INAF TA session 9

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INAF TA session 9

  1. 1. U6018International Finance & Monetary TheoryRecitation 9 - 4/8/10Prof. richardclarida<br />TA: Doug Dowson<br />Email: dd2440@columbia.edu<br />
  2. 2. Contents<br />2<br />Review<br />Central Bank Balance Sheet<br />Intervention in the Foreign Exchange Market<br />Monetary and Fiscal Policy Under Fixed Exchange Rates<br />Balance of Payments Crises and Capital Flight<br />Hot Money Inflows<br />More on Sterilized Intervention<br />
  3. 3. Review: Permanent Macro Policy<br />A permanent increase in the money supply shifts the AA curve upward and causes the expected future exchange rate Ee to rise<br />In the short term, permanent monetary policy is more effective than temporary monetary policy<br />In the long term, return to full employment with higher prices and permanent domestic currency depreciation<br />3<br />
  4. 4. Review: Permanent Macro Policy<br />A permanent fiscal expansion shifts the DD curve to the right and causes the expected future exchange rate Ee to fall<br />Change in market expectations causes AA curve to shift to the left and domestic currency to appreciate “crowding out” aggregate demand<br />Output returns to full employment level with permanent domestic currency appreciation<br />4<br />
  5. 5. Central Bank Balance Sheet<br />5<br /><ul><li>The central bank balance sheet records the assets and liabilities held by the central bank</li></ul>Assets <br />Foreign government bonds<br />Gold<br />Domestic government bonds <br />Loans to domestic banks<br />Liabilities<br />Deposits of domestic banks<br />Currency in circulation<br />
  6. 6. Central Bank Balance Sheet<br />6<br />A central bank’s total assets equal its total liabilities<br />Changes in central bank assets cause equal changes in central bank liabilities<br />When the central bank buys domestic bonds or foreign bonds, the domestic money supply increases<br />When the central bank sells domestic bonds or foreign bonds, the domestic money supply decreases<br />
  7. 7. Foreign Exchange Intervention<br />7<br />Sterilization is a policy in which a central bank offsets its foreign exchange market intervention with a domestic asset transaction in order to keep the domestic money supply constant<br />
  8. 8. Foreign Exchange Intervention<br />8<br />Sterilized intervention to strengthen the domestic currency<br />Central bank sells foreign assets and purchases domestic currency which reduces the domestic money supply: ↓foreign assets ↓Ms<br />Central bank then purchases domestic assets which increases the domestic money supply: ↑domestic assets ↑Ms<br />The goal is a stronger domestic currency and no change in the domestic money supply<br />
  9. 9. Foreign Exchange Intervention<br />9<br />Sterilized intervention to weaken the domestic currency <br />Central bank sells domestic currency and purchases foreign assets which increases the domestic money supply: ↑foreign assets ↑Ms<br />Central bank then sells domestic assets which decreases the domestic money supply: ↓domestic assets ↓Ms<br />The goal is a weaker domestic currency and no change in the domestic money supply<br />
  10. 10. Fixing the Exchange Rate<br />10<br />To fix the exchange rate, a central bank influences the supply and demand of currency by trading domestic and foreign assets<br />
  11. 11. Fixing the Exchange Rate<br />11<br />Recall the interest parity equation:<br />RUSD = RHKD + (EeUSD/HKD – EUSD/HKD) / EUSD/HKD<br />Under a fixed exchange rate regime, the expected appreciation of the currency is zero<br />(EeUSD/HKD – EUSD/HKD) / EUSD/HKD = 0<br /> and therefore<br />RUSD = RHKD<br />The central bank adjusts the money supply so that real domestic money supply, Ms/P, equals real domestic money demand, L(R*, Y) and RUSD = RHKD<br />
  12. 12. Monetary Policy Under Fixed Exchange Rates<br />The impossible trinity holds that no matter what policy regime it chooses, a central bank can never achieve all three of the following goals: exchange rate stability, capital mobility, and monetary policy autonomy.<br />12<br />
  13. 13. Monetary Policy Under Fixed Exchange Rates<br />13<br />By fixing the exchange rate without limiting capital mobility, the central bank loses its ability to use monetary policy to influence output and employment<br />
  14. 14. Monetary Policy Under Fixed Exchange Rates<br />If the central bank wanted to stimulate demand by increasing the domestic money supply, this would shift the AA curve up<br />To prevent depreciation of the domestic currency and maintain the pegged exchange rate E0, the central bank would have to intervene by selling foreign assets and buying domestic currency <br />The domestic money supply falls and the AA curve shifts back down to its original position<br />14<br />
  15. 15. Fiscal Policy Under Fixed Exchange Rates<br />15<br />Under a fixed exchange rate, fiscal policy is more effective in influencing output and employment<br />
  16. 16. Fiscal Policy Under Fixed Exchange Rates<br />Expansionary fiscal policy leads to a rise in output, increased demand for money, and upward pressure on interest rates and on the value of the domestic currency<br />To prevent an appreciation of the domestic currency, the central bank must intervene in the foreign exchange market by buying foreign assets, thereby increasing the money supply<br />16<br />
  17. 17. Demand Shocks Under Fixed Exchange Rates<br />17<br />A fixed exchange rate amplifies the effect of demand shocks on GDP<br />
  18. 18. Demand Shocks Under Fixed Exchange Rates<br />When world demand falls, output contracts, demand for domestic money decreases, and there is downward pressure on the domestic currency<br />Under a fixed exchange rate, the central bank must respond by selling foreign assets and buying domestic currency, thereby decreasing the money supply and keeping R = R* and E = E<br />18<br />
  19. 19. Speculative Attack<br />19<br />If a currency peg loses credibility, and the market expects a future devaluation, investors demand a higher rate of return to hold domestic assets causing a fall in reserves and a rise in domestic interest rates<br />RUSD = ↑RHKD + (↓EeUSD/HKD – EUSD/HKD) / EUSD/HKD<br />
  20. 20. Speculative Attack<br />Expected devaluation increases the expected return on foreign assets<br />To attract investors to hold domestic assets at the original exchange rate, the interest rate must rise through a sale of foreign assets<br />20<br />
  21. 21. Speculative Attack<br />The speculative attack is represented by a shift in the DD curve to the left<br />The central bank’s response of reducing the domestic money supply to maintain the fixed exchange rate E is represented by a shift in the AA curve to the left<br />21<br />
  22. 22. Speculative Attack<br />22<br />Capital flight is the loss of reserves that accompanies a devaluation scare as capital is shifted from domestic to foreign assets<br />A balance of payments crisis occurs when a central bank does not have enough foreign exchange reserves to maintain a fixed exchange rate<br />
  23. 23. Hot Money Inflows<br />23<br />If the market expects future appreciation, investors demand a lower rate of return to hold domestic assets<br />RUSD = ↓RHKD + (↑EeUSD/HKD – EUSD/HKD) / EUSD/HKD<br />
  24. 24. Hot Money Inflows<br />To keep the domestic currency from appreciating above the original exchange rate, the central bank must intervene in the market by buying foreign assets which increases the money supply and lowers the domestic interest rate<br />24<br />
  25. 25. Sterilized Intervention<br />25<br />When a central bank carries out sterilized foreign exchange intervention, its transactions leave the domestic money supply unchanged<br />Without a change in the money supply, there will be no change in domestic interest rates and therefore no change in the exchange rate<br />Conclusion: in theory, sterilized intervention should be ineffective when capital is mobile<br />
  26. 26. Sterilized Intervention: Russia in 2008<br />26<br />Georgia conflict and global financial crisis increase Russia’s risk premium, triggering capital flight out of the country<br />Russian Central Bank responds with foreign exchange intervention selling reserves and buying domestic currency<br />
  27. 27. Sterilized Intervention: Russia in 2008<br />27<br />Instead of allowing the domestic money supply to contract and the domestic interest rate to increase, the Russian Central Bank instead sterilizes its intervention by purchasing domestic assets, thereby keeping the money supply constant and preventing higher domestic interest rates<br />
  28. 28. Sterilized Intervention: Russia in 2008<br />28<br />The sterilized intervention only exacerbates capital outflows leading to further reserve losses<br />The Central Bank tries unsuccessfully to introduce capital controls on capital outflows <br />Eventually, the Russian Central Bank allows the ruble to depreciate<br />
  29. 29. Sterilized Intervention: Russia in 2008<br />Risk aversion shifts DD curve to the left<br />Russian Central Bank chooses not to contract the money supply to maintain the original exchange rate (shift AA left)<br />Instead, the Central Bank attempts sterilized intervention and capital controls and then gives up and allows for ruble depreciation<br />29<br />
  30. 30. Sterilized Intervention<br />30<br />Sterilized intervention can sometimes be effective for the following reasons:<br />Risk premium makes domestic and foreign bonds imperfect substitutes which violates the interest parity condition<br />Signaling effect of central bank’s intervention influences the market’s exchange rate expectations<br />

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