Chapter 19 Exchange-Rate Policy and the Central Bank Conceptual and Analytical Problems Explain the mechanics of a speculative attack on the currency of a country with a fixed exchange-rate regime. Answer: Assume that Country A has a fixed exchange rate, and that its central bank holds a specific volume of foreign currency reserves. Investors come to believe that Country A will have to let its currency depreciate. To benefit from the prospective depreciation, investors borrow that currency in the country’s financial market and take the proceeds of the loan to the central bank to exchange them for some other currency (normally, the U.S. dollar, euro, or yen). If this process happens on a large scale, the central bank will deplete its foreign currency reserves, and be forced to devalue its currency or abandon its fixed exchange rate entirely. Knowing that the central bank has limited foreign exchange resources, investors can put great pressure on the central bank of Country A that leads to depreciation. After the devaluation or abandonment of the peg, investors profit by repaying their loans with the depreciated currency. Country A frequently experiences large business cycle swings. Under what conditions might it be appropriate for Country A to dollarize? Answer: If Country A’s business cycle is synchronized with the U.S. cycle, then U.S. monetary policy also would suit Country A because it would be stimulative when the economy is weak and contractionary when it is strong. However, if Country A’s business cycle differs significantly from the U.S. cycle in timing, then U.S. monetary policy may aggravate Country A’s cyclical swings (by contracting when stimulus is needed, and vice versa). So, dollarizing is most likely to succeed when the business cycles are closely aligned. In the first half of 1997, the Bank of Thailand maintained a fixed exchange rate of 26 Thai baht to the U.S. dollar, but Thai interest rates were substantially higher than those in the United States and Japan. Thai bankers were borrowing money in Japan and lending it in Thailand. Why was this transaction profitable? What risks were associated with this method of financing? Describe the impact of a depreciation of the baht on the balance sheets of Thai banks involved in these transactions. Answer: Bankers could borrow money in Japan at a low rate, and lend in Thailand at a high rate. Because the exchange rate was fixed, they profited from the difference in the interest rates. There was the risk that the baht could depreciate, making it more costly to repay the money borrowed in Japan. In addition, there was risk that borrowers in Thailand could default on their loans. When the baht depreciated, the costs to the Thai banks of repaying their loans rose, which caused their reserves to shrink. During the time of the currency board, Argentinean banks offered accounts in both dollars and pesos, but loans were made largely in pesos. Describe the impact on banks of the collapse of the currency board. Answer: The Argentinean banks had to pay interest payments in dollars on the dollar-denominated accounts, but the interest revenues they received were in pesos. When the currency board collapsed and the peso depreciated, it became more costly for banks to make the dollar-denominated interest payments. Consider a scenario where investors become nervous just before a key government election. As a result, the risk premium on sovereign debt in that country increases dramatically and its currency depreciates significantly. How could concern over an election drive up the risk premium? How is the risk premium connected to the value of the currency? Answer: Investors could be concerned that the policies supported by one of the candidates could cause the country to default on its debt if that person was elected. When the country’s government bonds become more risky relative to alternatives, demand for the bonds falls. This also reduces demand for the currency, leading to a depreciation, Explain why a well-capitalized domestic banking system might be important for the successful maintenance of a fixed exchange-rate regime. Answer: In order for a fixed exchange rate regime to be successful, investors must believe that the central bank will manage interest rates in a manner consistent with the currency peg. If the banking system is not sufficiently capitalized, there may be pressure on the central bank to ease monetary policy to deal with problems in the banking sector. Explain why, in the absence of the time consistency problem, you might expect a central bank to be effective at holding the value of its domestic currency at an artificially low level for a sustained period but not at an artificially high level. Answer: To boost the value of its domestic currency, the central bank would have to sell foreign currency in exchange for domestic currency. The central bank can only continue to do this until it runs out of foreign exchange reserves. In contrast, in order to hold down the value of the domestic currency, the central bank would need to sell the domestic currency in return for foreign currency in the foreign-exchange market. As it is the monopoly supplier of the domestic currency, it can create as much of the domestic currency as it needs and so is likely to be able to pursue this latter policy for a longer period than the former. In the long run, however, the latter policy will lead to inflationary pressures in the economy. Describe how the time consistency challenge for monetary policy can make it difficult for a central bank to cap the value of its domestic currency. Answer: As the Swiss National Bank learned during the euro-area crisis, a commitment to supply an unlimited quantity of its own currency may not prove sustainable. In the Swiss case, political controversy encouraged speculators to doubt this commitment. Eventually, as its balance sheet expanded, the SNB abandoned its efforts to cap the Swiss franc and allowed it to rise in response to strong demand. Why might sterilized foreign exchange market intervention have a greater impact on the exchange rate in times of financial stress than in times of normal market conditions? Answer: When markets are functioning normally, the shift in central bank assets associated with a sterilized intervention are extremely small in relation to the volume of overall trade in the market and therefore do not have a significant impact on the price of the currency. In times of stress, however, market activity is often substantially reduced and so the size of the central bank intervention may be significant. When asked about the value of the dollar, the Chair of the Federal Reserve Board answers, "The foreign exchange policy of the United States is the responsibility of the Secretary of the Treasury; I have no comment." Discuss this answer. Answer: Since the U.S. Treasury is technically responsible for exchange rate policy or decisions about exchange rate intervention, the Federal Reserve does not comment on the value of the dollar. But since the value of the dollar is closely tied to interest rates and monetary policy, there is something misleading about this. The Fed Chair might instead say that the focus is on monetary policy and its impact on the domestic U.S. economy, and in formulating such policy the FOMC does take the exchange value of the dollar into consideration. Explain why a consensus has developed that countries should either allow their exchange rates to float freely or adopt a hard peg as an exchange-rate regime? Answer: The widespread removal of capital controls and advances in technology have facilitated the integration of international markets while the development of increasingly sophisticated financial instruments has provided speculators with new and effective ways to leverage their positions. The consensus view is that factors like these have made it impossible for a central bank, even with substantial levels of foreign exchange reserves, to withstand a speculative attack. Therefore, soft pegs are no longer a sustainable option. Explain the costs and benefits of dollarization. Could a dollarized regime collapse? Answer: Costs of dollarization: Lost revenue from money printing. Eliminates monetary policy and lender of last resort. Eliminates stabilization effects of exchange-rate changes. Benefits Eliminates exchange-rate risk, making international trade easier. Reduces risk of investing abroad. Ties policymakers’ hands. Helps integrate the country into the world trading system. Dollarization is reversible and so it can collapse. It does not preclude the fiscal authorities from starting to issue currency again. The success of the regime depends on fiscal policy restraint. You observe that two countries with a fixed exchange rate have current inflation rates that differ from each other. You check the recent historical data and find that inflation differentials have been present for several months and that they have not remained constant. How would you explain these observations in light of the theory of purchasing power parity? Answer: Purchasing power parity (PPP) tells us about the relationship between inflation rate differentials and exchange rate movements over long periods such as decades. On a month-to-month or even year-to-year basis, there can be significant deviations from the theory. In this example, foreign exchange market intervention could be sustaining the fixed exchange rate in the short run in the face of market pressures. Assuming the country is open to international capital flows, which of the following combinations of monetary and exchange-rate policies are viable? Explain your reasoning. A domestic interest rate as a policy instrument and a floating exchange rate. A domestic interest rate as a policy instrument and a fixed exchange rate. The monetary base as a policy instrument and a floating exchange rate. Answer: Combinations a and c are both viable as they both represent independent domestic monetary policy combined with a floating exchange rate. Option b is not viable as any foreign exchange market interventions to hold the exchange rate fixed would change reserves and therefore the domestic interest rate. The pursuit of an independent interest rate policy would be impossible. Show the impact on the Federal Reserve’s balance sheet of a foreign exchange market intervention where the Fed sells $1,000 worth of foreign exchange reserves. Explain what impact, if any, the intervention will have on the domestic money supply. Answer: Selling foreign exchange reserves in exchange for dollars will reduce foreign currency reserves on the asset side of the balance sheet. On the liability side, bank reserves fall, as the bank that receives the FX from the Fed pays by running down its reserve account at the Fed. As bank reserves are a component of the monetary base, and they fall, the money supply, will fall. This will result in higher domestic interest rates, which in turn make U.S. investments relatively more attractive and increase demand for the dollar. If the Federal Reserve decides to sterilize the foreign exchange market intervention described in Problem 15, show the impact on the Fed’s balance sheet. What would the overall impact be on the monetary base? What would be the impact, if any, on the exchange rate? You should assume that the intervention took place in a deep, well-functioning foreign exchange market. Answer: If the Fed decides to sterilize the FX market intervention, it will carry out an open market operation to offset the impact of the FX intervention on the monetary base. In this case, it will carry out an open market operation where it purchases $1,000 of U.S. securities. This will increase U.S. securities by $1,000 on the asset side of the balance sheet and increase bank reserves by $1,000 on the liability side of the balance sheet. The Fed pays the bank it gets the securities from by crediting their account at the Fed – thus increasing bank reserves. The overall impact on the balance sheet is shown below. On the asset side, there is a compositional change between FX and domestic securities while on the liability side there is no change. The fall in bank reserves as a result of the FX intervention is exactly offset by the increase due to the open market operation. That is what is meant by “sterilization”. There is no change in the monetary base or money supply and therefore no change in domestic interest rates. In the absence of a move in the domestic interest rate, there is no impact on the exchange rate. In a deep, well-functioning market, the foreign exchange intervention itself is tiny relative to the overall volume traded in the market. It is through changes in the domestic interest rate that foreign exchange market interventions affect the exchange rate. Use a supply-and-demand diagram for dollars to show the impact of an increase in U.S. interest rates relative to interest rates in the euro area in the wake of a foreign exchange market intervention by the Federal Reserve. Answer: If the U.S. interest rate rises as a result of a purchase of dollars from the market by the Fed, this makes U.S. dollar-denominated assets relatively more attractive. Consequently, there is a rise in demand for dollars by foreigners wishing to purchase U.S. assets and a fall in the supply of dollars from U.S. investors wishing to purchase foreign assets. The overall impact, in the absence of further action from the Fed, is an appreciation of the dollar. Do you think the U.S. dollar is more likely to strengthen or weaken over the next few months? Explain your reasoning. Answer: Shorter-term movements in floating exchange rates, like other asset prices, are typically unpredictable, with the current exchange rate usually being the best predictor of the future exchange rate. We can point to some important factors that may influence the direction of the exchange rate. For example, in the wake of the financial crisis of 2007–2009, investors exhibited “flight to quality” behavior, purchasing large volumes of US Treasury bills, which strengthened the US dollar. If investors continue to view U.S. dollar-denominated investments as a safe haven in the face of uncertain financial market conditions, this would contribute to dollar strength. On the other hand, concern about the path of U.S. fiscal policy and related concerns that the central bank may tolerate faster inflation could lead to a decline in the dollar. Consider a small open economy with a wide array of trading partners all operating in different currencies. The economy’s business cycles are not well synchronized with any of the world’s largest economies, and the policymakers in this country have a well-earned reputation for being fiscally prudent and honest. In your view, should this small open economy adopt a fixed exchange-rate regime? Answer: In this situation, fixing the exchange rate does not look like a good idea. Given that the country’s trading partners operate in different currencies, fixing against one currency would not help with problems associated with exchange rate volatility versus the others. (A possible option would be to fix against a trade-weighted basket of exchange rates.) Fixing your exchange rate to another currency involves adopting the other country’s interest rate policy. To reap the benefits of exchange rate stability, countries usually opt to fix their currency to that of a large economy, such as the dollar or the euro. Given that this small open economy’s business cycles are not well synchronized with those of the world’s large economies, the monetary policy decisions of the large country could exacerbate business cycle fluctuations. Fixing the exchange rate ties the hands of local policymakers who can often help to gain credibility where there has been a history of poor policymaking or corruption. This external discipline doesn’t appear to be necessary in this country. A small Eastern European economy asks your opinion about whether it should pursue the path to joining the European Economic and Monetary Union (EMU) or simply “euroize” (i.e., dollarize by using the euro for all domestic transactions). What advice would you give? Answer: Joining the EMU has many advantages over “euroization”. The economy would have a say in monetary policy decisions and share in the seignorage revenue from the printing of the euro. Its national central bank would also be more able to act as lender of last resort in making euro loans. 21. In the face of increased short-run synchronization of global stock markets, what strategies could you employ to continue to benefit from international diversification? Answer: If you employ a “buy and hold” strategy, you are more likely to reap the benefit of diversification as stock markets are less likely to move in unison over long periods. If you have a shorter-term investment horizon, you could invest in a portfolio of stocks that were denominated in different currencies (that were not fixed relative to one another) so that short-term exchange rate movements could provide a diversification benefit. Data Exploration Panama, Ecuador, and El Salvador began using the U.S. dollar as their domestic currency in 1904, 2000, and 2001, respectively. How do you expect their inflation rates to compare with U.S. inflation? Plot since 1960 the percent change from a year ago of consumer prices in Panama (FRED code: DDOE02PAA086NWDB), Ecuador (FRED code: DDOE02ECA086NWDB), El Salvador (FRED code: DDOE01SVA086NWDB) and the United States (FRED code: PCEPI). Download these data and (starting with the country’s date of dollarization), compare the average inflation rate in each country with U.S. inflation. Answer: The data is plotted below. Broadly speaking, the inflation rates of these countries after dollarization are similar to U.S. inflation. Panama’s inflation averaged 2.9 percent since 1960, compared to 3.4 percent in the United States. In Ecuador, inflation plunged from 96 percent in 2000 to 12 percent in 2002, and has averaged 4.3 percent thereafter. El Salvador experienced average inflation of 3.0 percent after 2000. Did the September 2000, currency intervention by the United States and other countries influence the dollar-euro exchange rate? Plot for the September-October 2000 period the daily dollar-euro exchange rate (FRED code: DEXUSEU) and, on the right scale, the Fed’s sales of dollars for euros (FRED code: USINTDMRKTDM). Was the intervention successful? If not, why not? Answer: The data is plot is below. The intervention appears to have boosted the euro only for a brief period, with the euro returning to its pre-intervention value and sinking further after several weeks. Because the FOMC had not changed the target federal funds rate, the Open Market Trading Desk sterilized the currency intervention (by selling Treasury bonds). Absent a change in the policy interest rate, currency interventions have little sustained impact on exchange rates in deep, liquid currency markets. Some claim that adoption of a gold standard would contribute to price stability. Was price stability a feature of the U.S. gold standard that prevailed prior to World War I (see Applying the Concept on page 539)? Based on a plot of the general price level (FRED code: M04051USM324NNBR), discuss U.S. price developments from 1880 to 1914. Answer: The data plot is below. Over the 30-year period from 1882 to 1914, the price level increased from a value of 87 to 100, implying average annual inflation of less than one-half percent. However, this apparent stability masks persistent price swings: The price level trended lower from the early 1880s until the mid-1890s, and then began to rise. To the extent that it was unanticipated, the deflationary episode raised the real burden of repaying debt (especially for farmers with falling crop prices). Japan’s experience with deflation since 1994 highlights the risks to economic well-being posed by an unexpected, sustained period of falling prices. Does purchasing power parity (PPP) hold in the long run? Does it hold in the short run? Following text equation (3), plot for Japan and the United States beginning in 1972 the percent change from a year ago of the Japanese yen/U.S. dollar exchange rate (FRED code: EXJPUS) minus the annual inflation rate in Japan (FRED code: JPNCPIALLMINMEI) plus the annual inflation rate in the United States (FRED code: CPIAUCSL). If PPP holds in the long run, what should this expression equal on average? Download the data and compute the average for the full period. Is the result consistent with long-run PPP? Observing the plot, does PPP seem to hold in the short run? Answer: The data is plotted below. If PPP holds, the computed expression should average to zero. For Japan and the United States, the data do fluctuate around zero, with the average value for the data around -0.4 percent. This appears reasonably consistent with long-run PPP. Over shorter periods, however, there are large deviations from zero that persist for several years. This is not consistent with short-run PPP. Organization for Economic Co-operation and Development, Consumer Price Index of All Items in Japan© [JPNCPIALLMINMEI], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/JPNCPIALLMINMEI. In September 1992, a speculative attack compelled the United Kingdom to devalue the British pound versus the German currency (the deutsche mark). How did monetary policies in both countries influence this outcome? Plot from 1990 to 1992 the discount rates in the United Kingdom (FRED code: INTDSRGBM193N) and Germany (FRED code: INTDSRDEM193N), and (on the right scale) the exchange rate of German marks per British pound (obtained by multiplying the number of U.S. dollars per pound (FRED code: EXUSUK) by the number of deutsche marks per U.S. dollar (FRED code: EXGEUS)). What do you conclude?
Answer: The plot appears below. In the early 1990s, the re-unification of west and east Germany triggered an economic boom, prompting the German central bank to raise interest rates. But the Bank of England was lowering interest rates as the U.K. economy slowed and entered a slump. Speculators sold the pound because they doubted that U.K. policymakers would hike interest rates during a recession to defend the fixed exchange rate. This is a classic problem of time consistency; speculators knew that U.K. policymakers had a strong incentive to renege on their promise to maintain the fixed exchange rate, because upholding that promise could trigger a deeper recession.
International Monetary Fund, Interest Rates, Discount Rate for Germany© [INTDSRDEM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRDEM193N. International Monetary Fund, Interest Rates, Discount Rate for United Kingdom© [INTDSRGBM193N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/INTDSRGBM193N indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
