes: both are fairly liquid
assets denominated in foreign currency.
– Quantities of both foreign currency deposits and
foreign government bonds that are bought and sold
influence the exchange rate.

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Sterilization
• Because buying and selling of foreign bonds in the
foreign exchange markets affects the domestic money
supply, a central bank may want to offset this effect.
• This offsetting effect is called sterilization.
• If the central bank sells foreign bonds in the foreign
exchange markets, it can buy domestic government
bonds in bond markets—hoping to leave the amount of
money in circulation unchanged.

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Fixed Exchange Rates (1 of 4)
• To fix the exchange rate, a central bank influences the
quantities supplied and demanded of currency by trading
domestic and foreign assets, so that the exchange rate
(the price of foreign currency in terms of domestic
currency) stays constant.
• Foreign exchange markets are in equilibrium when

RR 

 Ee E 
E
• When the exchange rate is fixed at some level E 0 and the
market expects it to stay fixed at that level, then
R  R
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Fixed Exchange Rates (2 of 4)
• To fix the exchange rate, the central bank must trade
foreign and domestic assets in the foreign exchange
market until R  R .
• Alternatively, we can say that it adjusts the quantity of
monetary assets in the money market until the domestic
interest rate equals the foreign interest rate, given the level
of average prices and real output:
MS
P

 L R  ,Y 

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Fixed Exchange Rates (3 of 4)
• Suppose that the central bank has fixed the exchange
rate at E0 but the level of output rises, raising the demand
of real monetary assets.
• This is predicted to put upward pressure on interest rates
and the value of the domestic currency.
• How should the central bank respond if it wants to fix
exchange rates?

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Fixed Exchange Rates (4 of 4)
• The central bank should buy foreign assets in the foreign
exchange markets,
– thereby increasing the domestic money supply,
– thereby reducing interest rates in the short run.
– Alternatively, by demanding (buying) assets
denominated in foreign currency and by supplying
(selling) domestic currency, the price/value of foreign
currency is increased and the price/value of domestic
currency is decreased.

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Figure 18.1 Asset Market Equilibrium
0
with a Fixed Exchange Rate, E

To hold the exchange rate fixed at E 0 when output rises from Y 1 to Y 2, the
central bank must purchase foreign assets and thereby raise the money supply
from M 1 to M 2.
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Monetary Policy and Fixed Exchange
Rates
• When the central bank buys and sells foreign assets to
keep the exchange rate fixed and to maintain domestic
interest rates equal to foreign interest rates, it is not able
to adjust domestic interest rates to attain other goals.
– In particular, monetary policy is ineffective in
influencing output and employment.

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Figure 18.2 Monetary Expansion Is
Ineffective under a Fixed Exchange Rate

Initial equilibrium is shown at point 1, where the output and asset markets simultaneously
clear at a fixed exchange rate of E0 and an output level of Y1. Hoping to increase output to
Y2, the central bank decides to increase the money supply by buying domestic assets and
shifting AA1 to AA2. Because the central bank must maintain E0, however, it has to sell
foreign assets for domestic currency, an action that decreases the money supply
immediately and returns AA2 back to AA1. The economy’s equilibrium therefore remains at
point 1, with output unchanged at Y1.
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Fiscal Policy and Fixed Exchange Rates
in the Short Run
• Temporary changes in fiscal policy are more effective in
influencing output and employment in the short run:
– The rise in aggregate demand and output due to
expansionary fiscal policy raises demand for real
monetary assets, putting upward pressure on interest
rates and on the value of the domestic currency.
– To prevent an appreciation of the domestic currency,
the central bank must buy foreign assets, thereby
increasing the money supply and decreasing interest
rates.

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Figure 18.3 Fiscal Expansion under a
Fixed Exchange Rate

Fiscal expansion (shown by the shift from DD1 to DD2) and the
intervention that accompanies it (the shift from AA1 to AA2) move the
economy from point 1 to point 3.
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Fiscal Policy and Fixed Exchange Rates
in the Long Run (1 of 2)
• When the exchange rate is fixed, there is no real appreciation
of the value of domestic products in the short run.
• But when output is above its potential level, wages and prices
tend to rise in the long run.
• A rising price level makes domestic products more expensive:
a real appreciation  EP falls  .


P 
– Aggregate demand and output decrease as prices rise:
DD curve shifts left.
– Prices tend to rise until employment, aggregate demand,
and output fall to their normal (potential or natural) levels.

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Fiscal Policy and Fixed Exchange Rates
in the Long Run (2 of 2)
• Prices are predicted to change proportionally to the
change in the money supply when the central bank
intervenes in the foreign exchange markets.
– AA curve shifts down (left) as prices rise.
– Nominal exchange rates will be constant (as long as
the fixed exchange rate is maintained), but the real
exchange rate will be lower (a real appreciation).

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Devaluation and Revaluation
• Depreciation and appreciation refer to changes in the
value of a currency due to market changes.
• Devaluation and revaluation refer to changes in a fixed
exchange rate caused by the central bank.
– With devaluation, a unit of domestic currency is made
less valuable, so that more units must be exchanged
for 1 unit of foreign currency.
– With revaluation, a unit of domestic currency is made
more valuable, so that fewer units need to be
exchanged for 1 unit of foreign currency.

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Devaluation
• For devaluation to occur, the central bank buys foreign
assets, so that domestic monetary assets increase and
domestic interest rates fall, causing a fall in the rate
return on domestic currency deposits.
– Domestic products become less expensive relative
to foreign products, so aggregate demand and
output increase.
– Official international reserve assets (foreign bonds)
increase.

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Figure 18.4 Effect of a Currency
Devaluation

When a currency is devalued from E0 to E1, the economy’s

equilibrium moves from point 1 to point 2 as both output and the
money supply expand.
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Financial Crises and Capital Flight (1 of 6)
• When a central bank does not have enough official
international reserve assets to maintain a fixed exchange
rate, a balance of payments crisis results.
– To sustain a fixed exchange rate, the central bank must
have enough foreign assets to sell in order to satisfy
the demand of them at the fixed exchange rate.

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Financial Crises and Capital Flight (2 of 6)
• Investors may expect that the domestic currency will be
devalued, causing them to want foreign assets instead of
domestic assets, whose value is expected to fall soon.
1. This expectation or fear only makes the balance of
payments crisis worse:
– Investors rush to change their domestic assets into
foreign assets, depleting the stock of official
international reserve assets more quickly.

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Financial Crises and Capital Flight (3 of 6)
2. As a result, financial capital is quickly moved from domestic
assets to foreign assets: capital flight.
– The domestic economy has a shortage of financial capital
for investment and has low aggregate demand.
3. To avoid this outcome, domestic assets must offer high interest
rates to entice investors to hold them.
– The central bank can push interest rates higher by reducing
the money supply (by selling foreign and domestic assets).
4. As a result, the domestic economy may face high interest
rates, a reduced money supply, low aggregate demand, low
output, and low employment.

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Figure 18.5 Capital Flight, the Money
Supply, and the Interest Rate

To hold the exchange rate fixed at E0 after the market decides it will be devalued to E1, the
central bank must use its reserves to finance a private financial outflow that shrinks the
money supply and raises the home interest rate.
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Financial Crises and Capital Flight (4 of 6)
• Expectations of a balance of payments crisis only worsen
the crisis and hasten devaluation.
– What causes expectations to change?
 Expectations about the central bank’s ability and
willingness to maintain the fixed exchange rate.
 Expectations about the economy: shrinking demand
of domestic products relative to foreign products
means that the domestic currency should become
less valuable.
• In fact, expectations of devaluation can cause a
devaluation: a self-fulfilling crisis.

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Financial Crises and Capital Flight (5 of 6)
• What happens if the central bank runs out of official international
reserve assets (foreign assets)?
• It must devalue the domestic currency so that it takes more
domestic currency (assets) to exchange for 1 unit of foreign
currency (asset).
– This will allow the central bank to replenish its foreign assets
by buying them back at a devalued rate,
– increasing the money supply,
– reducing interest rates,
– reducing the value of domestic products,
– increasing aggregate demand, output, and employment over
time.
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Financial Crises and Capital Flight (6 of 6)
• In a balance of payments crisis,
– the central bank may buy domestic bonds and sell
domestic currency (to increase the money supply) to
prevent high interest rates, but this only depreciates
the domestic currency more.
– the central bank generally cannot satisfy the goals of
low domestic interest rates (relative to foreign interest
rates) and fixed exchange rates simultaneously.

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Figure 18.6 The Swiss Franc’s Exchange Rate
against the Euro and Swiss Foreign Exchange
Reserves, 2006–2016

The Swiss National Bank intervened heavily to slow the Swiss franc’s
appreciation against the euro, setting a floor under the price of the euro in
September 2011 and abandoning that floor in January 2015.
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Interest Rate Differentials (1 of 3)
• For many countries, the expected rates of return are not

the same: R  R 

 E e
E  . Why?
E
• Default risk:
The risk that the country's borrowers will default on their
loan repayments. Lenders therefore require a higher
interest rate to compensate for this risk.
• Exchange rate risk:
If there is a risk that a country's currency will depreciate or
be devalued, then domestic borrowers must pay a higher
interest rate to compensate foreign lenders.

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Interest Rate Differentials (2 of 3)
• Because of these risks, domestic assets and foreign
assets are not treated the same.
– Previously, we assumed that foreign and domestic
currency deposits were perfect substitutes: deposits
everywhere were treated as the same type of
investment, because risk and liquidity of the assets
were assumed to be the same.
– In general, foreign and domestic assets may differ in
the amount of risk that they carry: they may be
imperfect substitutes.
– Investors consider these risks, as well as rates of
return on the assets, when deciding whether to invest.
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Interest Rate Differentials (3 of 3)
• A difference in the risk of domestic and foreign assets is
one reason why expected rates of return are not equal
across countries:
R R    E e
E

E
where  is called a risk premium, an additional amount
needed to compensate investors for investing in risky
domestic assets.
• The risk could be caused by default risk or exchange rate
risk.

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The Rescue Package: Reducing ρ
• The U.S. & IMF set up a $50 billion fund to guarantee the
value of loans made to Mexico's government,
– reducing default risk,
– and reducing exchange rate risk, since foreign loans
could act as official international reserves to stabilize the
exchange rate if necessary.
• After a recession in 1995, the economy began to recover.
– Mexican goods were relatively inexpensive, allowing
production to increase.
– Increased demand of Mexican products relative to
demand of foreign products stabilized the value of the
peso and reduced exchange rate risk.
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Figure 18.7 Effect of a Sterilized Central Bank
Purchase of Foreign Assets under Imperfect Asset
Substitutability

A sterilized purchase of foreign assets leaves the money supply unchanged but raises the risk-
adjusted return that domestic currency deposits must offer in equilibrium. As a result, the return
curve in the upper panel shifts up and to the right. Other things equal, this depreciates the
domestic currency from E1 to E2.
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Types of Fixed Exchange Rate Systems
1. Reserve currency system: one currency acts as official
international reserves.
– The U.S. dollar was the currency that acted as official
international reserves from under the fixed exchange
rate system from 1944 to 1973.
– All countries except the U.S. held U.S. dollars as the
means to make official international payments.
2. Gold standard: gold acts as official international
reserves that all countries use to make official
international payments.

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Reserve Currency System
• From 1944 to 1973, central banks throughout the world fixed the value
of their currencies relative to the U.S. dollar by buying or selling
domestic assets in exchange for dollar denominated assets.
• Arbitrage ensured that exchange rates between any two currencies
remained fixed.
– Suppose Bank of Japan fixed the exchange rate at 360¥/US$1
and the Bank of France fixed the exchange rate at 5Ffr/US$1.
 360 ¥ 
 US$1  72 ¥
– The yen/franc rate was   .
 5Ffr  1Ffr
 US$1 
 
– If not, then currency traders could make an easy profit by buying
currency where it was cheap and selling it where it was expensive.

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Gold and Silver Standard
• Bimetallic standard: the value of currency is based on both
silver and gold.
• The U.S. used a bimetallic standard from 1837 to 1861.
• Banks coined specified amounts of gold or silver into the
national currency unit.
– 371.25 grains of silver or 23.22 grains of gold could be
turned into a silver or a gold dollar.
– So gold was worth 371.25/23.22 = 16 times as much
as silver.
– See www.micheloud.com for a fun description of the
bimetallic standard, the gold standard after 1873, and the
Wizard of Oz!
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Figure 18.8 Growth Rates of
International Reserves

Annualized growth rates of international reserves did not decline sharply after the
early 1970s. Recently, developing countries have added large sums to their reserve
holdings, but their pace of accumulation has slowed starting with the crisis years of
2008–2009. The figure shows averages of annual growth rates.
Source: International Monetary Fund.
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Figure 18.9 Currency Composition
of Global Reserve Holdings

While the euro’s role as a reserve currency increased during the first decade of its existence,
it has taken a hit after the euro crisis. The dollar remains the overwhelming favorite.
Source: International Monetary Fund, Currency Composition of Foreign Exchange Reserves
(COFER), at www.imf.org. These data cover only the countries that report reserve
composition to the IMF, the major omission being China.
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Summary (1 of 4)
1. Changes in a central bank's balance sheet lead to
changes in the domestic money supply.
– Buying domestic or foreign assets increases the
domestic money supply.
– Selling domestic or foreign assets decreases the
domestic money supply.
2. When markets expect exchange rates to be fixed,
domestic and foreign assets have equal expected
returns if they are treated as perfect substitutes.

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Summary (2 of 4)
3. Monetary policy is ineffective in influencing output or
employment under fixed exchange rates.
4. Temporary fiscal policy is more effective in influencing
output and employment under fixed exchange rates,
compared to under flexible exchange rates.

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Summary (3 of 4)
5. A balance of payments crisis occurs when a central bank
does not have enough official international reserves to
maintain a fixed exchange rate.
6. Capital flight can occur if investors expect a devaluation,
which may occur if they expect that a central bank can no
longer maintain a fixed exchange rate: self-fulfilling crises
can occur.
7. Domestic and foreign assets may not be perfect
substitutes due to differences in default risk or due to
exchange rate risk.

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Summary (4 of 4)
8. Under a reserve currency system, all central banks but
the one that controls the supply of the reserve currency
trade the reserve currency to maintain fixed exchange
rates.
9. Under a gold standard, all central banks trade gold to
maintain fixed exchange rates.

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Figure 18A1.1 The Domestic Bond Supply
and the Foreign Exchange Risk Premium
under Imperfect Asset Substitutability

An increase in the supply of domestic currency bonds that the private

sector must hold raises the risk premium on domestic currency assets.
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Figure 18A2.1 How the Timing of a
Balance of Payments Crisis Is Determined

The market stages a speculative attack and buys the remaining foreign
reserve stock F T at time T, which is when the shadow floating exchange rate
E ST just equals the pre-collapse fixed exchange rate E0.
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Copyright

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