Intervention in Foreign Exchange Market Under Fixed Exchange Rate Regime

--These two diagram use the asset market (domestic assets) to explain what a central bank needs to do with (

---a) Maintaining an overvalued FX-rate: buy domestic currency; thus reduce the monetary base to raise domestic interest rates and thus shift (INcrease) demand for domestic assets) and make market correspond to fixed (par) exchange rate; or with (but central bank draws down its international reserves in process)

---(b)Maintaining an Undervalued FX-rate: sell domestic currency and buy foreign assets; an opposite action (compared to (a) above) by the central bank; to reduce demand for domestic assets and bring market equilibrium towards the fixed (par) rate of exchange. Central bank accumulates foreign reserves in this case. {Rock: Think China from 1998-today}

*{Problems of Maintaining a Fixed Exchange Rate (‘anchored’ or ‘tied’ to other currencies; usually, for many countries, to larger/richer country currencies)

--Over-Valued domestic currency: Central bank may exhaust its international reserves in supporting the overvaluation and ultimately come under attack from investors who fear for a sudden and large devaluation, that can become a self-fulfilling prophecy.

--Under-Valued domestic currency: Need to accumulate large foreign asset (international reserves) in order to keep holding the domestic currency down (e.g. by buying foreign assets and currency/deposits). This is the less difficult task compared to trying to maintain an overvalued currency.

Ch.18 PART 2

Chapter 18 The International Financial System, pp.470-487 PART 2

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pp.470-475

Case Studies of Exchange Rate Regimes and other Issues:

-(1st case) The first examines how China has accumulated close to $1 trillion of international reserves (by 2010: over $2 trillion), a concern to many (not only USA with huge deficit in trade with China) but all worried about ‘global imbalances’ that can lead to financial recycling and financial instability as well as sometimes to ‘trade wars’ (rising protectionist policies to prevent never-ending trade deficits).

---China’s undervaluation strategy (similar to that followed by Japan (1960s-1980s); South Korea, Taiwan, (1970s-1990s)

---to promote an ‘export-led growth model’ of domestic industry

---Difficulties:

-------- China owns huge amount of US assets (bonds mainly)

-------- Keeping Chinese products so cheap has threatened trade retaliation by other countries that cannot compete

-------- Purchase of US dollars effectively means large increase in Chinese monetary base with risk of inflation (although central control of banking flows (restricted capital mobility domestically) helps stop this from happening so far)

--------

p.470-71

How Bretton Woods Worked

--Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large persistent deficits in balance of payments)

--Loans from IMF to cover loss in international reserves

--IMF encouraged contractionary monetary policies (for persistent deficits)

--Devaluation only if IMF loans were not sufficient

--No tools for surplus countries {One side of Imbalance is thus, Unaddressed!}

--U.S. could not devalue currency {only in concert with other major currency countries, but even then the market might prevent success}

p.471

Managed Float

--Hybrid of fixed and flexible

--------Small daily changes in response to market

--------Interventions to prevent large fluctuations

--Appreciation hurts exporters and employment

--Depreciation hurts imports and stimulates inflation

--Special drawing rights as substitute for gold

p.472

European Monetary System

--8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar

--ECU value was tied to a basket of specified amounts of European currencies

--Fluctuated within limits (a ‘band’; upper and lower bounds for rate to move within)

--Led to foreign exchange crises involving speculative attack (famously in 1992 vs. UK-Pound)

---------see Fig.8 Foreign Exchange Market for UK Pounds, 1992 graph

p.472

Application: The September 1992 foreign exchange crisis of the ERM.

--Following unification of East and West Germany in 1990, the German central bank (to stem rising inflation) raised interest rates in Germany to very high levels attracting investors and putting stress on the other currencies fixed to the Deutsche Mark

--U.K.

------This led to a drop in the demand for British assets and hence a fall in the Mark/Pound exchange rate.

------The British attempted to keep the Pound at a higher rate (Marks/Pounds) and thus to do so was buying UK domestic currency (pounds) with its international reserves

------Eventually it could no longer do so and this led to the devaluation of the UK pound and fortunes made by speculators who had bet against (sold short) the pound

--Similar defenses were attempted by the central banks of Sweden, France, Italy, Spain but they were not very successful either.

--Since these defenses lead central banks to buy their own currencies

Fig. 3, p.473 represents the British pound-asset market and what the central bank was trying (unsuccessfully, ultimately) to do.

pp.474-475

Application: