Foreign Exchange Market Intervention

Intervention in the Foreign Exchange Market

• A central bank purchasing domestic currency and selling foreign assets leads to an equal decline in international reserves and the monetary base
• A central bank selling domestic currency results in an equal rise in international reserves and the monetary base

Unsterilized Foreign Exchange Intervention

• In an unsterilized foreign exchange intervention, domestic currency is sold to purchase foreign assets
• An unsterilized foreign exchange intervention leads to increased international reserves, increased money supply and depreciated domestic currency

Sterilized Foreign Exchange Intervention

• To counter the effect of the foreign exchange intervention, an offsetting open market operation is conducted
• There is no effect on the monetary base or the exchange rate

Balance of Payments

• The balance of payments is a bookkeeping system used to record international receipts and payments
• The current account shows transactions involving currently produced goods and services
• Exports less imports is the trade balance and it also includes investment income, service transactions, and transfers
• The capital account shows net receipts from capital transactions
• The current account + capital account = net change in government international reserves

Exchange Rate Regimes

• A fixed exchange rate regime pegs a currency's value to another (anchor currency)
• A floating exchange rate regime allows a currency's value to fluctuate against all others
• A managed float regime (dirty float) attempts to influence exchange rates by buying and selling currencies
• Gold standard means fixed exchange rates, no control over monetary policy and influenced by gold production/discoveries
• Bretton Woods System featured fixed exchange rates using the U.S. dollar as reserve currency; it included the International Monetary Fund, World Bank, and General Agreement on Tariffs and Trade (GATT)
• The European Monetary System (EMS) included an exchange rate mechanism

Fixed Exchange Rate Regime

• When domestic currency is overvalued, central bank must purchase domestic currency to keep rate fixed (losing international reserves) or conduct a devaluation
• If domestic currency is undervalued, the central bank must sell domestic currency to keep the rate fixed (gaining international reserves) or conduct a revaluation

Monetary Unions

• A monetary (or currency) union is a variance of a fixed exchange rate regime in which a group of countries adopt a common currency
• The earliest monetary union was in 1787, when the 13 American colonies formed the United States
• The European Monetary Union was formed in January 1999 where 11 initial member countries adopted the Euro
• Monetary unions ease trade across borders, but countries no longer have independent monetary policy

Managed Float

• Managed float is a hybrid of fixed and flexible exchange rates
• It includes small daily changes in response to the market and interventions to prevent large fluctuations
• Appreciation hurts exporters and employment
• Depreciation hurts imports and stimulates inflation
• Special drawing rights are used as a substitute for gold

Capital Controls

• Controls on outflows promote financial instability by forcing devaluation, are seldom effective, may increase capital flight, lead to corruption and lose opportunity to improve the economy
• Controls on inflows can lead to lending booms, excessive risk taking by financial intermediaries, block funds for productions uses, produce distortion/misallocation, and lead to corruption

Role of the IMF

• The IMF is the international lender of last resort
• Emerging market countries with poor central bank credibility and short-run debt contracts denominated in foreign currencies have limited ability to engage in the function of lender of last resort
• The IMF may be able to prevent contagion
• The IMF's safety net may lead to excessive risk taking (moral hazard problem)

How the IMF Should Operate

• It may not be tough enough
• Austerity programs focus on tight macroeconomic policies rather than financial reform
• It is too slow, which worsens crises and increases costs
• Countries were restricting borrowing until the recent subprime financial crisis

International Considerations and Monetary Policy

• Conducting monetary policy is easier when a country’s currency is a reserve currency (like the U.S.)
• Current account deficits in the U.S. suggest that American businesses may be losing ability to compete because the dollar is too strong
• U.S. deficits can mean surpluses in other countries, leading to large increases in international reserve holdings and world inflation
• A contractionary monetary policy will raise the domestic interest rate and strengthen the currency
• An expansionary monetary policy will lower interest rates and weaken currency

Pegging

• Achieving price stability through monetary policy strategies includes inflation targeting
• Using foreign exchange as a nominal anchor is called exchange-rate targeting
• Exchange-rate targeting contributes to inflation control, provides an automatic rule for monetary policy, and offers simplicity/clarity
• Exchange-rate targeting is disadvantaged by an inability to respond to domestic shocks and transmits shocks to the anchor country
• Exchange-rate targeting is open to speculative attacks on currency and weakens policymaker accountability as the exchange rate loses value as a signal
• Exchange-rate targeting for industrialized countries is desirable if domestic monetary and political institutions are not conducive to good policy making or if benefits arise from this strategy
• Exchange-rate targeting for emerging market countries is desirable if political and monetary institutions are weak, or if the strategy becomes a stabilization policy of last resort

Currency Boards

• Currency boards target a solution to lack of transparency and commitment
• Domestic currency is 100% backed by a foreign currency
• The note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate
• The money supply can expand only when foreign currency is exchanged for domestic currency
• A currency board comes with a stronger commitment by the central bank
• There is a loss of independent monetary policy and increased exposure to shocks from the anchor country
• A currency board loses the ability to create money and act as lender of last resort

Dollarization

• An alternative to a currency board is adopting another country’s money (like the U.S. dollar)
• It has an even stronger commitment mechanism
• Dollarization completely avoids speculative attacks on domestic currency
• There is a loss of independent monetary policy and increased exposure to shocks from anchor country
• There is an inability to create money and act as lender of last resort
• Dollarization leads to a loss of seignorage