2. 19-2
Exchange Rate Policy:
The Big Questions
• How are exchange-rate policy and
interest-rate policy connected?
• Are there times when exchange-rate
stabilization becomes a primary policy
objective?
• Should a country give up its own
currency?
3. 19-3
Exchange Rate Policy:
Roadmap
• Linking Exchange Rate-Rate Policy and
Domestic Monetary Policy
• Mechanics of Exchange-Rate
Management
• The Costs, Benefits, and Risks of Fixed
Exchange Rates
• Fixed Exchange-Rate Regimes
4. 19-4
Exchange Rate Policy
and Monetary Policy
When Capital flows freely across a
country’s borders, fixing the exchange
rate means giving up domestic
monetary policy
5. 19-5
Long-run
Implications of PPP
• Remember Purchasing power parity:
One unit of domestic currency will buy the
same basket of goods anywhere in the world
• Implication:
% Exchange rate = inflation differential
• Central bank must choose between controlling
inflation or fixing the exchange rate
6. 19-6
Short-run Implications
of Capital Market Arbitrage
• At what interest rates are investors
indifferent between bonds in two
different currencies?
• If the exchange rate is fixed, then the
interest rate must be the same.
• If interest rates differ, funds will move to
equate them.
7. 19-7
• Diversification reduces risk
• Investing overseas is diversification:
You should hold equity from emerging
markets
• Should you worry about crises?
• Since these countries are small, the
answer is almost surely no.
8. 19-8
Capital Controls and
the Policymaker’s Choice
A country cannot
1. Be Open to international capital flows
2. Control its domestic interest rate
3. Fix its exchange rate
A country must choose 2 of the 3.
9. 19-9
Capital Controls
• Common through much of 20th century.
• Benefits of open capital markets clear
for large industrialized countries.
• For emerging markets countries it’s very
tempting to try to put these into place
10. 19-10
Capital Controls
• Inflow Controls:
Restrict the ability of foreigners to
invest in the country
• Outflow Controls:
Keep foreigners from removing funds
that are there.
11. 19-11
• 1997 investors want out of emerging markets
• Drove the value of Malaysian ringitt down
and interest rates up.
• Malaysian banks and corporations were
short of funds to repay their loans
.
• Normal response is to borrow from the IMF
• Malaysia fixed the value of their currency and
instituted capital controls.
12. 19-12
Mechanics of Foreign Exchange
Management
• Simple way to fix the exchange rate:
Buy & sell your currency at a fixed rate
• What happens to the central bank’s
balance sheet when they do this?
Lose control of balance sheet size
13. 19-13
The Mechanics of Exchange Rate
Management
• The decision to control the exchange
rate means giving up control of the size
of reserves, so that the market
determines the interest rate.
15. 19-15
The Mechanics of Exchange Rate
Management: Intervention
• A foreign exchange intervention has the
same impact on reserves as a domestic
open market operation.
17. 19-17
The Mechanics of Exchange Rate
Management: Intervention
• What happens next?
– Does this move the exchange rate?
– The intervention increases reserves,
causing interest rates to fall.
– This increases investors’ desire to move
funds out of the U.S.
18. 19-18
The Mechanics of Exchange Rate
Management: Intervention
• Affects value of the dollar by changing
domestic interest rates.
• Any policy that changes interest rates
changes the exchange rate.
• The Central Bank must choose
between interest rate and exchange
rate policy.
19. 19-19
The Mechanics of Exchange Rate
Management: Intervention
• A foreign exchange intervention affects
the value of a country's currency by
changing domestic interest rates
• Any central bank policy that influences
the domestic interest rate will affect the
exchange rate
20. 19-20
The Mechanics of Exchange Rate
Management: Sterilized Intervention
• Fed intervention in foreign exchange does
not come with a change in the federal funds
rate target.
• Open market desk sterilizes the intervention:
Changes the quantity of securities so that
quantity of reserves is unaffected
22. 19-22
Fixed Exchange Rates:
Benefits
• Eliminates exchange rate risk, making
international trade easier
• Reduce risk of investing abroad
• Tie policymakers’ hands
23. 19-23
Fixed Exchange Rates:
Costs
• Eliminates stabilization effects of
exchange rate changes.
• Requires a high level of foreign
exchange reserves
24. 19-24
Fixed Exchange Rates:
Speculative Attacks
• Fixed exchange rate regimes are fragile
• Thailand 1997
– Fixed rate of 26 baht per $
– Bank of Thailand maintained the rate by
offering by buy whatever quantity of baht
dealers wanted to sell.
– What if the dealers start to question the
ability of the Bank to maintain the fixed
exchange rate peg?
25. 19-25
Speculative Attack:
Thailand 1997
• Borrow baht, take it to the central bank to get dollars
at 26 to one, invest proceeds at short-term $ interest
rates.
• Drains reserves from the Bank of Thailand
• The lower reserves go, the less likely the Central
Bank can maintain the peg.
• More and more speculators borrow baht and
exchange them for dollars.
• When reserves run out, the baht depreciates and the
speculators convert dollars to baht at more than 26
to 1, making a profit.
27. 19-27
• Idea is for dollars to be convertible into gold.
• Instead of stabilizing the price of goods, we
stabilize the price of gold
• Why should monetary policy be determined
by the rate at which gold comes out of the
ground?
• It is also a fixed exchange rate policy
• Blamed for the international transmission of
the Great Depression of the 1930s
28. 19-28
• Amount of money issued by the central bank
depended on the gold you had
• Current account deficit countries lost gold.
• Losing gold forced contraction of money.
• Monetary contraction drove prices down.
• U.S. was running a current account surplus
and a deflation at the same time!
29. 19-29
• Some financial advisors advocate
holding gold as an investment
• They argue that it reduces inflation risk
• If you are worried about inflation risk,
aren’t you better off with short-term
bonds?
30. 19-30
Fixed Exchange Rate Regimes:
Bretton Woods
• 1944 to 1971
• Dollars held as reserve currency
• Dollar convertible into gold at $35/oz
• Forced countries to adopt U.S.
monetary policy
• Eventually refused, system fell apart
31. 19-31
Fixed Exchange Rate Regimes:
Currency Board
• Central bank guarantees convertibility
of domestic currency into a foreign
currency like the dollar, euro or yen.
• Ties monetary policy to that of the
country issuing the backing currency.
• Argentina used it to reduce inflation
from 100+% to close to zero.
32. 19-32
Fixed Exchange Rate Regimes:
Problems with Currency Boards
• Give up monetary policy
• Give up lender of last resort
• If the currency is overvalued, destroys
domestic industry
• Doesn’t contain fiscal policy
33. 19-33
Fixed Exchange Rate Regimes:
Dollarization
• Adopt currency of another country
• Eliminates exchange rate risk and
helps integrate country into the world
trading system
• Lose revenue from money printing
• Eliminates monetary policy and lender
of last resort.
• This is not shared governance.
