Section 5 – Fixed Exchange

Rates
Section 5.1. The Central Bank

• Many countries try to fix or peg their exchange rate to a currency or

group of currencies by intervening in the foreign exchange market.

• Many with a flexible or floating exchange rate in fact practice a

managed floating exchange rate.

• In the case of a managed float the central bank manages the

exchange rate from time to time by buying and selling currency and
assets, especially in periods of exchange rate volatility.
2
3
• To study the effects of central bank intervention in the foreign
exchange market, first construct a simplified balance sheet for the
central bank.

• This records the assets and liabilities of a central bank.

• Balance sheets use double booking keeping: each transaction enters

the balance sheet twice.

4
• Assets
• Foreign government bonds (official international reserves)
• Gold (official international reserves)
• Domestic government bonds
• Loans to domestic banks (called discount loans in US)
• Liabilities
• Deposits of domestic banks
• Currency in circulation (previously central banks had to give up
gold when citizens brought currency)

5
• Assets = Liabilities + Net worth
• If we assume that net worth of the central bank always equals zero
then assets = liabilities.
• An increase in assets leads to an equal increase in liabilities.
• A decrease in assets leads to an equal decrease in liabilities.
• Changes in the central bank’s balance sheet lead to changes in
currency in circulation or changes in bank deposits, which lead to
changes in the money supply.
• If their deposits at the central bank increase, banks typically have
more funds available to lend to customers, so that the amount of
money in circulation increases.

6
• A purchase of any asset will be paid for with currency or a cheque
from the central bank,
• both of which are denominated in domestic currency, and
• both of which increase the supply of money in circulation.
• The transaction leads to equal increases of assets and liabilities.

• When the central bank buys domestic bonds or foreign bonds, the
domestic money supply increases.

7
• A sale of any asset will be paid for with currency or a cheque given to
the central bank,
• both of which are denominated in domestic currency.
• The central bank puts the currency into its vault or reduces the
amount of bank deposits,
• causing the supply of money in circulation to shrink.
• The transaction leads to equal decreases of assets and liabilities.
• When the central bank sells domestic bonds or foreign bonds, the
domestic money supply decreases.

8
• Central banks trade foreign government bonds in the foreign
exchange markets.
• Foreign currency deposits and foreign government bonds are often
substitutes: both are fairly liquid assets denominated in foreign
currency.
• Quantities of both foreign currency deposits and foreign
government bonds that are bought and sold influence the
exchange rate.

9
• Because buying and selling of foreign bonds in the foreign
exchange market affects the domestic money supply, a central bank
may want to offset this effect.

• This offsetting effect is called sterilization.

• If the central bank sells foreign bonds in the foreign exchange

market it can buy domestic government bonds in bond markets—
hoping to leave the amount of money in circulation unchanged.

10
11
• 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 (the price of foreign currency in
terms of domestic currency) stays constant.

• The foreign exchange market is in equilibrium when

R = R* +

• When the exchange rate is fixed at some level s0 and the market
expects it to stay fixed at that level then
R = R*
12
• To fix the exchange rate, the central bank must trade foreign and
domestic assets until R = R*.

• In other words, it adjusts the money supply until the domestic

interest rate equals the foreign interest rate, given the price level and
real output, until:

Ms/P = L(R*,Y)

13
• Suppose that the central bank has fixed the exchange rate at s0 but
the level of output rises, raising the demand for real money.

• This leads to higher interest rates and upward pressure on the value
of the domestic currency.

• How should the central bank respond if it wants to fix exchange rates?

14
• The central bank must buy foreign assets in the foreign exchange
market thereby
• increasing the money supply,
• reducing interest rates.

• 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.

15
16
• Because the central bank must buy and sell foreign assets to keep the
exchange rate fixed, monetary policy is ineffective in influencing
output and employment.
• Temporary fiscal policy is more effective in influencing output and
employment in the short run.
• The rise in output due to expansionary fiscal policy raises money
demand, putting upward pressure on interest rates and upward
pressure on the value of the domestic currency.
• To prevent an appreciation of the domestic currency, the central bank
must buy foreign assets, thereby increasing the money supply:
accommodating monetary policy.

17
Section 5.2. Cooperation and Non-Cooperation

• Fixed exchange rate systems are typically based on a reserve

currency system in which there are N countries participating.

• One of the countries, the centre country (the Nth country), provides
the reserve currency, which is the base or centre currency to which
all the other countries peg.

18
• When the centre country has monetary policy autonomy it can set its
own interest rate R* as it pleases.
• The other non-centre country, which is pegging, then has to adjust its
own interest rate so that R equals R* in order to maintain the peg.
• The non-centre country loses its ability to conduct stabilization
policy, but the centre country keeps that power.
• The asymmetry can be a recipe for political conflict and is known as
the Nth currency problem.
• Cooperative arrangements can be worked out to try to avoid this
problem.

19
• In Figure 5.1 in panel (a), the noncentre home country is initially in
equilibrium at point 1 with output at Y1, which is lower than desired output
Y0. In panel (b), the center foreign country is in equilibrium at its desired
output level Y*0 at point 1′.

• Home and foreign interest rates are equal, R1 = R*1, and home is unilaterally
pegged to foreign.

• Foreign has monetary policy autonomy. If the centre country makes no

policy concession, this is the non-cooperative outcome.

• With cooperation, the foreign country can make a policy concession and
lower its interest rate and home can do the same and maintain the peg.
20
• Lower interest rates in the other country shift each country’s IS curve in, but
the easing of monetary policy in both countries shifts each country’s LM
curve down.

• The net effect is to boost output in both countries.

• The new equilibria at points 2 and 2′ lie to the right of points 1 and 1′.

• Under this cooperative outcome, the foreign center country accepts a rise
in output away from its desired level, from Y*0 to Y*2.

• Meanwhile, home output gets closer to its desired level, rising from Y1 to Y2.

21
Figure 5.1.

22
• A unilateral peg gives the benefits of fixing to both countries but
imposes a stability cost on the non-centre country.
• A major problem is that, at any given time, the shocks that hit a
group of economies are typically asymmetric (see discussion
concerning German reunification).
• The centre country in a reserve currency system has tremendous
autonomy which it may be unwilling to give up thus making
cooperative outcomes hard to achieve consistently.

23
• What about non-cooperative behavior? Suppose a country that was
previously pegging at a rate 1 announces that it will henceforth peg at a
different rate, 2 ≠ 1.

• By definition if 2 >1 there is a devaluation of the home currency; if 2 1 there is

a revaluation of the home currency.

• It is assumed that the centre is a large country such as the US with monetary
policy autonomy that has set its interest rate at R$.

• Home is pegged to the U.S. dollar at home/$ and foreign is pegged at *foreign/$.
24
• In Figure 5.2. in panel (a), the non-centre home country is initially in equilibrium at
point 1 with output at Y1, which is lower than desired output Y0. In panel (b), the non-
centre foreign country is in equilibrium at its desired output level Y*0 at point 1′.

• Home and foreign interest rates are equal to the base (dollar) interest rate and to
each other, R1 = R*1 = R*$, and home and foreign are unilaterally pegged to the base.

• With cooperation, home devalues slightly against the dollar (and against foreign) and
maintains a peg at a higher exchange rate. The home interest and foreign interest
rates remain the same.

• But the home real depreciation causes home demand to increase: IS shifts out to IS2.
This is also a foreign real appreciation, so foreign demand decreases: IS* shifts in to
IS*2.

25
• Under this cooperative outcome at points 2 and 2′, foreign accepts a fall in
output away from its desired level, from Y*0 to Y*2.

• Meanwhile, home output gets closer to its desired level, rising from Y1 to Y2.

• With non-cooperation home devalues more aggressively against the dollar.

After a large home real depreciation, IS shifts out to IS3 and IS* shifts in to
IS*3.

• Under this non-cooperative outcome at points 3 and 3′, home gets its
desired output Y0 by exporting the recession to foreign, where output falls
all the way to Y*3.

26
Figure 5.2.

27
• We can now see that adjusting the peg is a policy that may be cooperative
or non-cooperative in nature.

• If non-cooperative, it is usually referred to as a beggar-thy-neighbor

policy: home can improve its position at the expense of foreign and
without foreign’s agreement.

• If home engages in such a policy, it is possible for foreign to respond with

a devaluation of its own in a tit-for-tat way.

• Cooperation may be most needed to sustain a fixed exchange rate system

with adjustable pegs, so as to restrain beggar-thy-neighbor devaluations.

28
Section 5.3. Loss of Monetary Autonomy Again

• Fix the spot exchange rate at .

• Fixing the exchange rate involves active intervention in the foreign exchange
market to keep the rate at a pre-specified level.

• Assume output is equal to the capacity constraint.

• The model is defined as

29
 (5.1)

(5.2)

(5.3)

(5.4)

(5.5)

(5.6)
30
• The foreign variables are exogenous.

• The domestic variables and are exogenous.

• The variables , and are endogenously determined.

• is not determined endogenously by the system of equations (5.1) –

(5.6).

• Instead, is kept at the value .

31
• In terms of solving for the equilibrium conditions there are 5
endogenous variables yet 6 equations.

• It is required that there is then a 6th endogenous variable.

• This is the money stock .

• Since is no longer endogenous then must be endogenous.

• will then be a policy instrument that is used to keep at the value .

32
• If then selling domestic currency will cause a devaluation and will
rise.

• Conversely, if the domestic currency is bought in exchange for foreign

currency the value of the domestic currency will increase vis-à-vis the
foreign currency.

• The domestic currency thus revalues and falls.

33
• If then buying domestic currency can bring about .

• By means of an open market operation the exchange rate can be fixed

at .

• However, it is clear that by carrying out such operations, the home

country loses control of its money stock as the existing money stock
governs whether the exchange rate remains fixed at the specified
value.

• Any deviation from this requires an intervention to bring about .

34
• Monetary policy is thus subservient to keeping the exchange rate
fixed at a given level.

• Monetary policy cannot then be used to achieve other

macroeconomic objectives.

35
Section 5.4. Stationary State Analysis.

• Assume that capital is perfectly mobile.

• Start with the short-run analysis.

• The price level is temporarily fixed.

• can depart from the natural rate .

36
• Let .

• Suppose that and are fixed at some value.

• Then s, p and q are also fixed.

• The home country’s interest rate is determined abroad .

• There is no expected change in exchange rate depreciation.

37
• The IS relation (5.1) is

• Suppose now that there is an increase in output or income.

• An increase in y then shifts the IS schedule to the right as seen in

Figure 5.3.

• Output increases from to .

38
• Figure 5.3.

39
• The LM schedule is

• If y increases then m must increase.

• Hence increases.

• The LM schedule shifts right from to .

40
• Why should the LM schedule shift right?

• If the IS schedule shifts rightwards then there is the tendency for the
interest rate to increase to ; the domestic interest rate is greater than
the foreign interest rate.

• At a fixed exchange rate investors will exchange foreign currency into

domestic currency, earn a higher return and be guaranteed of being
able to convert domestic currency back into foreign currency at the
fixed exchange rate.

41
• There is thus an inflow of reserves.

• This puts pressure on the fixed exchange rate as the monetary authority has to
intervene to buy the foreign currency.

• If it does not then the domestic currency would appreciate and the fixed rate
would break.

• In buying the foreign currency in exchange for domestic currency the domestic
money supply increases which has the effect of shifting the LM curve leftwards.

• There is the tendency to move to point C in Figure 5.3 but instead the economy
quickly shifts to point A.

42
• Point A in Figure 5.3 is a short-run equilibrium.

• The economy cannot remain at this equilibrium indefinitely.

• Since there is pressure in the market for goods.

• This will cause pressure on p to increase.

• As p increases then the LM schedule shifts leftwards back to point C if

the money stock remains at .

43
• The increase in p implies a decline in the real exchange rate as s is
fixed.

• A fall in q leads to a left shift in the IS schedule.

• Therefore IS shifts leftwards overtime.

• Since and have remained constant then in the long-run the IS and
LM schedules are in equilibrium at the original position in Figure 5.3.

44
• What can be concluded?

• Since monetary policy is ineffective under a fixed exchange rate then

fiscal policy is effective for domestic stabilisation.

• Suppose that output is below capacity .

• Consider Figure 5.4.

• An increase in g to from shifts IS to the right.

45
• The tendency is then for r to increase above .

• This increases the demand for domestic currency.

• In order to keep the exchange rate fixed the monetary authority

purchases foreign currency thereby increasing the supply of
domestic currency from to .

• This has the effect of shifting the LM curve to the right.

• Output increases to the capacity rate of .

46
• Figure 5.4.

47
• Suppose again that .

• Instead of obtaining full capacity employment by means of fiscal

policy suppose that monetary policy is employed.

• Monetary expansion from to shifts LM curve rightwards in Figure

5.5.

• The tendency is for r to fall .

• Investors will then sell the domestic currency to invest abroad.

48
• This creates depreciationary pressure on the exchange rate.

• To keep the exchange rate at the fixed rate , the money stock needs to
be reduced.

• There is a reduction in the money stock and a left shift of the LM

curve back to the initial position A.

• To conclude, in a fixed exchange rate regime monetary policy is

unavailable.

49
• Figure 5.5.

50
• But what if an exchange rate realignment is required.

• Suppose that initially .

• Suppose that there is a currency devaluation from to , that is s

increases.

• The prices p and are fixed.

• Given the real exchange rate q increases from to .

51
• The increase in q is depicted in Figure 5.6.

• The IS function shifts rightwards.

• The right shift puts pressure on the interest rate i.e. .

• There is an increase in demand for the domestic currency.

• The monetary authority sells the domestic currency in exchange for

foreign currency.

52
• Foreign reserves increase and the money supply increases .

• The LM curve shifts to the right.

• The short-run or fixed price adjustment is at point A.

• At A .

• There is a process of readjustment.

53
• In the long-run since there is price pressure on output.

• Prices increase .

• and q fall in value.

• The LM curve shifts leftwards.

• The process continues until .

54
• Since r and have not changed values, it follows that and q have the
same values in the long-run equilibrium as in the initial position.

• The effect of a devaluation is therefore temporary.

• Why would a county undertake such a devaluation?

• Increase output temporarily - beggar thy neighbour policy.

55
• If initially the devaluation would lead to an increase in y.

• Would a devaluation be temporary?

• What happens to the international reserve position?

• What would happen to the output gap?

56
• Figure 5.6.

57
Section 5.4. Steady State Analysis

• Given that the exchange rate is fixed .

• The aim is to determine the values of and q.

58
 (5.7)

(5.8)

(5.9)

(5.10)

(5.11)

(5.12)
59
• Since then .

• Home country inflation is equal to inflation in the country to which

the exchange rate is pegged.

• by (5.11).

• Hence by (5.9) .

• The domestic real interest rate follows the foreign real interest rate.

60
• By (5.8) and (5.12) so .

• Thus the growth rate of money stock is determined by the inflation

rate and hence monetary policy abroad.

61
• Section 5.5. Balance of Payments Crises

• As pointed out above, in order to fix an exchange rate the central bank
needs to intervene in the foreign exchange market to ensure that supply
and demand of the currency are such that the price of the currency
remains at .

• The central bank uses its reserves to manipulate the forex market to keep

• To sustain a fixed exchange rate, the central bank must have enough
foreign assets to sell in order to satisfy the demand of domestic currency
at the fixed exchange rate.
62
• When a central bank does not have enough official international reserve
assets to maintain a fixed exchange rate a balance of payments crisis
results.

• Investors may expect that the domestic currency will be devalued, causing
them to want to hold foreign assets instead of domestic assets the value
of which is expected to fall soon.

1. This expectation or fear only makes the balance of payments crisis

worse:
• Investors rush to change their domestic assets into foreign assets,
depleting the stock of official international reserve assets more
quickly.
63
2. As a result, financial capital is quickly moved from domestic assets to
foreign assets: capital flight.
• The domestic economy has a shortage of financial capital
for investment and has low aggregate demand.

3. To avoid this outcome, domestic assets must offer a high interest rates
to entice investors to hold them.
• The central bank can push interest rates higher by reducing the
money supply (by selling foreign and domestic assets).

4. As a result, the domestic economy may face high interest rates, a

reduced money supply, low aggregate demand, low output and low
employment.

64
 Expected
devaluation makes
the expected return
on foreign assets
higher

To attract investors to hold domestic

assets (currency) at the original
exchange rate, the interest rate must
rise through a sale of foreign assets.
65
• Expectations of a balance of payments crisis only worsen the crisis and
precipitate devaluation.

• What causes expectations to change?

• Expectations about the central bank’s ability and willingness to

maintain the fixed exchange rate.
• Expectations about the economy: shrinking demand of domestic
products relative to foreign products means that the domestic
currency should become less valuable.

• In fact, expectations of devaluation can cause a devaluation: a self-fulfilling

crisis.
66
• What happens if the central bank runs out of official international
reserve assets (foreign assets)?
• It must devalue the domestic currency so that it takes more domestic
currency (assets) to exchange for one unit of foreign currency (asset).
• This will allow the central bank to replenish its foreign assets by
buying them back at a devalued rate
• Increasing the money supply.
• Reducing interest rates.
• Reducing the value of domestic products.
• Increasing aggregate demand, output, employment over time.

67
• In a balance of payments crisis

• the central bank may buy domestic bonds and sell domestic
currency (to increase the money supply) to prevent high interest
rates, but this only depreciates the domestic currency more.

• the central bank generally cannot satisfy the goals of low domestic
interest rates (relative to foreign interest rates) and fixed exchange
rates simultaneously.

68
• Up until now Uncovered Interest Parity (UIP) has been assumed to hold.

• Interest Rate Differentials can have an impact upon fixed exchange rate regimes.

• For many countries, the expected rates of return are not the same:
R > R*+
• Why?
• Default risk: The risk that the country’s borrowers will default on their loan
repayments. Lenders therefore require a higher interest rate to compensate for this
risk.
• Exchange rate risk: If there is a risk that a country’s currency will depreciate or be
devalued, then domestic borrowers must pay a higher interest rate to compensate
foreign lenders.

69
• Because of these risks, domestic assets and foreign assets are not treated the
same.

• Previously, we assumed that foreign and domestic currency deposits were

perfect substitutes: deposits everywhere were treated as the same type of
investment, because risk and liquidity of the assets were assumed to be the
same.

• In general, foreign and domestic assets may differ in the amount of risk that they
carry: they may be imperfect substitutes.

• Investors consider these risks, as well as rates of return on the assets, when
deciding whether to invest.

70
• A difference in the risk of domestic and foreign assets is one reason
why expected rates of return are not equal across countries:

R = R*+ + 

where  is called a risk premium, an additional amount needed to

compensate investors for investing in risky domestic assets.

• The risk could be caused by default risk or exchange rate risk.

71
Exchange R1 R2 An increase in the perceived
rate, s risk of investing in domestic
assets makes foreign assets
s2 more attractive and leads to a
depreciation or devaluation of
the domestic currency.

s1
R* + + ρ
R* +
Domestic
interest rates, R

M1/P MS1/P Or at fixed exchange

rates, the central bank will
M0/P MS0/P need to sell foreign assets,
increasing the rate of
return on domestic assets
Quantity of (domestic interest rates)
and decreasing the
real monetary L(R, Y) domestic money supply.
assets
72
Case Study: The Mexican Peso Crisis 1994–1995

• In late 1994, the Mexican central bank devalued the value of the peso
relative to the U.S. dollar.

• This action was accompanied by high interest rates, capital flight, low
investment, low production and high unemployment.

• What happened?

73
 8.5
7.5

Mexican pesos per US dollar 6.5

5.5
4.5
3.5
2.5
1-Jul- 1-Aug- 1-Sep- 1-Oct- 1-Nov- 1-Dec- 1-Jan- 1-Feb- 1-Mar- 1-Apr- 1-May-
1994 1994 1994 1994 1994 1994 1995 1995 1995 1995 1995

Source: Saint Louis Federal Reserve

74
• In the early 1990s, Mexico was an attractive place for foreign
investment, especially from NAFTA partners.

• During 1994, political developments caused an increase in Mexico’s

risk premium () due to increases in default risk and exchange rate
risk:
• rebellion and political unrest in Chiapas
• assassination of leading presidential candidate from PRI

• Also, the Federal Reserve System raised U.S. interest rates during
1994 to prevent U.S. inflation. (So, R* ↑ )
75
• These events put downward pressure on the value of the peso.

• Mexico’s central bank had promised to maintain the fixed exchange

rate.

• To do so, it sold dollar denominated assets, decreasing the money

supply and increasing interest rates.

• The central bank needed to have adequate reserves of dollar

denominated assets. Did it?

76
U.S. Dollar Denominated International Reserves at the
Mexican Central Bank

January 1994 ……………… $27 billion

October 1994 …………………$17 billion
November 1994 ………..…… $13 billion
December 1994 ………..……$ 6 billion

During 1994, Mexico’s central bank hid the fact that its
reserves were being depleted. Why?
Source: Banco de México, http://www.banxico.org.mx
77
78
• 20 Dec 1994: Mexico devalues the peso by 13%. It fixes E at 4.0 pesos/dollar
instead of 3.4 pesos/dollar.

• Investors expect that the central bank has depleted its reserves.

•  ↑ further due to exchange rate risk: investors expect the central bank to devalue
again and they sell Mexican assets, putting more downward pressure on the value
of the peso.

• 22 Dec 1994: with reserves nearly gone, the central bank abandons the fixed rate.

• In a week, the peso falls another 30% to about 5.7 pesos/dollar.

79
• The U.S. & IMF set up a $50 billion fund to guarantee the value of loans
made to Mexico’s government
• reducing default risk
• and reducing exchange rate risk, since foreign loans could act as official
international reserves to stabilize the exchange rate if necessary.

• After a recession in 1995, the economy began to recover.

• Mexican goods were relatively inexpensive, allowing production to
increase.
• Increased demand of Mexican products relative to demand of foreign
products stabilized the value of the peso and reduced exchange rate
risk.

80
Section 5.6. Types of Fixed Exchange Rate Regimes

1. Reserve currency system: one currency acts as official international

reserves.
• The U.S. dollar was the currency that acted as official international reserves
from under the fixed exchange rate system from 1944–1973.
• All countries except the U.S. held U.S. dollars as the means to make official
international payments.
2. Gold standard: gold acts as official international reserves that all
countries use to make official international payments.

81
Reserve Currency System

• From 1944–1973, central banks throughout the world fixed the value of their
currencies relative to the US dollar by buying or selling domestic assets in
exchange for dollar denominated assets.
• Arbitrage ensured that exchange rates between any two currencies remained
fixed.
• Suppose Bank of Japan fixed the exchange rate at 360¥/US$1 and the
Bank of France fixed the exchange rate at 5 Ffr/US$1
• The yen/franc rate was (360¥/US$1)/(5Ffr/US$1) = 72¥/1Ffr
• If not, then currency traders could make an easy profit by buying currency
where it was cheap and selling it where it was expensive.

82
• Because most countries maintained fixed exchange rates by trading
dollar denominated (foreign) assets, they had ineffective monetary
policies.

• The Federal Reserve, however, did not have to intervene in foreign

exchange markets, so it could conduct monetary policy to influence
aggregate demand, output and employment.

• The U.S. was in a special position because it was able to use monetary
policy as it wished.

83
• In fact, the monetary policy of the U.S. influenced the economies of other
countries.

• Suppose that the U.S. increased its money supply thereby lowering interest rates
and putting downward pressure on the value of the U.S. dollar.

• If other central banks maintained their fixed exchange rates, they would have
needed to buy dollar denominated (foreign) assets, increasing their money
supplies.

• The monetary policies of other countries had to follow that of the U.S., which was
not always optimal for their levels of output and employment.

84
Gold Standard

• Under the gold standard from 1870–1914 and after 1918 for some
countries, each central bank fixed the value of its currency relative to
a quantity of gold (in ounces or grams) by trading domestic assets in
exchange for gold.

• For example, if the price of gold was fixed at $35 per ounce by the
Federal Reserve while the price of gold was fixed at £14.58 per ounce
by the Bank of England, then the $/£ exchange rate must have been
fixed at $2.40 per pound.

85
• The gold standard did not give the monetary policy of the U.S. or
any other country a privileged role.

• If one country lost official international reserves (gold) so that its

money supply decreased, then another country gained them so
that its money supply increased.

• The gold standard also acted as an automatic restraint on

increasing money supplies too quickly, preventing inflationary
monetary policies.

86
• But restraints on monetary policy restrained central banks from increasing the
money supply to increase aggregate demand, output and employment.

• And the price of gold relative to other goods and services varied, depending on
the supply and demand of gold.

• A new supply of gold made gold abundant (cheap), and prices of other goods and
services rose because the currency price of gold was fixed.

• Strong demand for gold jewellery made gold scarce (expensive), and prices of
other goods and services fell because the currency price of gold was fixed.

87
• A reinstated gold standard would require new discoveries of gold to
increase the money supply as economies and populations grow.

• A reinstated gold standard may give Russia, South Africa, the U.S. or
other gold producers inordinate influence on international financial
and macroeconomic conditions.

88
The Gold Exchange Standard

• The gold exchange standard is a system of official international reserves in

both a group of currencies (with fixed prices of gold) and gold itself.
• It allows more flexibility in the growth of international reserves, depending
on macroeconomic conditions, because the amount of currencies held as
reserves could change.
• Does not constrain economies as much to the supply and demand of gold
• The fixed exchange rate system from 1944–1973 used gold, and so
operated more like a gold exchange standard than a currency reserve
system.

89
Gold and Silver Standard

• Bimetallic standard: the value of currency is based on both silver and

gold.
• The U.S. used a bimetallic standard from 1837–1861.
• Banks coined specified amounts of gold or silver into the national
currency unit.
• 371.25 grains of silver or 23.22 grains of gold could be turned into
a silver or a gold dollar.
• So gold was worth 371.25/23.22 = 16 times as much as silver.

90
Section 5.7. Interest Rates, Exchange Rates and a Liquidity Trap

• Recall that a liquidity trap occurs when nominal interest rates fall to
zero and the central bank cannot encourage people to hold more
liquid (monetary) assets.

• Nominal interest rates can not fall below zero, or else depositors
would have to pay to put their money in banks.

• When interest rates fall to zero, people are indifferent between

holding monetary and interest-bearing assets, so that central bank
can not encourage them to spend or borrow more money.
91
92
• If interest rates are reduced to zero, then
R = 0 = R* +

R*+
• If as expectations about the exchange rate are fixed then

R*+

• With fixed expectations about the exchange rate (and inflation) and fixed
foreign interest rates, the exchange rate is fixed. A purchase of domestic assets
by the central bank does not lower the interest rate, nor does it change the
exchange rate.
93
Section 5.8. Optimum Currency Area – A Case Study of the
European Experience

• The European Union is a system of international institutions, the first of which

originated in 1957, which now represents 25 European countries through the:
• European Parliament: elected by citizens of member countries
• Council of the European Union: appointed by governments
of the member countries
• European Commission: executive body
• Court of Justice: interprets EU law
• European Central Bank, which conducts monetary policy, through a system of
member country banks called the European System of Central Banks

94
• The European Monetary System was originally a system of fixed
exchange rates implemented in 1979 through an exchange rate
mechanism (ERM).

• The EMS has since developed into an economic and monetary union
(EMU), a more extensive system of coordinated economic and
monetary policies.

• The EMS has replaced the exchange rate mechanism for most
members with a common currency under the economic and monetary
union.

95
• To be part of the economic and monetary union, EMS members
must

1. first adhere to the ERM: exchange rates were fixed in specified

bands around a target exchange rate,
2. next follow restrained fiscal and monetary policies as
determined by Council of the European Union and the European
Central Bank,
3. finally replace the national currency with the euro, whose
circulation is determined by the European System of Central
Banks.

96
• To be a member of the EU, a country must, among other things,
1. have low barriers that limit trade and flows of financial capital
2. adopt common rules for emigration and immigration to ease the
movement of people.
3. establish common workplace safety and consumer protection
rules
4. establish certain political and legal institutions that are
consistent with the EU’s definition of liberal democracy.

97
Members of the European Union

EEA = European
Economic Association,
a free trade group with
the EU.

98
EU/EMS Members of the Economic and Monetary
Union

Countries in red: EU members

that use the euro and are
members of the EMU.

Countries in blue: EU members

that do not use the euro and
are not members of the EMU.

99
• Countries that established the EU and EMS had several goals

1. To enhance Europe’s power in international affairs: as a union of countries,

the EU could represent more economic and political power in the world.

2. To make Europe a unified market: a large market with free trade, free flows
of financial capital and free migration of people—in addition to fixed
exchange rates or a common currency—were believed to foster economic
growth and economic well being.

3. To make Europe politically stable and peaceful.

100
EU members adopted the euro for principally 4 reasons:

1. Unified market: the belief that greater market integration and economic growth
would occur.

2. Political stability: the belief that a common currency would make political interests
more uniform.

3. The belief that German influence under the EMS would be moderated under a
European System of Central Banks.

4. Eliminate the possibility of devaluations/revaluations: with free flows of financial

capital, capital flight and speculation could occur in an EMS with separate
currencies, but would be more difficult with a single currency.
101
The EMS from 1979–1998
• From 1979–1993, the EMS defined the exchange rate mechanism to allow most currencies
to fluctuate +/- 2.25% around target exchange rates.
• The exchange rate mechanism allowed larger fluctuations (+/- 6%) for currencies of
Portugal, Spain, Britain (until 1992) and Italy (until 1990).
• These countries wanted greater flexibility with monetary policy.
• The wider bands were also intended to prevent speculation caused by differing
monetary and fiscal policies.
To prevent speculation,
• early in the EMS some exchange controls were also enforced to limit trading of currencies.
• But from 1987–1990 these controls were lifted in order to make the EU a common
market for financial capital.
• a credit system was also developed among EMS members to lend to countries that needed
assets and currencies that were in high demand in the foreign exchange markets.

102
• But because of differences in monetary and fiscal policies across the EMS, markets
participants began buying German assets (because of high German interest rates)
and selling other EMS assets.
• As a result, Britain left the EMS in 1992 and allowed the pound to float against
other European currencies.
• As a result, exchange rate mechanism was redefined in 1993 to allow for bands of
+/-15% of the target value in order devalue many currencies relative to
the deutschemark.
• But eventually, each EMS member adopted similarly restrained fiscal and
monetary policies, and the inflation rates in the EMS eventually converged (and
speculation slowed or stopped).
• In effect, EMS members were following the restrained monetary policies of
Germany, which has traditionally had low inflation.
• Under the EMS exchange rate mechanism of fixed bands, Germany was
“exporting” its monetary policy.
103
Convergence of Inflation Rates Among EMS Members 1978–
2000

104
• Policies of the EU and EMS

• Single European Act of 1986 recommended that many barriers to trade, financial capital flows
and immigration be removed by December 1992.
• Maastricht Treaty, proposed in 1991, required the 3 provisions to transform the EMS into a
economic and monetary union.
• It also required standardizing regulations and centralizing foreign and defense policies among EU
countries.
• The Maastricht Treaty requires that members which want to enter the economic and monetary
union
1. Attain exchange rate stability defined by the ERM before adopting the euro.
2. Attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest
national inflation rates among EU members.
3. Maintain a restrictive fiscal policy:
• a maximum ratio of government deficit to GDP of 3%.
• a maximum ratio of government debt to GDP of 60%.

105
• The Maastricht Treaty requires that members which want to remain in the economic and
monetary union maintain a restrictive fiscal policy:
• a maximum ratio of government deficit to GDP of 3%.
• a maximum ratio of government debt to GDP of 60%.
• financial penalties are imposed on countries with “excessive” deficits or debt.
• The Stability and Growth Pact, negotiated in 1997, also allows for financial penalties on
countries with “excessive” deficits or debt.
• The euro was adopted in 1999, and the previous exchange rate mechanism became obsolete.
• But a new exchange rate mechanism—ERM 2—was established between the economic and
monetary union and outside countries.
• It allowed countries (either within or outside of the EU) that wanted to enter the
economic and monetary union in the future to maintain stable exchange rates before
doing so.
• It allowed EU members outside of the economic and monetary union to maintain fixed
exchange rates if desired.

106
• The theory of optimum currency areas argues that the optimal area for a
system of fixed exchange rates, or a common currency, is one that is highly
economically integrated.
• economic integration means free flows of
• goods and services (trade)
• financial capital and physical capital
• workers/labour (immigration and emigration)
• Fixed exchange rates have costs and benefits for countries deciding whether
to adhere to them.
• Benefits of fixed exchange rates are that they avoid the uncertainty and
international transaction costs that floating exchange rates involve.
• Define this gain that would occur if a country joined a fixed exchange rate
system as the monetary efficiency gain.
107
• The monetary efficiency gain of joining a fixed exchange rate system depends
on the amount of economic integration.
1. If trade is extensive between members, then transaction costs would be
reduced greatly by monetary and economic union.
2. If financial capital can flow freely between members, then the uncertainty
about rates of return would be reduced greatly.
3. If people can migrate freely across borders to work, then the uncertainty
about wages would be reduced greatly.

In general, the higher the degree of economic integration, the greater the
monetary efficiency gain.

108
109
When considering the monetary efficiency gain
• It has been assumed that the members of the fixed exchange rate system
maintained a stable price level.
• But when variable inflation exists among member countries, then joining the
system would not reduce uncertainty (as much).
• It has been assumed that a new member would be fully committed to a fixed
exchange rate system.
• But if a new member is likely to leave the fixed exchange rate system, then
joining the system would not reduce uncertainty (as much).
• Economic integration also allows prices to converge between members of a fixed
exchange rate system and a potential member.
• The law of one price is expected to hold better when markets are integrated

110
• Costs of fixed exchange rates are that they require the loss of
monetary policy for stabilizing output and employment and the loss
of automatic adjustment of exchange rates to changes in aggregate
demand.

• Define the loss that would occur if a country joined a fixed exchange
rate system as the economic stability loss.

111
• The economic stability loss of joining a fixed exchange rate system
also depends on the amount of economic integration.
• After joining a fixed exchange rate system, if the new member faces
a fall in aggregate demand:
1. Relative prices will tend to fall, which will lead other members
to increase aggregate demand greatly if economic integration is
extensive, so that the economic loss is not as great.
2. Financial capital or labour will migrate to areas with higher
returns or wages if economic integration is extensive, so that the
economic loss is not as great.
3. The loss of the automatic adjustment of flexible exchange rates
is not as great if goods and services markets are integrated.
112
• Automatic adjustment would cause an appreciation of foreign
currencies, which would cause an increase in many prices for
domestic consumers when goods and services markets are integrated.

• In general, the higher the degree of economic integration, the lower

the economic stability loss.

• Draw a graph of the economic stability loss as a function of the

degree of economic integration.

113
114
• At some critical point measuring the degree of integration, the
monetary efficiency gain will exceed the economic stability loss for a
member considering joining a fixed exchange rate system.

115
116
• There could be an event that causes the frequency or magnitude of
changes in aggregate demand to increase for a country.

• If so, the economic stability loss would be greater for every measure
of economic integration between a new member and members of a
fixed exchange rate system.

• How would this affect the critical point where the monetary efficiency
gain equals economic stability loss?

117
118
Is the EU an Optimum Currency Area?

• If the EU/EMS/economic and monetary union can be expected to

benefit members, we expect that its members have a high degree of
economic integration:
• large trade volumes as a fraction of GDP
• a large amount of foreign financial investment and foreign direct
investment relative to total investment
• a large amount of migration across borders as a fraction of total
labour force

119
• Most EU members export from 10% to 20% of GDP to other EU
members
• This compares with exports of less than 2% of EU GDP to the US.
• But trade between regions in the US is a larger fraction of regional
GDP.

• Was trade restricted by regulations that were removed under the

Single European Act?

120
121
• Deviations from the law of one price also occur in many EU markets.
• If EU markets were greatly integrated, then the (currency adjusted)
prices of goods and services should be nearly the same across
markets.
• The price of the same BMW car varies 29.5% between British and
Dutch markets.
• How much does price discrimination occur?
• There is also no evidence that regional migration is extensive in the EU.
• Europe has many languages and cultures, which hinder migration and
labour mobility.
• Unions and regulations also impede labour movements between
industries and countries.
122
• Evidence also shows that differences of US regional unemployment
rates are smaller and less persistent than differences of national
unemployment rates in the EU, indicating a lack of EU labour mobility.
• There is evidence that financial capital flows more freely in the EU
after 1992 and 1999.
• But capital mobility without labour mobility can make the economic
stability loss greater.
• After a reduction of aggregate demand in a particular EU member,
financial capital could be easily transferred elsewhere while labour
is stuck.
• The loss of financial capital could further reduce production and
employment.

123
• The structure of the economies in the EU’s economic and monetary union is
important for determining how members respond to aggregate demand shocks.
• The economies of EU members are similar in the sense that there is a high
volume of intra-industry trade relative to the total volume.
• They are different in the sense that Northern European countries have high
levels of physical capital per worker and more skilled labour, compared with
Southern European countries.
• How an EU member responds to aggregate demand shocks may depend how
the structure its economy compares to that of fellow EU members.
• For example, the effects of a reduction in aggregate demand caused a
reduction in demand in the software industry will depend if a EU member
have a large number of workers skilled in programming relative to fellow EU
members.

124
• The amount of transfers among the EU members may also affect how
EU economies respond to aggregate demand shocks.
• Fiscal payments between countries in the EU’s federal system, or
fiscal federalism, may help offset the economic stability loss from
joining an economic and monetary union.
• But relative to inter-regional transfers in the US, little fiscal
federalism occurs among EU members.

125
126
Section 5.9. Britain and the ERM

• The push for a common currency European Union (EU) countries was part
of a larger program to create a single market across Europe.

• An important stepping-stone along the way to the euro was a fixed

exchange rate system created in 1979 called the Exchange Rate
Mechanism (ERM).

• The German mark or deutsche mark (DM) was the base currency or
centre currency (or Germany was the base country or centre country) in
the fixed exchange rate system.
127
• In panel (a) of Figure 5.7 German reunification in 1989 raises German
government spending and shifts IS* out.

• The German central bank contracts monetary policy, LM* shifts up,
and German output stabilizes at Y*1. Equilibrium shifts from point 1
to point 2, and the German interest rate rises from i*1 to i*2.

• In Britain, under a peg, panels (b) and (c) show that foreign returns FR
rise and so the British domestic return DR must rise to i2 = i*2.

• The German interest rate rise also shifts out Britain’s IS curve slightly
from IS1 to IS2.

128
• To maintain the peg, Britain’s LM curve shifts up from LM1 to LM2.

• At the same exchange rate and a higher interest rate, demand falls and
output drops from Y1 to Y2. Equilibrium moves from point 1 to point 2.

• If the Pound were to float, the LM curve could shift to any set of points.

• For example, at LM4 the British interest rates holds at i1 and output booms,
but the forex market ends up at point 4 and there is a depreciation of the
pound to E4.

• Britain could also select LM3, stabilize output at the initial level Y1, but the
peg still has to break with E rising to E3.
129
Figure 5.7.

130
• Following an economic slowdown, in September 1992 the British
Conservative government came to the conclusion that the benefits of being
in ERM and the euro project were smaller than costs suffered due to a
German interest rate hike that was a reaction to Germany-specific events.

• Two years after joining the ERM, Britain opted out.

• Did Britain make the right choice?

• In Figure 5.8 the economic performance of Britain are compared with that
of France, a large EU economy that maintained its ERM peg.

131
• In Figure 5.8 Britain’s decision to exit the ERM allowed for more
expansionary British monetary policy after September 1992.

• In other ERM countries that remained pegged to the mark, such as

France, monetary policy had to be kept tighter to maintain the peg.

• Consistent with the model, the data show lower interest rates, a more
depreciated currency, and faster output growth in Britain compared
with France after 1992.

132
Figure 5.8.

133
• The fundamental source of this divergence between what Britain
wanted and what Germany wanted was that each country faced
different shocks.

• The fiscal shock that Germany experienced after reunification was

not felt in Britain or any other ERM country.

• The issues that are at the heart of this decision are: economic
integration as measured by trade and other transactions, and
economic similarity, as measured by the similarity of shocks.

134
• The term economic integration refers to the growth of market linkages
in goods, capital, and labour markets among regions and countries.

• It has been argued that by lowering transaction costs, a fixed exchange

rate might promote integration and hence increase economic
efficiency. Why?

• The greater the degree of economic integration between markets in

two countries, the greater will be the volume of transactions between
the two, and the greater will be the benefits the home country gains
from fixing its exchange rate with the base country. As integration rises,
the efficiency benefits of a common currency increase.
135
• A fixed exchange rate can be costly when a country-specific shock
that is not shared by the other country: the shocks were dissimilar.

• In this example, German policy makers wanted to tighten monetary

policy to offset a boom, while British policy makers did not want to
implement the same policy because they had not experienced the
same shock.

• The general lesson we can draw is that for a home country that
unilaterally pegs to a foreign country, asymmetric shocks impose
costs in terms of lost output.

136
• Thus if there is a greater degree of economic similarity between the home
country and the base country, i.e. the countries face more symmetric
shocks and fewer asymmetric shocks, then the economic stabilization
costs to home of fixing its exchange rate to the base become smaller.

• As economic similarity rises the stability costs of common currency

decrease.

• To Conclude: As integration rises, the efficiency benefits of a common

currency increase.

• As symmetry rises, the stability costs of a common currency decrease.

137
Section 5.10. Current Account Balance

• Develop the ideas behind the capital flows.

• In a fixed exchange rate regime, m does not change.

• If m were to change then there would be pressure on the exchange

rate.

• If m does not change then the official settlements account must be in

balance and there is no deficit.
138
• The Current Account (CA) is approximately equal to net exports.

(5.13)

• (5.13) is embedded in the IS function rendered explicit here with the

following properties

(5.14)

139
• The CA balance occurs for the values of q and y such that

(5.15)

• For a given value of a sketch of (5.15) in the plane will be upward

sloping as if q increases since then increases.

• Since as y increases then decreases.

• See Figure 5.7.

140
• Figure 5.7.

141
• The position of the curve in Figure 5.7 depends on .

• Since an increase in will shift the curve to the right.

• Points above the curve entail a CA surplus and points below entail a
CA deficit.

• The loci of points defined by can be used with IS and LM curves to

determine the effects on the CA balance as policy or conditions
changes.

142
• Consider Figure 5.8.

• Suppose that government expenditure increases from to .

• The IS schedule shifts to the right.

• There is a tendency for r to increase.

• This causes reserves to flow into the home country.

• The money stock thus increases from to .

143
• The short-run equilibrium is at point A.

• At A the price level is unchanged at .

• Since the real exchange rate is unchanged.

• Given that there is a CA deficit in the short-run as illustrated by point

A’.

144
• Figure 5.8.

145
• Since in the long-run the price level will increase.

• As p increases, q will fall (recall that s is fixed).

• falls.

• Both the IS and LM curves shift leftwards.

• and are unchanged.

• The stationary equilibrium is at the original position where .

146
• is lower than to the extent that it offsets the higher value of g.

• The final point is B’.

147
• Consider now the effect on CA balances of an increase in foreign
income given that and are unchanged.

• This is depicted in Figure 5.9.

• As increases from to the IS curve shifts rightwards and the curve

shifts rightwards.

• The short-run equilibrium points are A and A’.

148
• There is a current account surplus.

• Since then p increases.

• This lowers and q and shifts the IS and LM schedules back to the
original point.

• At the initial point the CA balance is equal to its initial value as .

• All the terms on the left hand side of the last expression are
unchanged from the initial values.
149
• Figure 5.9.

150
Section 5.11. Fiscal Discipline, Seignorage and Inflation

• One common argument in favour of fixed exchange rate regimes in

developing countries is that an exchange rate peg prevents the
government from printing money to finance government expenditure.
• Under such a scheme, the central bank is called upon to monetise the
government’s deficit, i.e. give money to the government in exchange
for debt.
• This process increases the money supply and leads to high inflation.
• The source of the government’s revenue is an inflation tax called
seigniorage levied on the members of the public who hold money.

151
• At any instant, money grows at a rate ΔM/M = ΔP/P = π.
• If a household holds M/P in real money balances, then a moment
later when prices have increased by π, a fraction π of the real value
of the original M/P is lost to inflation. The cost of the inflation tax to
the household is t × M/P.
• The amount that the inflation tax transfers from household to the
government is called seigniorage, which can be written as:

M
Seigniorage  t   t  L( r *   )Y
    
Inflation tax
Tax rate P
Tax base

152
• If a country’s currency floats, its central bank can print a lot or a little
money, with very different inflation outcomes.
• If a country’s currency is pegged, the central bank might run the peg
well, with fairly stable prices, or run the peg so badly that a crisis
occurs, the exchange rate ends up in free fall, and inflation erupts.
• Nominal anchors—whether money targets, exchange rate targets, or
inflation targets—imply a “promise” by the government to ensure
certain monetary policy outcomes in the long run.
• However, these promises do not guarantee that the country will
achieve these outcomes.

153
• Thus it appears that fixed exchange rates are neither necessary nor
sufficient to ensure good inflation performance in many countries.

• The main exception appears to be in developing countries beset by

high inflation, where an exchange rate peg may be the only credible
anchor.

154