International Macroeconomics: Fixed Exchange Rate and Foreign Exchange Market

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International Macroeconomics Topic 6: Fixed Exchange Rate and Foreign Exchange Market UAH - ENI Degree, 2024-2025 Draft 0

Contents

1. Theory
2. Floating Exchange Rate vs. Fixed Exchange Rate
3. The Role of Central Banks: The Balance Sheet
4. Monetary Policy under a Fixed Exchange Rate
5. Fiscal Policy under a Fixed Exchange Rate
6. External Imbalances and Pressures under a Fixed Exchange Rate
7. Balance of Payments Crisis and Collapse of the Fixed Exchange Rate
8. Practice and Exercises
9. Documents and Supplementary Materials

Theory Objectives

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1 Theory

• To understand the structure and functioning of a central bank's balance sheet
• To analyse the different forms of central bank intervention in the foreign exchange market to defend the exchange rate
• To assess the effectiveness of monetary and fiscal policy under a fixed exchange rate regime
• Using the DD-AA model, to examine balance of payments crises and capital flight

Floating vs. Fixed Exchange Rate Regimes

1.1 Floating Exchange Rate vs. Fixed Exchange Rate

Exchange rate regimes define the degree of central bank intervention in the foreign exchange market and the manner in which the value of the national currency is determined relative to other currencies. There are two extreme regimes: the floating exchange rate and the fixed exchange rate, with multiple intermediate variants1.

Differences and Similarities Between Regimes

In a floating exchange rate system, the value of the currency is freely determined by supply and demand in the foreign exchange market. Monetary authorities do not commit to maintaining the exchange rate at a given level, although they may occasionally intervene to smooth exces- sive fluctuations (known as dirty or managed float).

In contrast, under a fixed exchange rate system, the central bank commits to maintaining the exchange rate at a specific level or within a narrow band. To sustain this level, it intervenes actively in the market by buying or selling foreign currency and, if necessary, adjusting mone- tary policy.

Both regimes share the goal of providing a framework for international transactions and can co- exist within the global economy. However, they differ fundamentally in the degree of monetary policy autonomy and the role of international reserves:

• Under a floating regime, monetary policy is autonomous, but the exchange rate is volatile.

1 From a terminological perspective, the terms devaluation or revaluation are used when changes in the exchange rate result from an official decision under a fixed exchange rate regime. In contrast, depreciation or appreciation is used when the exchange rate varies in a floating regime, as a consequence of supply and demand in the foreign exchange market. 2/20Universidad de Alcalá

• Under a fixed regime, monetary autonomy is sacrificed in order to maintain exchange rate stability.

Criteria for Choosing Exchange Rate Regimes

The choice between a fixed or floating exchange rate regime depends on various structural and political factors:

1. Degree of trade and financial openness: highly open economies often prefer fixed exchange rates to reduce exchange rate uncertainty in international transactions.
2. Price and wage flexibility: if domestic prices are rigid, a flexible exchange rate can help absorb external shocks.
3. Capital mobility: with high capital mobility, maintaining a fixed exchange rate severely limits monetary policy autonomy2.
4. Macroeconomic credibility and discipline: fixed exchange rates can serve as a nominal anchor for controlling inflation, especially in economies with a history of weak monetary credibility.
5. Political objectives: some authorities may favour fixed regimes to reinforce economic alliances or facilitate regional integration processes.

Current Examples of Exchange Rate Regimes

At present, most advanced economies, such as the United States, the United Kingdom, or Japan, operate under floating exchange rate regimes, although their central banks may inter- vene in cases of excessive volatility.

By contrast, some small or developing countries opt for fixed exchange rates or managed ex- change rate regimes. For example:

• Saudi Arabia maintains a fixed exchange rate against the US dollar.
• Denmark maintains a fixed parity within the European Exchange Rate Mechanism II (ERM II), pegged to the euro.

2 This dilemma is summarised in the well-known "monetary policy trilemma" or impossible trinity: a country cannot simultaneously maintain a fixed exchange rate, autonomous monetary policy, and free capital mobility. Only two of the three objectives can be achieved. For example, if monetary autonomy and capital mobility are to be preserved, the exchange rate must be allowed to float. 3/20Universidad de Alcalá

Exchange rate, E 1' Eº 3' Domestic currency return on foreign currency deposits, R* + (Eº - E)/E 0 Domestic interest rate,R R* Real money demand, L(R, Y1) 1 I 1 L(R, Y2) I I M1 Real money supply P |1 3 1 M2 / P 2 1 1 I Real domestic money holdings

Figure 1: Following an increase in Y, the central bank must implement an expansionary mon- etary policy to maintain the exchange rate at E0.

4/20 1Universidad de Alcalá

• Some dollarised countries, such as Ecuador or El Salvador, have adopted the US dollar as their official currency, thereby eliminating their own exchange rate policy.
• China maintains a managed or semi-fixed exchange rate system, in which the yuan moves within a daily band against the dollar, determined by the People's Bank of China. Al- though greater flexibility has been introduced in recent years, the exchange rate remains subject to close official supervision and control.

In the euro area, member countries share a common currency, and therefore no exchange rate exists between them. Against third countries, the euro has a floating exchange rate managed by the European Central Bank.

The Role of Central Banks: Balance Sheet

1.2 The Role of Central Banks: The Balance Sheet

Central banks play a fundamental role in the economy through the management of monetary policy, supervision of the financial system, and intervention in the foreign exchange market. One of the key instruments they employ is the control of the money supply, which is directly reflected in their balance sheet. Understanding the basic structure of a central bank's balance sheet allows for an analysis of the effects of its operations on liquidity and financial markets.

The Balance Sheet of a Central Bank

A central bank's balance sheet reflects the assets it holds and the sources of funding for those assets, that is, its liabilities. Its structure provides key information about the instruments used by the monetary authority to achieve its policy objectives.

In general terms, the central bank's balance sheet is divided into:

• Assets: include financial instruments and reserves that underpin the creation of money. Among them are:
  • International reserves: foreign currencies, deposits with foreign central banks, mon- etary gold, and foreign government debt securities3.
  • Government securities: public debt acquired through open market operations.
  • Loans to financial institutions: liquidity provided on a short- or medium-term basis, often under standing facilities.
  • Other assets: non-financial assets, equity in international financial institutions, etc.

3Government bonds issued by other countries (for example, US Treasury bonds acquired by the European Central Bank) are recorded as part of the central bank's international reserves. These assets allow the central bank to intervene in the foreign exchange market and provide international liquidity, and are therefore included in this category on the asset side. 5/20Universidad de Alcalá

• Liabilities: represent the obligations of the central bank towards the banking system, the public sector, and the general public. These include:
  • Banknotes and coins in circulation: physical money used by the public.
  • Bank reserves: deposits that credit institutions hold with the central bank.
  • Government deposits: Treasury or Ministry of Finance funds held at the central bank.
  • Other liabilities: such as financial liabilities arising from instruments issued by the central bank itself (e.g. sterilisation bonds).

By way of illustration, let us consider a more detailed central bank balance sheet before any monetary policy operation is carried out:

Assets Liabilities International reserves 80 Currency in circulation 100 Government securities 200 Bank reserves 180 Loans to banks 40 Government deposits 30 Other assets 30 Other liabilities 40 Total 350 Total 350

This balance sheet shows how the central bank backs its liabilities with a combination of financial assets. The monetary base consists of the sum of currency in circulation and bank reserves, i.e. 100 + 180 = 280 monetary units. This base can be expanded or contracted through decisions of the central bank's monetary policy.

Expansion of the Money Supply and Balance Sheet Impact

Suppose the central bank wishes to increase the money supply. To do so, it purchases gov- ernment securities on the open market for an amount of 50 monetary units. This operation is reflected in the balance sheet as follows:

Assets Liabilities International reserves 80 Currency in circulation 100 Government securities 250 Bank reserves 230 Loans to banks 40 Government deposits 30 Other assets 30 Other liabilities 40 Total 400 Total 400

The central bank has increased its assets through the purchase of securities, which has generated 6/20Universidad de Alcalá

an equivalent increase in liabilities, specifically in bank reserves4. This increase in the monetary base constitutes an expansion of the money supply. If the banking system lends part of these new reserves, the effect on the broader monetary aggregate may be even greater through the money multiplier5.

Contraction of the Money Supply and Balance Sheet Impact

Conversely, if the central bank decides to reduce the money supply, it may sell government securities on the open market. Let us suppose a sale worth 40 monetary units. The new balance sheet would be:

Assets Liabilities International reserves 80 Currency in circulation 100 Government securities 160 Bank reserves 140 Loans to banks 40 Government deposits 30 Other assets 30 Other liabilities 40 Total 310 Total 310

The contraction of the central bank's assets due to the sale of securities results in a reduction in bank reserves, i.e. in liabilities. In this way, the monetary base and, consequently, the money supply are reduced.

Monetary Policy Under Fixed Exchange Rate

1.3 Monetary Policy under a Fixed Exchange Rate

Under a fixed exchange rate regime, the central bank commits to maintaining the value of the national currency constant relative to a foreign currency. This commitment significantly restricts monetary policy autonomy, especially in open economies with free capital mobility.

The DD-AA model provides a useful tool to graphically analyse this constraint and its macroe- conomic implications.

The DD-AA Model and Short-Run Equilibrium

Short-run equilibrium in an open economy is achieved at the intersection of the DD curve (representing equilibrium in the goods market) and the AA curve (representing equilibrium in the asset market). The DD curve slopes upwards: a real depreciation improves competitiveness

4 In open market operations, the central bank buys or sells government securities from financial institutions, not from the general public. Therefore, the counterpart of the transaction is recorded in the reserve accounts that commercial banks hold with the central bank. No cash is handed over or received; instead, electronic balances are transferred. 5 The currency in circulation component on the liability side of the central bank only changes if commercial banks convert part of their reserves into cash to meet customer withdrawals. In other words, cash in circulation varies when there is a physical movement of banknotes, not as an automatic result of open market operations. 7/20