Central Banks & ExchangeRate Regimes Flexible Fixed Managed Floating
Flexible Exchange Rate Exchange rates are freely determined by the demand & supply of currencies.
Increase in Demand for £Under Flexible Exchange Rate e$/£ S£ e’ e D£’ D£ Q£
Fixed Exchange Rate Gold standard (up to 1914) Peg currency to gold at a mint parity. ($20.67/ounce of gold, £4.25/ounce of gold).
Fixed Exchange Rate Gold standard Pegged rate system Peg is the central value of exchange rate around which the government maintains narrow limits. (Haitian Gourde = $.20 since 1907 for a long period of time). Government intervenes in foreign exchange markets to maintain the exchange rate within prescribed limits.
Increase in Demand for £Under Pegged Rate System e$/£ S£ S£’ ē D£’ D£ Q£
Fixed Exchange Rate Devaluation Peg is increased. • £ was devalued in Nov. 1967 from $2.80/£ to $2.40/£ . Revaluation Peg is decreased.
Managed Floating Government intervenes in the foreign exchange market to influence the exchange rate, but does not commit itself to maintain a certain fixed rate or some narrow limits around it.
Goods Market Equations Y = C + I + G0 + NX (Equim condition) C = C0 + cYd (Consn function) Yd = Y – T + R0 (Disposable income) T = T0 + tY (Tax function) I = I0 – br (Investment function)
Goods Market Equations Endogenous Variables Parameters Y: National Income c: MPC C: Consumption t: Personal Tax Rate Yd: Disposable Income b: Interest Sensitivity of I T : Personal Tax Revenue C0 : Exogenous Component of C I : Investment I0 : Exogenous Component of I G0 : Government Expenditure R0 : Transfer Payments T0 : Fixed personal tax revenue
Goods Market Equilibrium:IS Curve (General form) Goods market equilibrium condition: AS = AD Sn – I = NX - A0 + br + sY = NX0 – mY r = (A0 + NX0)/b – (s + m)/b*Y = (A0 + NX0)/b – 1/αb*Y whereA0 = C0 + c(R0 – T0) + I0 + G0NX0 = X0 – Q0 + (g + j)eP*/Pα = 1/[1 – c(1 – t) + m]
Assets Markets Markets in which money, bonds, stocks, real estate & other forms of wealth or stores of value are exchanged. We consider two types of assets domestic bonds domestic money
Total Real Wealth in the Economy Supply of real wealth W/P = M/P + VS where W : Nominal wealth P : General price level VS: Stock of bonds Demand for real wealth W/P = L + V L: Demand for money V: Demand for bonds In equilibrium L + V = M/P + VS Or (L - M/P) + (V - VS) = 0
Walras law As long as money market is in equilibrium (i.e. L = M/P), bond market will also be in equilibrium.
Money Market EquationsL = M/P (Money market equim condition) L = L0 + kY – hr (Money demand) M = uH (Money supply) H = IR + CBC0 (High Powered Money) IR = IR-1 + BP-1 (Int. Reserves adjustment)
Money Market Equations Endogenous Variables Exogenous Variables L: Liquidity Demand k: Income Sensitivity of L r: Real interest Rate h: Interest Sensitivity of L M: Nominal Money Supply u: Money Multiplier H: High-Powered Money L0: Exogenous component of L IR: International Reserves P: General Price Level CBC0: Central Bank Credit
Demand for Money The demand for money can be linearized to: L = L0 + kY – hr
Supply of Money MS = Cp + CD Cp: Currency (coin, dollar notes) in the hand of the public CD: Checkable deposits M = H where : the money multiplier H: the high powered money (monetary base)
Central Bank’s Balance Sheet Assets = IR + CBC Liabilities = Cp + RE IR + CBC = Cp + RE = H H is created when the Central Bank acquires assets in the form of international reserves, IR (foreign exchange & gold), & Central Bank credit, CBC (loans, discounts & government bonds).
Simplified Central Bank Balance Sheet Assets ClaimsInternational Reserves $100b Currency $240 bCentral Bank Credit $200b Cash in vaults $20 b Currency in the hand of the public $220b Deposits at the central bank $60 bHigh Powered Money $300b High Powered Money $300 b
Effects of Open Market Purchaseon Central Bank’s Balance Sheet Central bank purchase of securities (increase in CBC). Central bank check is deposited in the commercial bank. If the commercial bank decides to convert the check into cash, the currency in vault (RE) increases. If commercial bank deposit the check at the central bank, commercial bank deposit (RE) increases.
Effects of a Drain of International Reserves on Central Bank’s Balance Sheet IR decreases & Commercial bank deposit decreases. A BP deficit (surplus) decreases (increases) H &, therefore, tends to decrease (increase) MS.
Foreign Trade Equations BP = 0 (Foreign sector equim condition) BP = NX + CF (Balance of Payments) NX = X – Q (Net Export function) X = X0 + gePW/P (Export function) Q = Q0 + mY – jePW/P (Import function) e = e-1 – qBP (Exchange Rate adjustment) CF = f(r – rW) (Capital Flow equation)
Foreign Trade Equations Endogenous Variables Exogenous Variables NX : Net Exports (Trade Surplus) g : Exchange Rate Sensitivity of X X : Value of Exports Q : Value of Imports m : Marginal Propensity to Imp. BP : Balance of Payments j : Exch. Rate Sensitivity of Q Surplus f : Capital Mobility Coefficient CF : Capital Flow (KAB Surplus) e : Exchange Rate q : Exchange Rate Coefficient (Domestic/Foreign Currency) rW : World Interest Rate X0 : Exogenous Component of X Q0 : Exogenous Component of Q
Foreign Trade Sector Equilibrium:The BP Curve BP = 0 => NX + f (r – rW) = 0 With no capital mobility (f = 0) NX = NX0 - mY = 0 Y = NX0/m With perfect capital mobility r = rW With imperfect capital mobility NX0 – mY + f (r – rW) = 0 => r = [rW - NX0/f] + m/f * Y
BP with No Capital Mobility Y = NX0/m In particular form: Y=
BP Curve withPerfect Capital Mobility rr = rW BP Y
BP Curve withImperfect Capital Mobility r BP Y
Short-run Equilibrium An immediate-run equilibrium sustaining a BP deficit & losses of international reserves leads to a decline in MS & a leftward shift of the LM curve. A short-run equilibrium exists when all the three markets are in equilibrium.
Short-run Equilibrium withNo Capital Mobility r BP M I rE L S Y YE
Short-run Equilibrium withPerfect Capital Mobility r M I rE BP L S Y YE
Short-run Equilibrium withImperfect Capital Mobility r M I BP rE L S YE Y
Sterilization OperationsOperations carried out by the Central Bank in order to neutralize the effects that its intervention in foreign exchange markets has on H. H = IR + CBC = 0 or CBC = - IR