stephen g. cecchetti kermit l. schoenholtz exchange-rate policy and the central bank copyright ©...

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

Exchange-Rate Policy and the Central Bank

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter Nineteen

19-2

Introduction

• We need to examine the mechanics of how a central bank manages its country’s exchange rate.

• Both the U.S. and Europe are huge and largely self-contained economies.

• For the most part, these economies produce what they consume and invest.• They can focus on domestic economy and let their

exchange rates take care of themselves.

19-3

Introduction

• In small countries, however, imports and exports are sometimes more than 50 percent of GDP.• Central banks in these countries do not have the

luxury of leaving their exchange rates to take care of themselves.

• These countries are more exposed to what goes on in the rest of the world.• Change in their exchange rates can have dramatic

impact on them.

19-4

Introduction

• If exchange-rate policy is inseparable from interest-rate policy, we have left something out of our analysis.

1. Why is a country’s exchange rate linked to its domestic monetary policy?

2. Are there circumstances when exchange-rate stabilization becomes the overriding objective of central bankers?

3. Should central bankers try to fix their exchange rate?

4. Should a country consider giving up its currency entirely?

19-5

Linking Exchange-Rate Policy with Domestic

Monetary Policy• Exchange-rate policy is integral to any

monetary policy regime.• When capital flows freely across a country’s

borders, a fixed exchange rate means giving up domestic monetary policy.

19-6

Linking Exchange-Rate Policy with Domestic

Monetary Policy• There are two ways to see the connection

between exchange rates and monetary policy.

1. We can think about the market for goods and purchasing power parity.

2. Capital market arbitrage shows us how short-run movements in exchange rates are tied to the supply and demand in the currency markets.

19-7

Inflation and the Long-Run Implications of Purchasing

Power Parity• In Chapter 10 we discussed the law of one

price:• Ignoring transportation costs, this says that identical

goods should sell for the same price regardless of where they are sold.

• The concept of purchasing power parity (PPP) extends the logic of the law of one price to a basket of goods and services.

19-8


Power Parity• As long as goods can move freely across

international boundaries, one unit of domestic currency should buy the same basket of goods anywhere in the world.

• When prices change in one country but not in another, the exchange rate will adjust to reflect the change.

• In the long run, changes in the exchange rate are tied to differences in inflation.

19-9


Power Parity• PPP has immediate implications for monetary

policy.• If Mexico’s central bank wants to fix its

exchange rate, then Mexican monetary policy must be conducted so that Mexican inflation matches U.S. inflation.

• The central bank must choose between a fixed exchange rate and an independent inflation policy; it cannot have both.

19-10

Interest Rates and the Short-Run Implications of Capital

Market Arbitrage• In the short run,

• A country’s exchange rate is determined by supply and demand.

• Investors play a crucial role, because they are the ones who can move large quantities of currency across international borders.

• When the bonds have different yields, the prices will be bid up or down until the returns are equal.• Arbitrage in the capital market ensures that two

equally risky bonds have the same expected return.

19-11


Market Arbitrage• Consider a hypothetical case where the Bank of

England fixes the exchange rate at $1.50 per pound.

• Say a U.S. investor is considering how to invest $1500 over the next year.• Buy a one-year Chicago bond with interest rate, i.

• Buy a one-year London bond with interest rate, if.

• Investing in the London bond requires converting dollars to pounds and then pounds to dollars at the end of the year.

19-12


Market Arbitrage• At a fixed exchange rate of $1.50 per pound,

$1500 becomes £1000.• After one year, this amount becomes

£1000(1 + if) or $1500(1 + if) after conversion.• If has invested in Chicago bond, then would

have $1500(1 + i) at the end of the year.• Arbitrage equates the two returns, so under a

fixed exchange rate:

$1500(1 + if) = $1500(1 + i)

if = i

19-13


Market Arbitrage• Investors will be indifferent between investing

in a dollar-denominated bond or a pound-denominated bond only when the interest rates in the two cities are the same.

• If interest rates differ in Chicago and London, and the dollar-pound exchange rate is fixed, investors will move funds back and forth, wiping out the difference.

19-14

• Diversification reduces risk.• Investing overseas is diversification: You

should hold equity from emerging markets.• But, should you worry about crises?• If you are diversified and in long term

investments, then they are not likely to affect you.

19-15

Capital Controls and the Policymaker’s Choice

• If capital cannot flow freely between London and Chicago, there is no mechanism to equate interest rates in the two countries.

• So long as capital can flow freely between countries, monetary policymakers must choose between fixing their exchange rate and fixing their interest rate.

19-16


• A country cannot:• Be open to international capital flows,• Control its domestic interest rate, and• Fix its exchange rate.

• Policymakers must choose two of these three options.

• If a country is willing to forgo participation in international capital markets, it can:• Impose capital controls, • Fix its exchange rate, and • Still use monetary policy to pursue its domestic

objectives.

19-17


• However, this goes against the grain of modern economic thinking.

• Internationally integrated capital markets ensure that capital goes to its most efficient uses.

• As this view took hold in the late 20th century, countries removed the restrictions on the flow of capital that had been initiated earlier in the century.

19-18


• The benefits of open capital markets are easy to see.

• On the downside, disturbances in one country’s financial market can be quickly transmitted to markets and institutions in other countries.

• For emerging-market countries, greater openness of capital markets poses other risks, too.• Capital that flows in can also flow out, and can do

so quickly.

19-19


• That means that countries with open capital markets are vulnerable to sudden changes in investor sentiment.

• Investors may decide to sell a country's bonds.• Prices are driven down.

• Interest rates are driven up.

• The value of the domestic currency is driven down.

• The result is similar to a bank run.• All investors leave at once, precipitating a financial

collapse.

19-20


• It is tempting for government officials to implement capital controls to avert such a crisis.

• Inflow controls restrict the ability of foreigners to invest in a country.

• Outflow controls place obstacles in the way of selling investments and taking funds out.

• Outflow controls include restrictions on the ability of domestic residents to purchase foreign assets, and often include prohibitions on removing currency from the country.

19-21

• In 1997, financial crises in many emerging markets caused investors to pull out.• Typical response would be for these countries to

borrow from the IMF.

• Malaysia decided instead to implement strict capital controls.• By placing severe limits on investor's ability to

remove money from the country, they ensured that foreign investment would remain.

• They could then fix their currency and lower domestic interest rates.

19-22

• Malaysia’s recovery took only two years, compared to five years for Thailand and Indonesia.

• But, if countries start instituting capital controls every time there is a whiff of crisis, they will dramatically increase the risk of investing in emerging markets.• Investors will become wary of putting money into

foreign countries if they aren’t sure they will be able to take it out when they want.

19-23

Mechanics of Exchange-Rate Management

• If either the Fed or the ECB chose to, it could give up controlling interest rates and target the exchange rate.

• How would they do that?• We will begin with the central bank’s balance

sheet.• We can look more closely at what large central

banks like the Fed and ECB actually do.

19-24

The Central Bank’s Balance Sheet

• If all policymakers want to do is fix the exchange rate, they can offer to buy and sell their country’s currency at a fixed rate.

• As the Fed works to maintain a fixed dollar-euro exchange rate, its balance sheet shifts.• When it buy euros, it increases its dollar liabilities.

• When it sells euros, it reduces its dollar liabilities.

• These interventions have an impact on interest rates and the quantity of money in the economy.

19-25


• Buying euros or selling dollars increases the supply of reserves to the banking system.• This puts downward pressure on interest rates and

expands the quantity of money.

• Controlling the exchange rate means giving up control of the size of reserves so that the market determines the interest rate.

19-26


• In September 2000, the world’s largest central banks intervened to bolster the value of the euro.

• The Fed purchased €1.5 billion in exchange for $1.34 billion.• They did this by purchasing German government

bonds.

• The Fed increased its euro-denominated foreign exchange assets by $1.34 billion.

• On the liabilities side, commercial bank reserves have increase by the same amount.

19-27


19-28


• This T-account is identical to a purchase of U.S. Treasury bonds.

• A foreign exchange intervention has the same impact on reserves as a domestic open market operation.

• The Fed did supply dollars to the market through its intervention, but more importantly, the interest rate has fallen.

19-29


• The U.S. interest rate will fall while European interest rates remain the same.

• Foreign investors will want to buy fewer U.S. bonds, and they will need fewer dollars to do it.• The demand for dollars in the foreign exchange

market falls.

• U.S. investors will want to buy more foreign bonds.• The supply of dollars will increase.

19-30


19-31


• The demand and supply shifts together drive the value of the dollar down and the value of the euro up.

• But the reason that the exchange rate moved was that the domestic interest rate changed.

• A foreign exchange intervention affects the value of a country's currency by changing domestic interest rates.

19-32


• Any central bank policy that influences the domestic interest rate will affect the exchange rate.

• An open market purchase or sale works the same way as an exchange-rate intervention.

• This would have been exactly the same result if the Fed had purchased U.S. Treasury bonds.• There is nothing special about a foreign exchange

intervention.

19-33

Sterilized Intervention

• When all these countries intervened to buy euros, none of them changed their domestic interest-rate targets.• No wonder the value of the euro didn’t change.

• We assumed that when the Fed bought euros, it increased commercial bank reserves, which would reduce the interest rate in the absence of any other action.

19-34


• This is an example of an unsterilized foreign exchange intervention:• One that changes central bank liabilities.

• In large countries, central banks don’t operate that way.

• They engage in sterilized foreign exchange interventions:• A change in foreign exchange reserves alters the

asset side of the central bank’s balance sheet but the domestic monetary base remains unaffected.

19-35


• A sterilized intervention is a combination of two transactions:

1. There is the purchase or sale of foreign currency reserves, which changes the central bank’s liabilities.

2. Then an immediate open market operation, of exactly the same size, designed to offset the impact of the first transaction on the monetary base.

19-36


• For example, the Fed’s purchase of a German government bond, is offset by the sale of a U.S. Treasury bond.• These two actions leave the level of reserves

unchanged.

• This intervention is sterilized with respect to its effect on the monetary base, or the size of the central bank’s balance sheet.

• An intervention is unsterilized if it changes the monetary base and sterilized if it does not change the monetary base.

19-37


• When the Fed purchased the German government bonds, the level of reserves in the banking system increased.

• But the FOMC had not changed the target federal funds rate, so the job of the Open Market Trading Desk had not changed.• The foreign exchange desk had purchase bonds

issued by a euro-area government, paying for them with reserves, and the Open Market Desk had sold U.S. Treasury bonds to reverse the potential impact.

19-38


19-39


• From Figure 19.3 we see the result on the Fed’s balance sheet.

1. Commercial bank reserves remain unchanged following a sterilized intervention, so domestic monetary policy does not change.

2. The intervention changes the composition of the asset side of the central bank’s balance sheet.

• The sterilized intervention in support of the euro in 2000 had no sustained effect.

19-40


• However, change in the composition of a central bank balance sheet can alter the relative prices of assets if:

1. Markets are thin or functioning poorly, and

2. The policy shift is large compared to the level of market transactions.

19-41

The Costs, Benefits, and Risks of Fixed Exchange

Rates• Many countries allow their exchange rates to

float freely.• But others, especially small, emerging-market

countries, fix their exchange rates.• Fixing the exchange rate has costs and benefits.• We will discuss the trade-offs.

19-42

Assessing the Costs and Benefits

• Capital crosses international borders like goods and services do.

• Fixed exchange rates not only simplify operations for businesses that trade internationally, they also reduce the risk that investors face when they hold foreign stocks and bonds.

19-43


• Another potential benefit is that a fixed exchange rate ties policymakers’ hands.

• In countries that are prone to bouts of high inflation, a fixed exchange rate may be the only way to establish a credible low-inflation policy.• It forces low-inflation discipline on both central

bankers and politicians, and

• An exchange rate target enhances transparency and accountability.

19-44


• One serious drawback to a fixed exchange rate, however, is that it imports monetary policy.• You must adopt the other country’s interest-rate

policy.

• A fixed exchange rate policy makes the most sense when the two countries involved have similar macroeconomic fluctuations.• Otherwise, the country with the flexible exchange

rate that is in control of monetary policy might be raising interest rates at the same time the other country in going into a recession.

19-45


• Policymakers should consider several additional matters.

1. When a country fixes its exchange rate, the central bank is offering to buy and sell its own currency at a fixed rate.

• Monetary policymakers will need ample currency reserves.

2. Fixing the exchange rate means reducing the domestic economy’s natural ability to respond to macroeconomic shocks.

19-46

The Danger of Speculative Attacks

• Fixed exchange rates have benefits, but they are fragile and prone to a type of crisis called a speculative attack.

• Suppose for some reason, financial market participants come to believe that the government will need to devalue its currency in the near future.• Investors will attack the currency and force an

immediate devaluation.

19-47

• Through the mid-1990’s, the Bank of Thailand was committed to maintaining a fixed exchange rate.

• They had to make sure foreign currency traders believed that the Bank of Thailand had enough dollars on hand to buy however many baht the traders wanted to sell.

• In summer 1997, financial market participants began to question whether the reserves at the central bank really were big enough.


19-48


• Speculators borrowed baht at domestic Thai interest rates,

• Took them to the central bank to convert them to dollars at a rate of 25 to one, and

• Then invested the dollars in short-term, interest-bearing securities in the U.S.

• This action drained the Bank of Thailand's dollar reserves.• The more baht speculators borrowed to convert into

dollars, the further the reserves fell.

19-49


• After the baht depreciated, speculators were able to repay the loan with much fewer dollars.• There was an instant profit for the speculators.

• International currency sponsors have very deep pockets, so they can quickly drain billions of dollars from a central bank.

19-50


What causes a speculative attack?

1. Fiscal policy:• If investors begin to think that at current levels,

government spending must ultimately increase inflation, they will stop believing that officials can maintain the exchange rate at its fixed level.

2. Financial instability:• If a country’s banking system is insufficiently

capitalized or otherwise unsound, a central bank may face pressure to relax monetary policy to avoid or contain a financial crisis.

19-51


• If investors doubt that the central bank will keep interest rates high enough for a sufficient time to defend the currency peg, an attack may follow.

3. Spontaneously:• If enough currency speculators simply decide that

a central bank cannot maintain its exchange rate, they will attack.• Spontaneous speculative attacks are like bank

runs; they can be contagious.

• Many observers suspect that in today’s world, no central bank has the resources to withstand such an attack.

19-52

• The gold standard obligates the central bank to fix the price of something we don’t really care about - gold.• Instead of stabilizing the price of goods, we

stabilize the price of gold.

• Any political disruption in parts of the world where gold is mined could have dramatic monetary policy effects.

• The promise to convert dollars into gold means that international transactions must be settled in gold.

19-53

• Under a gold standard, countries running current account deficient will be forced into deflation.

• Economic historians believe that gold flows played a central role in spreading the Great Depression of the 1930’s throughout the world.

• The sooner a country left the gold standard and regained control of its monetary policy, the faster its economy recovered.

19-54

• Some financial advisors advocate holding gold as an investment.

• They argue that it reduces inflation risk.• However, gold doesn’t pay interest and its price is

highly volatile.

• If you are worried about inflation risk, aren’t you better off with short-term bonds?• They are both cheaper and easier than buying gold.

19-55

Summarizing the Case for a Fixed Exchange

Rate• We can list the conditions under which

adopting a fixed exchange rate makes sense.• A poor reputation for controlling inflation on its

own.

• An economy that is well integrated with the one to whose currency the rate is fixed.

• A high level of foreign exchange reserves.

• Fixed exchange rates are still risky to adopt and difficult to maintain.

19-56

Fixed Exchange Rate Regimes

• We will study some examples of fixed exchange-rate regimes, to see how they work.

• We will look at: • Managed exchange-rate pegs,

• Currency boards, and

• Dollarization.

19-57

Exchange-Rate Pegs and the Bretton Woods System

• In 1944, a group of 44 countries agreed to form the Bretton Woods system.• It was a system of fixed exchange rates that offered

more policy flexibility over the short term than had been possible under the gold standard.

• The system lasted from 1945 to 1971.• Each country maintained an agreed-upon

exchange rate with the U.S. dollar.• It pegged its exchange rate to the dollar.

19-58


• The dollar was what is knows as a reserve currency.

• It was convertible into gold at a rate of $35 per ounce.

• The choice of the dollar was based on the facts that:

1. The U.S. was the biggest of the Allies in WWII, both economically and militarily, and

2. Dollars were relatively abundant.

19-59


• Because other countries did not want to adopt U.S. monetary policy, their fixed exchange rates required complex capital controls.• Countries had to intervene regularly to maintain

their exchange rates at the peg.

• Adjustments were made to the exchange-rate pegs, but only in response to perceived long-term imbalances.

19-60


• The system had some flexibility because of the International Monetary Fund (IMF).• They were created to manage the Bretton Woods

System by making loans to countries in need of short-term financing to pay for an excess of imports over exports.

• With a fixed exchange rate and the free movement of capital, countries could not have independent monetary policies.

19-61


• Because their exchange rate was fixed to the dollar, participating countries were forced to adopt policies that resulted in the same amount of inflation as in the US.

• When U.S. inflation began to rise in the late 1960s, many countries were unhappy.• By 1971, the system had completely fallen apart.

19-62


• The response of American officials has been to allow the dollar to float freely ever since.

• Europeans took a different tack:• For much of the time from the collapse of the

Bretton Woods system to the adoption of the euro in 1999, they maintained various fixed exchange-rate mechanisms.

• Because capital flowed freely among these countries, that meant giving up their ability to set interest rates.

19-63

• In March 2010, the amount of foreign exchange reserves held by China’s central bank surpassed $2.4 trillion.• About 30% of all currency reserves in the world.

• The increase of reserves reflects China’s astonishing, sustained current account surpluses - the excess of exports over imports.

• China’s fixed exchange-rate regime supports these enormous export surpluses.

19-64

• China has promoted export-led growth by pegging their currency, the Yuan, to the U.S. dollar.

• Although policy makers have adjusted the dollar peg repeatedly, the appreciation has been too modest to offset China’s rapid gains in international competitiveness.

• When a country runs a current account surplus, it also runs a capital account deficit.• It is either making loans to foreigners or buying

their assets.

19-65

• In June 2009, China owned about $1.2 trillion of Treasury and agency debt.• Chinese firms have also increased their direct

investment abroad.

• China will probably face large currency losses on its foreign assets when the Yuan eventually rises to reflect the country's trade competitiveness.• If China tries to avert these projected losses by

lowering its dollar holdings, the risk is that the Yuan will rise sooner against the dollar, undermining the fixed exchange rate and hurting exports.

19-66

• China’s leaders can slow the rate of reserve accumulation by promoting domestic consumption, but this process is likely to take place gradually over many years.

• A rise of trade protectionism in other countries could change this picture more abruptly.

19-67

Hard Pegs: Currency Boards and Dollarization• In a hard-peg system, the central bank

guarantees convertibility of domestic currency into the foreign currency to which it is pegged.

• Only two exchange-rate regimes can be considered hard pegs:• Currency boards, and

• Dollarization.

19-68

Hard Pegs: Currency Boards and Dollarization• With a currency board, the central bank

commits to holding enough foreign currency assets to back domestic currency liabilities at a fixed rate.

• With dollarization, one country formally adopts the currency of another country for use in all its financial transactions.

19-69

Currency Boards and the Argentinean Experience

• Somewhere between 10 and 20 currency boards operate in the world today.

• The Hong Kong Monetary Authority (HKMA) operates a system whose sole objective is to maintain a fixed exchange rate of 7.8 Hong Kong dollars to one U.S dollar.• The rules of the currency board provide that the

HKMA can increase the size of Hong Kong’s monetary base only if it can accumulate additional dollar reserves.

19-70


• With a currency board, the central bank’s only job is to maintain the exchange rate.

• While that means that policymakers cannot adjust monetary policy in response to domestic economic shocks, the system does have it advantages.• It controls inflation.

19-71


• Currency boards do have their problems.• The central bank loses its role as the lender of

last resort to the domestic banking system.• The Banco Central de la Republica Argentina

solved this problems by establishing standby letters of credit from large U.S. banks.

• However, their lending was limited to the amount of dollar credit that foreign banks were willing to extend.

19-72


• In 2001, the Argentinean currency board collapsed and authorities were forced to allow the peso to float.

• What caused the collapse?

1. The peso was pegged to the U.S. dollar, even though Argentina’s economy doesn’t have much to do with the U.S. economy.

• When the dollar appreciated, the peso appreciated.

• The overvalued peso priced Argentinean exporters out of their markets severely damaging their economy.

19-73


2. Fiscal policy was the other problem.• While the Argentinean economy grew at a healthy

rate through much of the 1990’s, government spending rose even faster.

• The more the government borrowed, the more wary lenders became of continuing to lend.

• Politicians spent until they simply ran out of money.

19-74


• When politicians began printing their own money, the claim that Argentinean inflation would roughly mirror U.S. inflation was no longer credible and the currency board collapsed.

• Irresponsible politicians can undermine any monetary policy regime.

19-75

Dollarization in Ecuador

• Some countries just give up and adopt the currency of another country for all their transactions, completely eliminating their own monetary policy.

• In 1865, Monaco adopted the French franc and uses the euro today.

19-76


• In 1999, Ecuador experienced severe financial crisis.• In 2000, Ecuador officially gave up its currency.

• Within 6 months, the central bank had bought back all the sucres in circulation.

• Almost immediately,• Interest rates dropped,

• The banking system reestablished itself,

• Inflation fell dramatically, and

• Growth resumed.

19-77


• Ecuador’s move to dollarization was successful enough that a year later El Salvador followed suit.

• Panama has been dollarized since 1904.• Why would a country choose to give up its

currency?

19-78


• In a small emerging-market country, there are a host of reasons.

1. With no exchange rate, there is no risk of an exchange-rate crisis.

2. Using dollars or euros or yen can help a country to become integrated into world market, increasing trade and investment.

3. By rejecting the possibility of inflationary finance, a country can reduce the risk premium it must pay on loans and generally strengthen its financial institutions.

19-79


• It does, however, need to find a way to get the dollars it will need to keep the monetary base growing, which can prove to be challenging.

• There are costs to dollarization as well.

1. There is a loss of revenue that comes from issuing currency:

• What is called seignorage.

2. Dollarization effectively eliminates the central bank as the lender of last resort as they cannot print their own money.

19-80


3. There is a loss of autonomous monetary or exchange-rate policy.

4. Any country that adopts the dollar as its currency gets U.S. monetary policy, like it or not.

19-81


• Dollarization is not the same as a monetary union.

• The decision by European countries to adopt a common currency, the euro, was fundamentally different from a country's decision to adopt the dollar.

• When the FOMC makes its decisions, the affairs of Ecuador and El Salvador carry no weight.

• All European countries participating in the monetary union take part in monetary policy decisions.

• A monetary union is shared governance; dollarization is not.

19-82

• Monetary policy is one of several important determinants of the exchange rate.

• In the past, poor fiscal prospects in an emerging-market economy frequently led to a loss of confidence in its currency.

• In the financial crisis of 2007-2009, industrial countries also developed fiscal problems that could weaken their currencies.

• Even for the international reserve currency, the U.S. dollar, confidence depends in part on whether the fiscal path of the U.S. government will be seen as healthy.

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ

Exchange-Rate Policy and the Central Bank

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

End of Chapter Nineteen

stephen g. cecchetti kermit l. schoenholtz exchange-rate policy and the central bank copyright ©...

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