26 Exchange Rates, Part 2 PDF

Todays Agenda
1. Exchange Rates and the AD/AS Model
2. Fixed Exchange Rates

Exchange Rates,
3. The Policy Trilemma
Part 2
4. Fixed versus Flexible Exchange Rates
26-1 26-2
Exchange Rates and the AD/AS Model

In the short-run, when prices are sticky an
appreciation (or depreciation) of the nominal
exchange rate implies an appreciation (or
Exchange Rates and depreciation) of the real exchange rate.
the AD/AS Model
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1
Exchange Rates and the AD/AS Model Exchange Rates and the AD/AS Model
An appreciation of the exchange rate, E: An appreciation of the exchange rate, E:
1. Makes export more expensive to foreigners who 1. Makes imports less expensive, and
buy fewer exports so X , and
2. Reduces the domestic aggregate price level.
2. Makes imports less expensive to domestic
residents who buy more imports so M , so that
3. This is also a temporary positive supply shock.
3. Net exports decrease, NX.
4. This is a negative aggregate demand shock.
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E (Yen:$) S$0
SRAS0(e = 0)
E0 0
D$0 AD0
Q$ Assets Y0 Y
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2
That is: An appreciation of the exchange rate, E:
leads to declines in both:
E => NX => Y
1. Economic activity, and
and
2. Inflation.
E =>
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The exchange rate will appreciate or
depreciation if there is a change in either:
1. The domestic real interest rate, rD, SRAS0(e = 0)

0
2. The foreign real interest rate, rF, and/or
3. The expected future exchange rate, Eet+1.

AD0
Y0 Y
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3
Exchange Rates and the AD/AS Model
E (Yen:$) S$0
E0
Fixed Exchange Rates
D$0
Q$ Assets
26-13 26-14
Fixed Exchange Rates Fixed Exchange Rates

Historically there have been two ways to fix an With fixed exchange rates, the value of the
exchange rate: domestic currency is pegged by the government
relative to the value of another currency (called
1. Fixing the value of the domestic currency to a the anchor currency).
commodity such as gold (i.e., the gold standard),
or The central bank of the country offers to buy or sell
the currency at the fixed exchange rate.
2. Fixing the value of the domestic currency to that
of a large, low-inflation country like the U.S. (i.e., In a fixed exchange rate regime with a currency
the anchor country). board, the domestic currency is also backed 100%
with the anchor currency.
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4
Fixed Exchange Rates Fixed Exchange Rates
The exchange rate that is pegged by the
government is called the official rate.
Also called the par or pegged rate.
What happens if the official rate differs from

the fundamental rate determined by the supply
of, and demand for, the domestic currency-
denominated assets?
26-17 26-18
Fixed Exchange Rates: Overvalued Fixed Exchange Rates: Overvalued

When the fixed or par value of the exchange E (Yen:$) S$0
rate, Epar, is above the equilibrium exchange

rate, E*, the currency is overvalued.
E*
D$0
Q$ Assets
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5
The government has three choices for dealing 1. The government could devalue the currency,
with an overvalued currency. reducing the official rate to the fundamental
rate.
1. Devalue the currency.
A devaluation occurs when a central bank resets the
2. Impose capital controls. par exchange rate to a lower level.
3. Intervene in the foreign exchange market. It generally does this because it will eventually run out of
international reserves by maintaining an overvalued
currency.
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E (Yen:$) S$0 2. The government could impose capital
controls, reducing the supply of domestic
Epar Official Rate
currency-denominated assets.
E* Fundamental Rate
D$0
Q$ Assets
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6
E (Yen:$) S$0 3. The central bank could intervene in the
foreign exchange market by buying its own
Epar Official Rate
currency, increasing the fundamental rate to
the official rate.
E* Fundamental Rate
Foreign exchange interventions are international financial
transactions engaged in by central banks to influence
exchange rates.
D$0
Q$ Assets
26-25 26-26

3. What happens when the central bank 3. What happens when the central bank
intervenes in the foreign exchange market to intervenes in the foreign exchange market to
defend an overvalued currency? defend an overvalued currency?
a. The central bank buys its domestic currency in the
foreign exchange market. c. The domestic money supply declines.
b. The central bank sells foreign currency- d. The real interest rate on domestic assets, rD,
denominated assets, i.e., international reserves. increases,
International reserves are the foreign currency
denominated asset holdings on the central banks e. Causing the demand for domestic currency-
balance sheet. denominated assets to increase.
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7
E (Yen:$) S$0 An overvalued currency cannot be maintained
forever.
Epar Official Rate
The country will eventually run out of international
reserves and then be forced to devalue the currency.
E* Fundamental Rate
If investors think an overvalued currency may soon
be devalued, a speculative run may develop.
D$0 This leads to even larger losses of international reserves
from the central bank and hastens the likelihood of a
devaluation.
Q$ Assets
26-29 26-30
Fixed Exchange Rates: Overvalued Fixed Exchange Rates: Undervalued

When the fixed or par value of the exchange
rate, Epar, is below the equilibrium exchange
rate, E*, the currency is undervalued.
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8
Fixed Exchange Rates: Undervalued Fixed Exchange Rates: Undervalued
E (Yen:$) S$0 The government has three choices for dealing
with an undervalued currency.
1. Revalue the currency.

E*
2. Relax capital controls.
3. Intervene in the foreign exchange market.

D$0
Q$ Assets
26-33 26-34

1. The government could revalue the currency, E (Yen:$) S$0
increasing the official rate to the fundamental

rate.
A revaluation occurs when a central bank resets the E* Fundamental Rate

par exchange rate to a higher level.
It generally does this because it does not want to continue Epar Official Rate
acquiring the international reserves needed to maintain an
D$0
undervalued currency.
Q$ Assets
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9
2. The government could relax capital controls, E (Yen:$) S$0
increasing the supply of domestic currency-

denominated assets.
E* Fundamental Rate
Epar Official Rate

D$0
Q$ Assets
26-37 26-38

3. The central bank could intervene in the 3. What happens when the central bank
foreign exchange market by selling its own intervenes in the foreign exchange market to
currency, reducing the fundamental rate to the defend an undervalued currency?
official rate. a. The central bank sells its domestic currency in the
foreign exchange market.
Foreign exchange interventions are international financial
transactions engaged in by central banks to influence b. The central bank acquires foreign currency-
exchange rates.
denominated assets, i.e., international reserves.
International reserves are the foreign currency
denominated asset holdings on the central banks
balance sheet.
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10
3. What happens when the central bank E (Yen:$) S$0
intervenes in the foreign exchange market to
defend an overvalued currency?
c. The domestic money supply increases.

E* Fundamental Rate
d. The real interest rate on domestic assets, rD,
declines, Epar Official Rate
D$0
e. Causing the demand for domestic currency-
denominated assets to decrease.
Q$ Assets
26-41 26-42

An undervalued currency can seemingly be
maintained forever.
As long as the central bank is willing to keep

acquiring foreign currency-denominated assets.
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11
Summary: Foreign Exchange Interventions
An intervention in which the central bank buys
the domestic currency by selling foreign assets
leads to a loss of international reserves and an
appreciation of the domestic currency.
The Policy Trilemma
An intervention in which the central bank sells
the domestic currency to purchase foreign
assets leads to an increase in international
reserves and a depreciation of the domestic
currency.
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The Policy Trilemma The Policy Trilemma

If If the real interest rate appreciates in the anchor
country, then:
1. There is perfect capital mobility and
2. A country fixes its exchange rate, then 1. The anchor countrys currency will appreciate and
3. It loses control of its own monetary policy. 2. The fixing countrys currency will depreciate.
3. The fixing countrys currency will now be

The real interest rate in the fixing country must overvalued.
move with the real interest rate in the anchor
country.
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In order to maintain the fixed exchange rate, the The policy trilemma describes the situation in
fixing country will have to: which a country can only pursue two of the
following three policies at the same time:
4. Sell the anchor currency (losing international
reserves) and 1. Free capital mobility,
2. A fixed exchange rate, and

5. Buy its domestic currency (reducing liquidity in
the banking system), causing 3. An independent monetary policy.
6. An increase in its real interest rate.

This is also called the impossible trinity.
26-49 26-50

Hong Kong has chosen: The U.S. has chosen:
1. Free capital mobility, and 1. Free capital mobility, and
2. A fixed exchange rate. 2. An independent monetary policy.
As a result, Hong Kong cannot have an As a result, the U.S. cannot have a fixed
independent monetary policy. exchange rate.
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13
China has chosen:
1. A fixed exchange rate, and
2. An independent monetary policy.
As a result, China cannot have perfect capital

mobility.
China maintains capital controls, restrictions on the free

movement of (financial) capital across its borders.
26-53 26-54
Fixed versus Flexible Exchange Rates

Major advantages of fixed exchange rates:
1. Fixed exchange rates make international trade

Fixed versus Flexible easier and less costly.
Exchange Rates 2. Fixed exchange rates help discipline monetary

policy, making it impossible for a country to
engage in an independent expansionary policy.
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14
Fixed versus Flexible Exchange Rates Fixed versus Flexible Exchange Rates
Major advantages of fixed exchange rates: Major disadvantages of fixed exchange rates:
3. If the anchor country has a non-inflationary 1. Fixed exchange rates with perfect capital mobility
monetary policy, the fixing country will also have eliminate a countrys ability to use monetary
a non-inflationary monetary policy. policy independently to offset domestic shocks.
4. If the fixed exchange rate is credible, it will help a. Economic shocks in the anchor country will be directly
anchor inflationary expectations to inflation in the transmitted to the fixing country.
anchor country.
b. The fixing countrys monetary policy response to its
own domestic economic shocks cannot be different
from the monetary policy of the anchor country.
26-57 26-58
Major disadvantages of fixed exchange rates: Major advantages of flexible exchange rates:
2. If a countrys fixed exchange rate is overvalued, 1. Flexible exchange rates allow countries to use
the currency is open to speculative attacks. monetary policy independently to offset the effects
of domestic economic shocks.
a. Massive sales of an overvalued currency, leading
2. Flexible exchange rates allow countries to follow
b. To significant loss of international reserves, and either independent monetary and fiscal policies.
c. A sharp devaluation or depreciation of the exchange
rate.
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15
Major disadvantages of flexible exchange rates: Fixed exchange rates are better when:
1. Flexible exchange rates are more volatile than 1. There are large benefits to be gained from
fixed exchange rates. This introduces uncertainty increased international trade and integration,
into international transactions, making them more and/or
costly.
2. The countries can coordinate their monetary and
2. Flexible exchange rates do not provide an fiscal policies closely.
independent restraint on expansionary monetary or
fiscal policies.
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Flexible exchange rates are better when: An alternative to a fixed exchange rate is a
crawling peg.
1. Countries value having independent monetary
policies either because of different macro- The currency is allowed to depreciate at a steady
economic shocks or because they have different rate so that the inflation rate in the pegging country
views about the costs of unemployment and can be higher than that of the anchor country.
inflation.
This is based on relative purchasing power parity.
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An alternative to a flexible exchange rate is a
managed float.
Countries attempt to influence the value of their

exchange rates by buying and selling currencies but
not to peg it to an anchor currency.
This is sometimes called a dirty float.
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Fixed versus Flexible Exchange Rates
The End

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17

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Todays Agenda

1. Exchange Rates and the AD/AS Model

2. Fixed Exchange Rates

Exchange Rates and the AD/AS Model

4. This is a negative aggregate demand shock.

1. The domestic real interest rate, rD, SRAS0(e = 0)

3. The expected future exchange rate, Eet+1.

Fixed Exchange Rates Fixed Exchange Rates

What happens if the official rate differs from

Fixed Exchange Rates: Overvalued Fixed Exchange Rates: Overvalued

rate, Epar, is above the equilibrium exchange

Fixed Exchange Rates: Overvalued Fixed Exchange Rates: Overvalued

Fixed Exchange Rates: Overvalued Fixed Exchange Rates: Overvalued

Fixed Exchange Rates: Overvalued Fixed Exchange Rates: Undervalued

1. Revalue the currency.

3. Intervene in the foreign exchange market.

Fixed Exchange Rates: Undervalued Fixed Exchange Rates: Undervalued

increasing the official rate to the fundamental

A revaluation occurs when a central bank resets the E* Fundamental Rate

increasing the supply of domestic currency-

Epar Official Rate

Fixed Exchange Rates: Undervalued Fixed Exchange Rates: Undervalued

c. The domestic money supply increases.

Fixed Exchange Rates: Undervalued Fixed Exchange Rates: Undervalued

As long as the central bank is willing to keep

The Policy Trilemma The Policy Trilemma

3. The fixing countrys currency will now be

2. A fixed exchange rate, and

6. An increase in its real interest rate.

The Policy Trilemma The Policy Trilemma

1. Free capital mobility, and 1. Free capital mobility, and

2. A fixed exchange rate. 2. An independent monetary policy.

1. A fixed exchange rate, and

2. An independent monetary policy.

As a result, China cannot have perfect capital

China maintains capital controls, restrictions on the free

Fixed versus Flexible Exchange Rates

1. Fixed exchange rates make international trade

Exchange Rates 2. Fixed exchange rates help discipline monetary

Countries attempt to influence the value of their

This is sometimes called a dirty float.

Fixed versus Flexible Exchange Rates

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