04-Exchange Rate Policies Slides

Exchange Rate Policies
Szabolcs Sebestyén
szabolcs.sebestyen@iscte-iul.pt
Master Programmes
I NTERNATIONAL F INANCE
Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 1 / 110

Outline
1 The Balance of Payments

Breaking the Rules: China’s Twin Surpluses
Case Study: The Demand for International Reserves
2 Central Banks and Monetary Policy
Central Banks: A Global Perspective
The Money Supply Process
The Tools of Monetary Policy
The Conduct of Monetary Policy
3 Foreign Exchange Interventions
Unsterilised and Sterilised Interventions
How a Fixed Exchange Rate Regime Works
Case Study: The Foreign Exchange Crisis of September 1992
Managed Floating and Sterilised Intervention

The Balance of Payments
Outline


Definition and Composition

A country’s balance of payments (BoP) accounts keep track of
both its payments to and its receipts from foreigners
Any transaction resulting in a receipt (payment) from (to)
foreigners is entered in the BoP as a credit (debit)
Three types of international transaction are recorded in the BoP:
1 Current account: accounts for flows of goods and services (imports
and exports)
2 Financial account: records all international purchases and sales of
financial assets. The difference between purchases and sales of
foreign assets is the country’s financial account balance or its net
financial flows
3 Capital account: flows of special categories of assets (capital);
typically non-market, non-produced, or intangible assets like debt
forgiveness, copyrights and trademarks
Every international transaction automatically enters the BoP
twice: once as a credit and once as a debit
The Fundamental BoP Identity
Due to the double entry of each transaction, the BoP accounts will
balance by the following equation:
Current account + Capital account = Financial account
Since the sum of the current and capital accounts is the total
change in a country’s net foreign assets, the sum necessarily
equals the difference between a country’s purchases of assets from
foreigners and its sales of assets to them — the financial account
balance (net financial flows)
Information regarding the offsetting debit and credit items
associated with a given transactionmay be collected from different
sources =⇒ Net errors and omissions item is necessary

Balance of Payments of the Euro Area
Cumulated Value for a One-Year Period Ending December

2021 (e billions)
Current Account 316.7

Total Exports 4,399.9
Of which: Goods 2,528.6
Services 987.2
Income receipts 750.4
Current transfers 133.6
Total Imports 4,083.1
Of which: Goods 2,228.7
Services 860.8
Income payments 697.4
Current transfers 296.2
Capital Account 42.5
Financial Account 388.2

Direct Investment 274.8
Portfolio Investment 511.9
Financial Derivatives (Net) 53.0
Other Investment −580.1
Reserve Assets 128.7
Net Errors and Omissions 29.0

Current Account Balances in the Euro Area, 1996–2014
Source: OECD.
Official Reserve Transactions

A very important type of financial account transaction is the purchase or
sale of official reserve assets by central banks
Official international reserves are foreign assets held by central banks
as a cushion against national economic misfortune
Central banks often buy or sell them to affect home macroeconomic
conditions: official foreign exchange intervention
The level of net central bank financial flows is called the official
settlements balance or the “balance of payments”
It is the sum of the current account and the capital account, less the
non-reserve portion of the financial account and the statistical
discrepancy
A negative official settlements balance may indicate that a country
▶ is depleting its official international reserve assets; or
▶ may be incurring large debts to foreign central banks so that the
domestic central bank can spend a lot to protect against financial
instability
The Balance of Payments Breaking the Rules: China’s Twin Surpluses
Outline


Current and Combined Financial/Capital Account

Balances for the US, 1992–2010 ($ billions)
Source: Eiteman, Stonehill and Moffett (2013), Exhibit 4.6

China’s Twin Surplus, 1998–2010 ($ billions)

China’s Foreign Exchange Reserves ($ billions)

Largest Foreign Exchange Reserves ($ billions)

The Balance of Payments Case Study: The Demand for International Reserves
Outline


The Demand for International Reserves
Historically, central banks have liked to hold international

reserves
Central banks manage their reserves in a precautionary manner,
holding a stock that is believed to be sufficient in future times of
crisis
What influences countries’ demand for international reserves?
▶ Reserve levels may be measured in terms of the number of months
of import needs those reserve could cover
▶ The main cost of holding reserves is their interest cost
▶ If the reserve currency appreciates (depreciates), the central bank
will gain (lose)
With flexible exchange rates, many economists expected that the
demand for reserves would drop sharply, but nothing of the sort
happened

Growth Rates of International Reserves
Source: Krugman, Obstfeld and Melitz (2012), Figure 18.7.

Currency Composition of Global Reserve Holdings

International Reserves, 2000–2020
Source: FRED.
Data on International Reserves
List of countries by foreign-exchange reserves

List of countries by gold reserves

Central Banks and Monetary Policy
Outline


Central Banks and Monetary Policy Central Banks: A Global Perspective
Outline


The Price Stability Goal
Price stability, defined as low and stable inflation, is the most

important goal of monetary policy
It is desirable as inflation creates uncertainty in the economy,
leads to lower economic growth and strains social fabric
Nominal anchor: a nominal variable which ties down the price
level to achieve price stability by steering inflation expectations
It can be the nominal exchange rate, wage and price controls, or
the money supply
The nominal anchor can limit the time-inconsistency problem
▶ Discretionary monetary policy leads to poor long-run outcomes

Other Goals of Monetary Policy

High employment
▶ Unemployment is not zero due to frictional and structural
unemployment
▶ The goal is to reach the natural rate of unemployment where
labour demand equals labour supply
Economic growth
▶ Closely related to the high-employment goal
▶ Supply-side economics policies where the role of monetary policy
is debatable
Stability of financial markets
▶ The stability of the financial system is an important goal for a
central bank
Interest-rate stability
▶ Volatile interest rates can create uncertainty and make planning for
the future harder
Stability in foreign exchange rate markets
▶ It is an important goal for countries very dependent on foreign
trade
Should Price Stability Be the Primary Goal?
In the long run there is no conflict between the goals

In the short run it can conflict with the goals of high employment
and interest-rate stability
Hierarchical mandate
▶ Price stability is the primary goal for the central bank
▶ As long as it is achieved other goals can be pursued
▶ Examples: ECB, Bank of England, Bank of Canada
Dual mandate
▶ Two co-equal mandates: price stability and maximum employment
▶ Example: Fed
The two types of mandates are not very different if maximum
employment is defined as the natural rate of employment
In practice, there could be a substantial difference: long-run price
stability vs short-run output fluctuations

Structure of the Federal Reserve System
The Federal Reserve System includes:

▶ 12 Federal Reserve banks
▶ the Board of Governors of the Federal Reserve System
▶ the Federal Open Market Committee (FOMC)
▶ the Federal Advisory Council
▶ around 2,900 member commercial banks

Federal Reserve System
Source: Mishkin (2010), Figure 16.1.

Federal Reserve Banks

Quasi-public institutions owned by private commercial banks in the
district that are members of the Fed system
Member banks elect 6 directors for each district; 3 more are appointed
by the Board of Governors; the 9 directors appoint the president of the
bank subject to approval by Board of Governors
Functions:
▶ Clear checks
▶ Issue new currency
▶ Withdraw damaged currency from circulation
▶ Administer and make discount loans to banks in their districts
▶ Evaluate proposed mergers and applications for banks to expand their
activities
▶ Act as liaisons between the business community and the FRS
▶ Examine bank holding companies and state-chartered member banks
▶ Collect data on local business conditions
▶ Use staffs of professional economists to research topics related to the
conduct of monetary policy
Federal Reserve Banks and Monetary Policy
Directors “establish” the discount rate

Decide which banks can obtain discount loans
Directors select one commercial banker from each district to serve
on the Federal Advisory Council which consults with the Board of
Governors and provides information to help conduct monetary
policy
Five of the 12 bank presidents have a vote in the Federal Open
Market Committee (FOMC)

Board of Governors of the Federal Reserve System
Seven members head-quartered in Washington, D.C.

Appointed by the president and confirmed by the Senate
14-year non-renewable term
Required to come from different districts
Chairman is chosen from the governors and serves a four-year,
renewable term

Duties of the Board of Governors
Votes on conduct of open market operations (7 governors and 5

presidents of the district banks)
Sets reserve requirements
Controls the discount rate through “review and determination”
process
Sets margin requirements
Sets salaries of president and officers of each Federal Reserve
Bank and reviews each bank’s budget
Approves bank mergers and applications for new activities
Specifies the permissible activities of bank holding companies
Supervises the activities of foreign banks operating in the US

Federal Open Market Committee (FOMC)

Meets eight times a year
Consists of seven members of the Board of Governors, the
president of the Federal Reserve Bank of New York and the
presidents of four other Federal Reserve banks
Chairman of the Board of Governors is also chair of FOMC
Issues directives to the trading desk at the Federal Reserve Bank
of New York
An FOMC meeting consists of
▶ Report by the manager of system open market operations on
foreign currency and domestic open market operations and other
related issues
▶ Presentation of Board’s staff national economic forecast
▶ Outline of different scenarios for monetary policy actions
▶ Presentation on relevant Congressional actions
▶ Public announcement about the outcome of the meeting
Structure and Responsibility for Policy Tools in the

Sebestyén
Source: Mishkin(ISCTE-IUL)
(2004), Figure 16.1. Exchange Rate Policies International Finance 32 / 110
How Independent is the Fed?
Instrument and goal independence

Independent revenue from its holdings of securities and from its
loans to banks
The Government Accountability Office cannot audit the monetary
policy or foreign exchange market functions of the Fed
However, Fed’s structure is written by Congress, and is subject to
change at any time
Presidential influence
▶ Influence on Congress
▶ Appoints members
▶ Appoints chairman although terms are not concurrent

The European Central Bank
The European Central Bank (ECB) and European System of

Central Banks (ESCB) conduct monetary policy for members of
the Economic and Monetary Union (EMU)
The Maastricht Treaty patterned the ECB after the Deutsche
Bundesbank
The decisions in the Eurosystem are taken in a centralised manner
by the ECB, but implemented via the NCBs in a decentralised way
The ECB is owned by the NCBs and has a legal personality unlike
the ESCB
All central banks within the euro area are members of the
payment system TARGET 2 to make payments in real time
The ECB has no say as to how much foreign reserves each
national central bank should hold

Primary Objective of the ECB
The primary objective of the ECB’s monetary policy is to maintain

price stability
The ECB aims at inflation rates of below, but close to, 2% over the
medium term
“The primary objective of the European System of Central Banks
(hereinafter referred to as “the ESCB”) shall be to maintain price sta-
bility. Without prejudice to the objective of price stability, the ESCB
shall support the general economic policies in the Union with a view
to contributing to the achievement of the objectives of the Union as
laid down in Article 3 of the Treaty on European Union. The ESCB
shall act in accordance with the principle of an open market economy
with free competition, favouring an efficient allocation of resources,
and in compliance with the principles set out in Article 119.”
Source: Treaty on the Functioning of the European Union, Article 127.

Organisation of the ECB
The decision-making process takes place at three levels:

▶ Governing Council: decision maker
▶ Executive Board: daily execution
▶ General Council: advisory board

Governing Council
The Governing Council (GC) is the main decision-making body of
the ECB, consisting of
▶ the 6 members of the Executive Board
▶ the governors of the NCBs of the 19 euro area countries
The GC usually meets bi-monthly in Frankfurt am Main, Germany
At its first meeting, the GC assesses economic and monetary
developments and takes its monthly monetary policy decision
At its second meeting, the GC discusses mainly issues related to
other tasks and responsibilities of the ECB and the Eurosystem
The monetary policy decision is explained in detail at a press
conference held shortly after the first meeting each month, chaired
by the president and assisted by the vice-president
It operates by consensus
To stay at a manageable size as new countries join, the Governing
Council will be on a system of rotation
Executive Board
It consists of the president, vice-president and four other members

Those four members are appointed by common agreement of the
heads of states of the euro area countries
The EB’s main task is to ensure the day-to-day implementation of
monetary policy through giving detailed instructions to all NCBs
in accordance with the guidelines of the GC
It is also responsible for managing the daily business of the ECB

General Council
It includes the president and the vice-president of the ECB and the
governors of the NCBs of the 28 EU member states
The other members of the EB, the president of the EU Council and
one member of the European Commission may attend the
meetings of the General Council but do not have the right to vote
It is a transitional body that will be dissolved once all EU member
states join the euro area

How Independent Is the ECB?

The ECB is the most independent central bank in the world, its
independence is laid down in the institutional framework for the
single monetary policy (in the Treaty and in the Statute)
Members of the EB have long terms (8 years) and so do NCB
governors
The Eurosystem determines its own budget, and the governments
of member states are not allowed to issue instructions to the ECB
The ECB is prohibited from granting loans to national public
sector entities
It strictly forbids the NCBs from taking instructions from
European Community institutions, any government or any
international body
It is instrument independent, but less goal dependent (price
stability)
Should Central Banks Be Independent?
Pros:
▶ Political pressure would impart an inflationary bias to monetary
policy
▶ Political business cycle
▶ Central banks could be used to facilitate government financing of
large budget deficits
▶ Too important to leave to politicians – the principal-agent problem
is worse for politicians
Cons:
▶ Undemocratic
▶ Unaccountable
▶ Difficult to coordinate fiscal and monetary policy
▶ Some central banks have not used its independence successfully

Central Banks and Monetary Policy The Money Supply Process
Outline


Players in the Money Supply Process
Central bank
Banks (depository institutions, financial intermediaries)
Depositors (individuals and institutions)

The Fed’s Balance Sheet

Assets Liabilities
Government securities Currency in circulation
Discount loans Reserves
Monetary liabilities:
▶ Currency in circulation: in the hands of the public
▶ Reserves: bank deposits at the Fed and vault cash; there are
required and excess reserves
Assets:
▶ Government securities: holdings by the Fed that affect money
supply and earn interest
▶ Discount loans: provide reserves to banks and earn the discount
rate

Assets of the Federal Reserve System
Source: Federal Reserve Board.

Liabilities of the Federal Reserve System
Source: Federal Reserve Board.

The Eurosystem’s Balance Sheet
Eurosystem
Assets Liabilities
Open market operations Current accounts

Marginal lending facility Deposit facility
Net liquidity effect from autonomous factors
Monetary liabilities:
▶ Current accounts: euro accounts of banks
▶ Deposit facility: hold overnight deposits remunerated at the pre-specified
interest rate
▶ Net liquidity effect from autonomous factors: mostly currency in
circulation and government deposits
Assets:
▶ Open market operations: liquidity-providing operations
▶ Marginal lending facility: provide overnight liquidity from a national
central bank at a pre-specified interest rate against eligible assets
Assets of the Eurosystem
Source: ECB.
Liabilities of the Eurosystem
Source: ECB.
TARGET2 Balances by Country 1999–2022

The Monetary Base
The monetary base (high-powered money) equals currency in

circulation, C, plus total reserves in the banking system, R,
MB = C + R
Central banks exercise control over the monetary base through

their purchases and sale of (government) securities in the open
market, open market operations, and through their extension of
loans to banks

Open Market Purchase from a Bank
Banking System Eurosystem

Assets Liabilities Assets Liabilities
Securities −e 100 Securities +e 100 Reserves +e 100
Reserves +e 100
Net result is that reserves have increased by e 100

No change in currency in circulation
Monetary base has risen by e 100

Open Market Purchase from Non-Bank Public (1)
Non-Bank Public Banking System

Securities −e 100 Reserves +e 100 Deposits +e 100
Deposits +e 100
Eurosystem
Assets Liabilities
Securities +e 100 Reserves +e 100
Identical result as the purchase from a bank

Reserves increase by the amount of the open market purchase,
and the monetary base increases by the same amount

Open Market Purchase from Non-Bank Public (2)
Non-Bank Public Eurosystem

Securities −e 100 Securities +e 100 Currency +e 100
Currency +e 100
Reserves are unchanged

Currency in circulation increases by the amount of the open
market purchase
Monetary base increases by the amount of the open market
purchase

Open Market Purchase: Summary
The effect of an open market purchase on reserves depends on

whether the seller of the bonds keeps the proceeds from the sale in
currency or in deposits
The effect of an open market purchase on the monetary base is
always the same, the monetary base increases by the amount of
the purchase
The effect of open market operations on the monetary base is
much more certain than the effect on reserves
=⇒ the central bank can control the monetary base with open
market operations more effectively than it can control reserves

Shifts from Deposits into Currency
Non-Bank Public Banking System

Deposits −e 100 Reserves −e 100 Deposits −e 100
Currency +e 100
Eurosystem
Assets Liabilities
Currency +e 100
Reserves −e 100
Net effect on monetary liabilities is zero

Reserves can be changed by random fluctuations
The monetary base is a much more stable variable

Marginal Lending Facility

Reserves +e 100 MLF +e 100 MLF +e 100 Reserves +e 100
Monetary liabilities of the Eurosystem have increased by e 100

Monetary base also increases by this amount

Paying Off Marginal Lending Facility

Reserves −e 100 MLF −e 100 MLF −e 100 Reserves −e 100
Net effect on monetary base is a reduction

Monetary base changes one-for-one with a change in the
borrowings from the Eurosystem

Other Factors Affecting the Monetary Base
Autonomous factors affect the monetary base, but are not

controlled by the Eurosystem
▶ Float: during the check-clearing process the ECB often credits the
amount of the check to a bank that has deposited it before it debits
the bank on which the check is drawn
▶ Government deposits
▶ Net foreign assets (residual)
The liquidity effects of autonomous factors are considerable, the
most volatile element being government deposits with the
national central banks
In its liquidity-providing operations, the Eurosystem prepares a
forecast of all major autonomous factors with a minimum
forecasting horizon of 10 business days on a daily basis

ECB’s Ability to Control the Monetary Base (1)
Open market operations are controlled by the ECB (pre-crisis

period)
However, the ECB cannot determine the amount of borrowing by
banks from the Eurosystem
The monetary base can be decomposed into a borrowed and a
non-borrowed component (US terminology)
In the euro area, borrowed reserves are provided through the
marginal lending facility, which is overnight liquidity from the
NCBs against eligible assets
The interest rate on the marginal lending facility normally
provides a ceiling for the overnight market interest rate

ECB’s Ability to Control the Monetary Base (2)

As open market operations, the ECB mostly uses repurchase
agreements or collateralised loans rather than outright purchases
▶ Main refinancing operations (MRO): regular liquidity-providing
reverse transactions with a frequency and maturity of one week;
they are executed by the NCBs on the basis of standard tenders and
according to a pre-specified calendar
▶ Longer-term refinancing operations (LTRO): liquidity-providing
reverse transactions that are regularly conducted with a monthly
frequency and a maturity of three months; longer-term refinancing
operations that are conduced at irregular intervals or with other
maturities; executed by the NCBs on the basis of standard tenders
and according to a pre-specified calendar
▶ Fine-tuning operations (FTO): executed on an ad hoc basis to
manage the liquidity situation in the market and to steer interest
rates; they are primarily executed as reverse transactions, but may
also take the form of outright transactions, foreign exchange swaps
and collection of fixed-term deposits
The ECB’s Response to the Financial Crisis
Lowering the policy rate

Changes in liquidity operations:
▶ Fixed rate full allotment (FRFA) tender procedure in all refinancing
operations
▶ Lenghtening the maturity of liquidity provision
▶ Expansion of the list of eligible collateral for refinancing operations
▶ Extension of the list of eligible counterparties for fine-tuning
operations
Swap agreement with the Federal Reserves System
Covered bond purchase programmes (CBPP, CBPP2, CBPP3),
Securities Markets Programme (SMP), Outright Monetary
Transactions (OMT), Asset-backed securities purchase
programme (ABSPP), Public sector purchase programme (PSPP)

Security Holdings of the ECB
Source: ECB.
Central Banks and Monetary Policy The Tools of Monetary Policy
Outline


The Tools of the ECB and the Fed
The operational framework of the Eurosystem consists of the

following set of instruments:
▶ open market operations (OMOs)
▶ standing facilities
▶ minimum reserve requirements for credit institutions

Demand in the Market for Reserves

What happens to the quantity of reserves demanded by banks,
ceteris paribus, as the policy rate changes?
Reserves can be split into required and excess reserves
Excess reserves are insurance against deposit outflows
The cost of holding these is the interest rate that could have been
earned minus the interest rate that is paid on these reserves, ier
(deposit facility rate at the ECB)
ier is set at a fixed amount below the policy rate (MRO rate at the
ECB) so changes when the target changes
When the overnight money market rate (EONIA in the euro area,
federal funds rate in the US) is above ier , as the EONIA decreases,
the opportunity cost of holding excess reserves falls and the
quantity of reserves demanded rises
Downward sloping demand curve that becomes flat (infinitely
elastic) at ier
Supply in the Market for Reserves

The supply of reserves, Rs , has two components: non-borrowed
reserves, NBR, and borrowed reserves, BR
The cost of borrowing from the ECB (Fed) is the marginal lending
facility (MLF) rate (discount rate), id
id is set at a fixed amount above the policy rate, so changes when
the target changes
Borrowing from the ECB/Fed is a substitute for borrowing from
other banks
If iff < id , then banks will not borrow from the ECB/Fed and
BR = 0
Hence, the supply of reserves is just equal NBR, and the supply
curve will be vertical
As iff rises above id , banks will borrow more and more at id , and
lend out at iff
The supply curve becomes horizontal (perfectly elastic) at id
Equilibrium in the Market for Reserves

Response to an Open Market Operation

Affecting the Policy Rate via OMOs
Effects of OMOs depends on whether the supply curve initially

intersects the demand curve in its downward sloped section
versus its flat section
In the former case (the typical case), an open market purchase
(sale) causes the EONIA/federal funds rate to fall (rise)
In the latter case, OMOs have no effect on the EONIA/federal
funds rate

Response to a Change in the MLF/Discount Rate

Affecting the Policy Rate via Standing Facilities
If the intersection of supply and demand occurs on the vertical

section of the supply curve (the typical case), a change in the
MLF/discount rate will have no effect on the EONIA/federal
funds rate
If the intersection of supply and demand occurs on the horizontal
section of the supply curve, a change in the MLF/discount rate
shifts that portion of the supply curve and the EONIA/federal
funds rate may either rise or fall depending on the change in the
discount rate

Response to a Change in Required Reserves

Affecting the Policy Rate via Reserve Requirements
When the ECB/Fed raises (decreases) reserve requirement, the

EONIA/federal funds rate rises (falls)

How the Operating Procedures Limit Fluctuations in

EONIA/Federal Funds Rate

ECB Policy Rates and EONIA, 1999–2006
6
MLF
DF
MRO
EONIA
4
0
1999 2000 2001 2003 2004 2006
Source: ECB

ECB Policy Rates and EONIA, 2007–2019
6
MLF
DF
MRO
EONIA
4
0
2007 2008 2009 2011 2012 2013 2015 2016 2017 2019
Source: ECB

ECB Policy Rates and €STR, 2019–2022
0.5
MLF
DF
MRO
€STR
0
−0.5
−1
2020 2021 2022
Source: ECB
Central Banks and Monetary Policy The Conduct of Monetary Policy
Outline


Monetary Targeting
In monetary targeting, the central bank announces that it will

achieve a certain value of the annual growth rate of a monetary
aggregate
The central bank is accountable for hitting the target
In the 1970s, monetary targeting was adopted by several
countries: Germany, Switzerland, Canada, the UK, Japan and the
US
In practice, central banks never adhered to strict rules for
monetary growth
In some countries, monetary targeting was not pursued very
seriously

Pros and Cons of Monetary Targeting
Monetary targeting is flexible, transparent and accountable

Pros:
▶ Almost immediate signals help fix inflation expectations and
produce less inflation
▶ Almost immediate accountability, so time-inconsistency is less
likely
Cons:
▶ There must be a strong and reliable relationship between the goal
variable and the targeted monetary aggregate

Inflation Targeting
Given the breakdown of the relationship between monetary
aggregates and inflation, many countries have adopted inflation
targeting to achieve price stability
Inflation targeting involves:
▶ Public announcement of medium-term numerical target for
inflation
▶ Institutional commitment to price stability as the primary, long-run
goal of monetary policy and a commitment to achieve the inflation
goal
▶ Information-inclusive approach in which many variables are used
in making decisions
▶ Increased transparency of the strategy through communication
▶ Increased accountability of the central bank for attaining its
inflation objectives
Countries that adopted inflation targeting: New Zealand (1990),
Canada (1991), UK (1992), etc.
Pros and Cons of Inflation Targeting
Pros:
▶ Does not rely on one variable to achieve target
▶ Easily understood
▶ Reduces potential of falling in time-inconsistency trap
▶ Stresses transparency and accountability
Cons:
▶ Delayed signalling
▶ Too much rigidity
▶ Potential for increased output fluctuations
▶ Low economic growth during disinflation

Monetary Policy with an Implicit Nominal Anchor
There is an implicit nominal anchor in the form of an overriding

concern for the Fed to control inflation in the long run
Forward-looking behaviour and periodic “preemptive strikes”
The goal is to prevent inflation from getting started
Monetary policy needs to act long before inflationary pressures
appear in the economy
“Just do it” policy

Pros and Cons of the “Just Do It” Approach
Pros:
▶ Uses many sources of information
▶ Avoids time-inconsistency problem with the forward-looking
behaviour
▶ Demonstrated success (Greenspan years in the US)
Cons:
▶ Lack of transparency and accountability
▶ Strong dependence on the preferences, skills, and trustworthiness
of individuals in charge
▶ Inconsistent with democratic principles

Pros and Cons of Different Monetary Policy Strategies
Source: Mishkin (2010), Table 19.1.

Foreign Exchange Interventions
Outline


Foreign Exchange Interventions Unsterilised and Sterilised Interventions
Outline


Introduction
So far we have assumed that exchange rates are completely

flexible
In reality, this assumption is rarely accurate
Monetary authorities frequently intervene in the FX market to
influence exchange rates
Fixed and managed floating exchange rate regimes have been the
rule rather than the exception in history
Central banks intervene in the FX market via purchase/sale of
their foreign assets (international reserves)

Foreign Exchange Intervention and the Monetary Base
Eurosystem
Assets Liabilities
Foreign Assets −e 1 billion Currency −e 1 billion
Eurosystem
Assets Liabilities
Foreign Assets −e 1 billion Reserves −e 1 billion
A central bank’s purchase (sale) of domestic currency and

corresponding sale (purchase) of foreign assets in the foreign
exchange market leads to an equal decline (rise) in its
international reserves and the monetary base

Unsterilised Intervention
Unsterilised foreign exchange intervention: in which a central

bank allows the purchase/sale of domestic currency to affect the
monetary base
A purchase (sale) of domestic currency works just like an open
market sale (purchase) of bonds
When domestic currency is sold (purchased) to purchase (sell)
foreign assets leads to a gain (drop) in international reserves, an
increase (decrease) in the money supply, and a depreciation
(appreciation) of the domestic currency

Effect of a Sale of Dollars and a Purchase of Foreign

Assets

Sterilised Intervention
What if the central bank does not want the purchase/sale of

domestic currency to affect the monetary base?
It can conduct an offsetting open market operation in the
government bond market
This is called a sterilised foreign exchange intervention
There is no effect on the monetary base and almost no effect on
the exchange rate
Eurosystem
Assets Liabilities
Foreign Assets −e 1 billion Monetary Base e 0
Government Bonds +e 1 billion

Portfolio Balance Effect and Signalling Effect
A sterilised intervention changes the amount of foreign securities

relative to domestic securities: portfolio balance effect
Through this effect, the central bank might be able to affect the
interest differential between domestic and foreign assets, which in
turn affects the relative expected return of domestic assets
According to empirical evidence, this effect is not significant
A sterilised intervention could indicate what central banks want
to happen to the future exchange rate and so might provide a
signal about the course of future monetary policy
This could change the demand for domestic assets and ultimately
affect the exchange rate
However, the future change in monetary policy – not the sterilised
intervention – is the source of the exchange rate effect

Foreign Exchange Interventions How a Fixed Exchange Rate Regime Works
Outline


Fixed Exchange Rates

To fix the exchange rate, a central bank influences the quantities
supplied and demanded of currency by trading domestic and
foreign assets, so that the exchange rate stays constant
It can succeed in holding the exchange rate fixed only if its
financial transactions ensure that asset markets remain in
equilibrium when the exchange rate is at its fixed level
FX markets are in equilibrium when
Ee − E
R = R∗ +
E
When the exchange rate is fixed at some level Epar and the market
expects it to stay fixed at that level, then
R = R∗


To fix the exchange rate, the central bank must trade foreign and
domestic assets in the FX market until R = R∗
To hold the domestic interest rate at R∗ , the central bank’s
intervention must adjust the money supply so that R∗ equates real
domestic money demand and the real money supply
Suppose that the central bank has fixed the exchange rate at E0 but
the level of output rises, raising the real money demand
This puts an upward pressure on interest and exchange rates
How should the central bank respond?
The central bank should buy foreign assets in the FX markets,
▶ thereby increasing the domestic money supply
▶ thereby reducing interest rates in the short run
▶ Alternatively, by demanding (buying) assets denominated in
foreign currency and by supplying (selling) domestic currency, the
price/value of foreign currency is increased and the price/value of
domestic currency is decreased
Asset Market Equilibrium with a Fixed Exchange Rate

Stabilisation Policies with a Fixed Exchange Rate
Under a fixed exchange rate, monetary policy is powerless to

affect the economy’s money supply or output
However, fiscal policy is even more effective than under a floating
rate because a fiscal expansion is not accompanied by a currency
appreciation

Intervention in the FX Market Under a Fixed

Exchange Rate Regime

Overvalued and Undervalued Currencies

When the domestic currency is overvalued, the central bank must
▶ purchase domestic currency to keep the exchange rate fixed (it loses
international reserves: capital flight); or
▶ conduct a devaluation
When the domestic currency is undervalued, the central bank
must
▶ sell domestic currency to keep the exchange rate fixed (it gains
international reserves); or
▶ conduct a revaluation
With perfect capital mobility, a sterilised intervention cannot keep
the exchange rate at Epar
Currency crises may occur because a government is following
policies that are inconsistent with the fixed exchange rate regime
over the long term
There can also be self-fulfilling currency crises
Capital Flight, the Money Supply, and the Interest Rate

Capital Flight, the Money Supply, and the Interest Rate
The expectation of a future devaluation causes a balance of

payment crisis marked by a sharp fall in reserves and a rise in the
home interest rate above the world interest rate

Foreign Exchange Interventions Case Study: The Foreign Exchange Crisis of September 1992
Outline


Foreign Exchange Interventions Case Study: The Foreign Exchange Crisis of September 1992
Foreign Exchange Market for British Pounds in 1992

Foreign Exchange Interventions Managed Floating and Sterilised Intervention
Outline


Ineffectiveness of Sterilised Intervention

Empirical studies show central banks to have practiced sterilised
intervention under flexible and fixed exchange rate regimes alike
If a sterilised intervention leaves the money supply unchanged
and thereby does not affect the exchange rate, what is the
rationale of such policy?
Sterilisation is fruitless under a fixed exchange rate
For example, an expansionary fiscal policy implies that the central
bank must buy foreign assets and expand the domestic money
supply
The policy raises output but it eventually also causes inflation =⇒
the central bank may sterilise the increase in the money supply
However, when the central bank sells domestic assets to reduce
the domestic money supply, it will have to buy more foreign
assets to keep the exchange rate fixed
=⇒ sterilisation is a self-defeating policy
Imperfect Asset Substitutability

The assumption that the FX market is in equilibrium only when
the expected returns on domestic and foreign assets are the same
is called perfect asset substitutability
In this case the interest parity condition holds
Hence any FX market intervention can be replicated by purely
domestic OMOs
Imperfect asset substitutability exists when it is possible for
assets’ expected returns to differ in equilibrium
The main factor that may lead to this in the FX market is risk
If bonds denominated in different currencies have different
degrees of risk, investors may be willing to earn lower expected
returns on bonds that are less risky
In this case both risk and return matter, so central bank actions
that alter the riskiness of domestic assets can move the exchange
rate even when the money supply remains unchanged
FX Market Equilibrium Under Imperfect Asset

Substitutability
Under perfect asset substitutability,
Ee − E
R = R∗ +
E
Under imperfect asset substitutability, there is a risk premium ρ
Ee − E
R = R∗ + +ρ
E
The risk could be caused by default risk or exchange rate risk
In this case even sterilised purchases (sales) of foreign assets cause
the home currency to depreciate (appreciate)
The central bank can also use sterilised intervention to hold the
exchange rate fixed
Evidence on the Effects of Sterilised Intervention
Little evidence is on the idea that sterilised intervention exerts a

major influence over exchange rates regardless of the stances of
monetary and fiscal policies
Considerable evidence against the view that bonds denominated
in different currencies are perfect substitutes
The signalling effect may play a role

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Exchange Rate Policies

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 1 / 110

1 The Balance of Payments

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 2 / 110

1 The Balance of Payments

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 3 / 110

Definition and Composition

The Fundamental BoP Identity

Current account + Capital account = Financial account

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 5 / 110

Balance of Payments of the Euro Area

Cumulated Value for a One-Year Period Ending December

Current Account 316.7

Capital Account 42.5

Financial Account 388.2

Net Errors and Omissions 29.0

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 6 / 110

Current Account Balances in the Euro Area, 1996–2014

Official Reserve Transactions

1 The Balance of Payments

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 9 / 110

Current and Combined Financial/Capital Account

Source: Eiteman, Stonehill and Moffett (2013), Exhibit 4.6

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 10 / 110

China’s Twin Surplus, 1998–2010 ($ billions)

Source: Eiteman, Stonehill and Moffett (2013), Exhibit 4.7

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 11 / 110

China’s Foreign Exchange Reserves ($ billions)

Source: Eiteman, Stonehill and Moffett (2013), Exhibit 4.8

Largest Foreign Exchange Reserves ($ billions)

Source: Eiteman, Stonehill and Moffett (2013), Exhibit 4.9

1 The Balance of Payments

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 14 / 110

The Demand for International Reserves

Historically, central banks have liked to hold international

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 15 / 110

Growth Rates of International Reserves

Source: Krugman, Obstfeld and Melitz (2012), Figure 18.7.

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 16 / 110

Currency Composition of Global Reserve Holdings

Source: Krugman, Obstfeld and Melitz (2012), Figure 18.8.

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 17 / 110

International Reserves, 2000–2020

Data on International Reserves

List of countries by foreign-exchange reserves

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 19 / 110

1 The Balance of Payments

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 20 / 110

1 The Balance of Payments

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 21 / 110

The Price Stability Goal

Price stability, defined as low and stable inflation, is the most

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 22 / 110

Other Goals of Monetary Policy

Should Price Stability Be the Primary Goal?

In the long run there is no conflict between the goals

Sebestyén (ISCTE-IUL) Exchange Rate Policies International Finance 24 / 110

Structure of the Federal Reserve System