FETP/MPP8/Macroeconomics/Riedel

The Macro Economy and Macro Policy under Fixed Exchange Rates
 INTRODUCTION
Previous lectures explained how the equilibrium exchange rate is determined in the market
for foreign exchange and how the macro economy responds to various shocks and how
government can use monetary and fiscal policy to maintain macro stability when the
exchange rate is market determined. This lecture considers the implications of a policy of
fixing (or pegging) the exchange rate how fixing the exchange rate influences the
effectiveness of monetary and fiscal policy.
Government fixes (or pegs) the exchange rate by standing ready to buy or sell foreign
currency whenever there is an excess supply or demand in the foreign exchange market.
Foreign exchange purchases (sales) go into (out of) the central bank’s holdings of official
foreign reserves. Since foreign reserves are a component of base money, the money supply
(e.g. M2) is influenced by the central bank’s intervention in the foreign exchange market.
Previous chapters treated the money supply as exogenous and the exchange rate as
endogenous. In this chapter, the exchange rate is exogenous and the money supply
endogenous. In other words, when a country fixes its exchange rate, it gives up monetary
policy. Fixing the exchange rate is a monetary policy!
 Exchange Rate Regimes
Exchange Rate Policy de jure Exchange Rate Policy de facto
 THE MONEY SUPPLY PROCESS

Money supply = Currency in circulation (CC) plus bank deposits (DEP)

Base money (B) = Liabilities of the central bank = Assets of the central bank
Liabilities of the central bank = CC + commercial bank reserves (RR + ER)
Assets of the central bank = Foreign assets (foreign exchange resevres, R) plus domestic
assets (D).
 MONEY MULTIPLIER AND INSTRUMENTS OF MONETARY POLICY
The money supply is a multiple of base money. The ratio of the money supply (e.g. M2) to
base money is the money multiplier (mm):
𝑀 𝐶𝐶 + 𝐷𝐸𝑃
𝑚𝑚 = =
𝐵 𝐶𝐶 + 𝑅𝑅 + 𝐸𝑅

𝐶𝐶 𝐷𝐸𝑃 + 𝐷𝐸𝑃 𝐷𝐸𝑃 𝑐𝑐 + 1

𝑚𝑚 = =
𝐶𝐶 𝐷𝐸𝑃 + 𝑅𝑅 𝐷𝐸𝑃 + 𝐸𝑅 𝐷𝐸𝑃 𝑐𝑐 + 𝑟𝑟 + 𝑒𝑟
The central bank conducts monetary policy by changing the size of its balance sheet
(∆𝐵 = ∆𝑅 + ∆𝐷) and by adjusting the money multiplier (mm), principally by changing the
reserve requirement ratio (rr).
• When the central bank increases or decreases its asset holding, the money supply rises
or falls.
• When the central bank borrows from or lends to commercial banks through its discount
window, the money supply goes up or down.
• When the central bank raises or lowers reserve requirement ratio the money supply goes
down or up.
BASE MONEY AND THE MONEY MULTIPLIER IN THE U.S.: 1990-2010
 Base Money and its Components in Vietnam: 2005-2011

Source: Pham and Riedel, 2012, “On the Conduct of Monetary Policy in Vietnam, Asia Pacific Economic Literature, 2012
 The Money Multiplier in Vietnam

Source: Pham and Riedel, 2012, “On the Conduct of Monetary Policy in Vietnam, Asia Pacific Economic Literature, 2012
 Key Determinants of the Money Multiplier in Vietnam

Source: Pham and Riedel, 2012, “On the Conduct of Monetary Policy in Vietnam, Asia Pacific Economic Literature, 2012
 Foreign Exchange Market Equilibrium under Fixed Exchange Rates
Recall the foreign exchange market equilibrium condition:
𝐸′ − 𝐸
= 𝑅 − 𝑅∗
𝐸
where R and R* are bank deposit rates of interest at home and abroad, respectively. If
0 ′ 0 𝐸 0 −𝐸
the exchange rate is fixed at 𝐸 then 𝐸 = 𝐸 and therefore = 0 and 𝑅 = 𝑅∗ .
𝐸
If 𝑅 = 𝑅∗ , then the domestic money market equilibrium condition is:
𝑀𝑆
= 𝐿(𝑅∗ , 𝑌)
𝑃
which implies that for given values of P and Y the domestic money supply is fully
determined by the foreign interest rate (R*).
This means that by fixing the exchange rate, a country gives up the ability of conduct
an independent monetary policy. The fixed exchange rate is a monetary policy!
 Foreign Exchange Market Equilibrium under Fixed Exchange Rates
Response to an increase in income (Y↑) 𝐸
If income rises, the demand for real money
deposits rises, putting upward pressure on the
domestic interest (R) and on the value of the a
0
domestic currency (E↓). 𝐸
a' 𝐸 0−𝐸
The central bank in this case must buy foreign 𝑅∗ +
assets in the foreign exchange market—in 𝐸
R
effect exchanging domestic money for foreign R*
money—increasing the domestic money supply 𝐿(𝑅, 𝑌1 )
(𝑀 𝑆 ↑) and reducing interest rates until 𝑆
b b' 𝐿(𝑅, 𝑌2 )
equilibrium is restored at the fixed exchange 𝑀1 𝑃
rate (𝐸 0 ).
The increase in income puts pressure on the 𝑀2𝑆 𝑃 c
currency to appreciate, but instead of
appreciating, foreign reserves increase. 𝑀 𝑆 /𝑃
 Foreign Exchange Market Equilibrium under Fixed Exchange Rates
Response to an increase in the
Foreign Interest Rate(R*↑) 𝐸
A rise in the foreign interest rate raises the c
demand for foreign exchange, creating pressure
on the currency to depreciate. a a' 𝐸0 − 𝐸
𝐸 0
𝑅2∗ +
But, the central bank stands read to sell foreign 𝐸
0−𝐸
exchange the fixed rate (𝐸 0 ). To meet the 𝑅1∗ +
𝐸
increased demand for foreign exchange the 𝐸
R
central bank is forced to draw down its holding 𝑅1∗ 𝑅2∗
𝐿(𝑅∗ , 𝑌)
of official foreign reserves. 𝑀2𝑆 𝑃
b'
b
As the central banks foreign reserves fall, the 𝑀1𝑆 𝑃
money supply falls and the domestic interest
rate rises to the level of higher foreign interest
rate (𝑅 = 𝑅2∗ ).
Note, the domestic money supply is influenced
by foreign monetary policy 𝑀 𝑆 /𝑃
 The Ineffectiveness of Monetary Policy under Fixed Exchange Rates

Suppose the government wants to use

monetary policy to stimulate output and
employment.
We know that a monetary expansion will push
down the domestic interest rate and the value
of the domestic currency (exchange rate
depreciation).
Under a fixed exchange rate policy, the central
bank is obliged to prevent depreciation by
selling foreign exchange from its reserves, which
serves to reduce the money supply and push
interest rates and the value of the currency back
up. Thus the monetary stimulus policy is
defeated by the fixed exchange rate policy.
 The Effectiveness of Fiscal Policy under Fixed Exchange Rates
While monetary policy is ineffective under
fixed exchange rates, fiscal policy is doubly
effective.
As illustrated, an increase in government
spending under floating rates raises income
from 𝑌1 to 𝑌 2 , but under fixed exchange rates
raises income to 𝑌 3 .
The additional stimulus under fixed rates
comes from the monetary expansion induced
by the central bank’s intervention in the
foreign exchange market, exchanging domestic
money for foreign exchange to avoid the
appreciation that would otherwise occur if the
central bank did not intervene.
 Devaluation and Revaluation
A country that fixes its exchange rate may
from time to time wish to change the rate at
which it fixes the exchange rate. When the
central bank raises (lowers) the price of
foreign currency it is DEVALUING
(REVALUING) the domestic currency
For a devaluation to occur, the central bank
buys foreign assets, thereby increasing the
domestic money supply and lowering the
interest rate. As a result of the fall in the
interest rate, the currency is devalued (E
rises).
The effect of the devaluation is to make
domestic goods more price competitive,
leading to higher output, and to increase the
nation’s stock of foreign reserves.
 Foreign Exchange Market Equilibrium under Fixed Exchange Rates
The effect of a loss of confidence in the central 𝐸
bank’s ability to defend the exchange rate.
c
When the market questions the ability and/or
willingness of the central bank to defend the a 𝐸1 − 𝐸
a'
exchange rate, usually the game is over—a run 𝐸 0
𝑅2∗ +
𝐸
on the currency often follows. 𝐸 0−𝐸
𝑅1∗ +
The change in the expected change rate puts 𝐸
R
pressure on the central bank to sell off its 𝑅1∗ 𝑅2∗ + 𝐸 ′
foreign reserves, which only make the market’s 𝐿(𝑅∗ , 𝑌)
confidence the central bank weaker. 𝑀2𝑆 𝑃 b b'
The monetary contraction that is required to
defend the currency creates political pressures 𝑀1𝑆 𝑃
as well as economic ones, which also
undermines market confidence in the fixed
exchange rate policy. 𝑀 𝑆 /𝑃
 Three Generations of Currency Crises

First generation models of a currency crisis (Krugman, 1979)

When a central bank tries to fix the exchange rate below the market-clearing price by selling
foreign reserves, the level of reserves will eventually fall to a level that will induce a
speculative attack leading to a massive monetary contraction, soaring interest rates and a
decline in output and employment.
Not many good examples.
Second generation models of a currency crisis (Obstfeld, 1994)
Sometimes a crisis erupts, not from dwindling reserves, but when governments find that
their commitment to a fixed exchange rate interferes with other domestic objectives (e.g.
full employment). When speculators realize the inconsistency between the fixed
exchange rate of other policy objectives they may attack the currency, pushing up interest
rates (R) and forcing the government to abandon the currency peg.

Best example is the European Monetary System Crisis in 1992

 Three generations of models
Third generation models of a currency crisis
These models were inspired by the Mexican crisis (1994),
Asian crisis (1997) and Argentinian crisis (2002).
The problem usually begins with a financial bubble
financed by foreign capital inflows. Eventually there is an
attack on the currency and a resulting large-scale
devaluation.
These models emphasize the impact of the devaluation
on the balance sheets of banks and firms that hold a large
stock of foreign debt. The decline in the net assets of
firms and especially banks, leads to a massive contraction
of credit and a fall in investment, output and
employment, which fuel further devaluation.
The impact of 3rd generation crises is typically very large.
Vietnam, 2008????
 Macro Crises: Crisis and Reform
Do economic crises induce economic reform?
My study of Macroeconomic Crises and Long-term Growth in Turkey (World Bank, 1993)
found that they do. Severe macroeconomic crises erupted at the end of each decade (1959,
1969, 1979), leading repeatedly to a coup d’etat, a new package of reforms and after a year
or two the return of democratic civilian government, then …
Drazen and Easterly (2001) find evidence, based on data for 156 countries over a 45 years
period, that crises induces reform when inflation and black market premium on the
exchange rate are extremely high. They do not find evidence that moderate inflation, black
market premium, high current account deficits, high budget deficits or negative growth
induce reform.
Why not? Because when conditions are moderately bad, countries get an ODA bailout, but
when they are extremely bad they get cut off from ODA and have to reform.
Was Đổi Mới motivated by economic/political crisis?
Where Dung Xiao Ping’s reforms in the early 1980 and 1990s motivated by crisis?
 The Policy Trilemma
The theory discuss above indicates that:
1. Under floating rates, monetary policy is Free trade &
powerful, but fiscal policy is weak capital mobility
because of crowding out effects
2. Under fixed exchange rates, fiscal policy is
especially powerful, but monetary policy
is ineffective
These results suggest a Policy Trilemma. If
international economic integration is desired,
then a country must choose either to:
1. Fix the exchange rate and give up an
independent monetary policy
2. Float the exchange rate and retain Exchange rate De-globalization Monetary policy
monetary policy for domestic policy stability autonomy
objectives