5.9 financial markets and central bank online test
duty13
Week-10-pp.pptxWeek 10 Topic: Exchange Rate Policy and the Central Bank 1 Chapter 19 of main text: Stephen Cecchetti and Kermit Schoenholtz
Learning Objectives
At the end of this and next week’s lesson, you are expected to critically engage in:
Explaining the links between exchange rates and monetary policy.
Describing the mechanics of exchange rate management.
Assessing the costs, benefits, and risks of fixed exchange rates.
Analysing how fixed exchange rate regimes work.
19-2
© 2021 McGraw-Hill. All Rights Reserved.
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.
19-3
© 2021 McGraw-Hill. All Rights Reserved.
Linking Exchange Rate Policy with Domestic Monetary Policy
There are two ways to see the connection between exchange rates and monetary policy.
Think about the market for goods and purchasing power parity.
Capital market arbitrage shows us how short-run movements in exchange rates are tied to the supply and demand in the currency markets.
19-4
© 2021 McGraw-Hill. All Rights Reserved.
Inflation and the Long-Run Implications of Purchasing Power Parity
Ignoring transportation costs, the law of one price 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.
19-5
© 2021 McGraw-Hill. All Rights Reserved.
5
Inflation and the Long-Run Implications of Purchasing 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.
19-6
© 2021 McGraw-Hill. All Rights Reserved.
Inflation and the Long-Run Implications of Purchasing Power Parity
PPP has immediate implications for monetary policy.
The central bank must choose between a fixed exchange rate and an independent inflation policy; it cannot have both.
19-7
© 2021 McGraw-Hill. All Rights Reserved.
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.
19-8
© 2021 McGraw-Hill. All Rights Reserved.
8
Diversification reduces risk.
Short-run benefits of holding foreign assets have eroded, but for long-run investors, international diversification still has advantages.
19-9
© 2021 McGraw-Hill. All Rights Reserved.
9
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.
19-10
© 2021 McGraw-Hill. All Rights Reserved.
10
Capital Controls and the Policymaker’s Choice
A country cannot:
Be open to international capital flows
Control its domestic interest rate
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
Still use monetary policy to pursue its domestic objectives
19-11
© 2021 McGraw-Hill. All Rights Reserved.
11
Capital Controls and the Policymaker’s Choice
Internationally integrated capital markets ensure that capital goes to its most efficient uses.
The benefits of open capital markets are easy to see.
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.
19-12
© 2021 McGraw-Hill. All Rights Reserved.
Capital Controls and the Policymaker’s Choice
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, known as a sudden stop, is similar to a bank run.
All investors leave at once, precipitating a financial collapse.
19-13
© 2021 McGraw-Hill. All Rights Reserved.
Capital Controls and the Policymaker’s Choice
It is tempting for government officials to implement capital controls to avert 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.
Include restrictions on the ability of domestic residents to purchase foreign assets, and often include prohibitions on removing currency from the country.
19-14
© 2021 McGraw-Hill. All Rights Reserved.
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.
19-15
© 2021 McGraw-Hill. All Rights Reserved.
15
The Central Bank’s Balance Sheet
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.
19-16
© 2021 McGraw-Hill. All Rights Reserved.
The Central Bank’s Balance Sheet
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 bonds issued by euro-area governments.
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.
19-17
© 2021 McGraw-Hill. All Rights Reserved.
17
The Central Bank’s Balance Sheet
19-18
© 2021 McGraw-Hill. All Rights Reserved.
18
The Central Bank’s Balance Sheet
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.
If reserves are scarce, the policy interest rate falls when the Fed expands its balance sheet through an open-market purchase, regardless of whether the assets it buys are foreign or domestic.
The demand and supply shifts drive the dollar down and the value of the other currency up.
19-19
© 2021 McGraw-Hill. All Rights Reserved.
The Central Bank’s Balance Sheet
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.
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.
So long as the central bank can continue to purchase foreign securities without limit, it can keep its currency from appreciating.
19-20
© 2021 McGraw-Hill. All Rights Reserved.
The Central Bank’s Balance Sheet
19-21
© 2021 McGraw-Hill. All Rights Reserved.
21
Sterilized Intervention
When all these countries intervened to buy euros, none of them changed their domestic interest-rate targets.
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.
This is an example of an unsterilized foreign exchange intervention:
One that changes central bank liabilities.
19-22
© 2021 McGraw-Hill. All Rights Reserved.
22
Sterilized Intervention
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.
19-23
© 2021 McGraw-Hill. All Rights Reserved.
23
Sterilized Intervention
A sterilized intervention is a combination of two transactions:
There is the purchase or sale of foreign currency reserves, which changes the central bank’s liabilities.
Then an immediate open market operation, of exactly the same size, designed to offset the impact of the first transaction on the monetary base.
19-24
© 2021 McGraw-Hill. All Rights Reserved.
Sterilized Intervention
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.
19-25
© 2021 McGraw-Hill. All Rights Reserved.
Sterilized Intervention
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 purchased 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.
19-26
© 2021 McGraw-Hill. All Rights Reserved.
Sterilized Intervention
19-27
© 2021 McGraw-Hill. All Rights Reserved.
27
Sterilized Intervention
A change in the composition of a central bank balance sheet can alter the relative prices of assets if:
Markets are thin or functioning poorly
The policy shift is large compared to the level of market transactions
19-28
© 2021 McGraw-Hill. All Rights Reserved.
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.
19-29
© 2021 McGraw-Hill. All Rights Reserved.
29
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.
19-30
© 2021 McGraw-Hill. All Rights Reserved.
30
Assessing the Costs and Benefits
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
An exchange rate target enhances transparency and accountability
19-31
© 2021 McGraw-Hill. All Rights Reserved.
31
Assessing the Costs and Benefits
One serious drawback to a fixed exchange rate 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.
19-32
© 2021 McGraw-Hill. All Rights Reserved.
Assessing the Costs and Benefits
Policymakers should consider several additional matters.
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.
Fixing the exchange rate means reducing the domestic economy’s natural ability to respond to macroeconomic shocks.
19-33
© 2021 McGraw-Hill. All Rights Reserved.
