Monetary Policy and Exchange Rates Overview
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Monetary Policy and Exchange Rates Overview

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Questions and Answers

What is a potential downside of fixing an exchange rate?

  • It can reduce macroeconomic volatility.
  • It increases exchange rate volatility.
  • It can constrain monetary policy. (correct)
  • It enhances monetary policy flexibility.

    • If the exchange rate is undervalued, what must a central bank do to maintain the peg?

  • Sell its currency. (correct)
  • Buy back its currency.
  • Deplete its international reserves.
  • Increase interest rates.

    • What happens when the exchange rate is overvalued?

  • The central bank accumulates international reserves.
  • The central bank buys back its currency. (correct)
  • Import costs decrease significantly.
  • There is an excess demand for the currency.

    • In a fixed exchange rate regime, which factor does a central bank rely on to maintain the exchange rate?

    <p>International reserves.</p> Signup and view all the answers

    What does it indicate if the pegged exchange rate is less than its fundamental value?

    <p>The currency is undervalued.</p> Signup and view all the answers

    What is a key concern regarding fixed exchange rates?

    <p>Pegged rates could be misaligned with fundamentals.</p> Signup and view all the answers

    How does a central bank respond when there's excess supply of its currency in a pegged system?

    <p>They buy back their currency.</p> Signup and view all the answers

    What limits a central bank's ability to defend an overvalued exchange rate?

    <p>The amount of international reserves.</p> Signup and view all the answers

    What was the primary reason the Thai central bank maintained high real interest rates before the 1997 crisis?

    <p>To support the pegged exchange rate</p> Signup and view all the answers

    What consequence did the speculative attack on the Thai baht have on the economy?

    <p>It caused a decrease in baht-denominated asset values</p> Signup and view all the answers

    How did investors leverage low interest rates in the US before the crisis?

    <p>By borrowing funds to invest in Asia</p> Signup and view all the answers

    What effect did the devaluation of the baht have on the value of assets purchased by investors?

    <p>The assets depreciated in value</p> Signup and view all the answers

    What was a significant consequence of the artificially high real interest rates in Thailand?

    <p>Creation of an asset bubble</p> Signup and view all the answers

    What is the primary consequence of having a fixed exchange rate with free capital flows and an independent monetary policy?

    <p>Maintaining an overvalued fixed exchange rate becomes challenging.</p> Signup and view all the answers

    Which statement best describes the policy trilemma?

    <p>It is not possible to achieve all three goals of fixed exchange rates, independent monetary policy, and free capital flows simultaneously.</p> Signup and view all the answers

    What risk is associated with maintaining an undervalued peg in exchange rates?

    <p>Speculative attacks that could destabilize the currency.</p> Signup and view all the answers

    How can central banks use international reserves to support a fixed exchange rate system?

    <p>By selling reserves to maintain currency value against foreign currencies.</p> Signup and view all the answers

    During the East Asian Crisis, what was a common response by central banks facing downward pressure on their exchange rates?

    <p>They raised real interest rates to deter devaluation.</p> Signup and view all the answers

    What is an effect of a speculative attack on a currency?

    <p>It can lead to a sudden devaluation of the currency.</p> Signup and view all the answers

    What happens when a central bank lowers interest rates while maintaining a fixed exchange rate?

    <p>It risks undermining the fixed exchange rate and could lead to instability.</p> Signup and view all the answers

    Why is maintaining an independent monetary policy incompatible with a fixed exchange rate and free capital flows?

    <p>Lowering interest rates to stabilize the economy may undermine the fixed exchange rate.</p> Signup and view all the answers

    What occurs during a speculative attack on a currency?

    <p>Investors sell domestic currency assets expecting devaluation.</p> Signup and view all the answers

    What is a potential outcome of maintaining an overvalued exchange rate for too long?

    <p>Forced devaluation of the currency.</p> Signup and view all the answers

    How can central banks attempt to counteract selling pressure during a speculative attack?

    <p>By increasing interest rates to enhance demand for domestic currency assets.</p> Signup and view all the answers

    What is a 'self-fulfilling prophecy' in the context of currency devaluation?

    <p>Speculative selling leads to a devaluation that investors anticipated, perpetuating the cycle.</p> Signup and view all the answers

    What is constrained by the need to maintain a fixed exchange rate?

    <p>The ability of a central bank to conduct independent monetary policy.</p> Signup and view all the answers

    What are the three goals a central bank must choose between in the policy trilemma?

    <p>Independent monetary policy, fixed exchange rate, free international capital flows.</p> Signup and view all the answers

    What happens to the exchange rate when a central bank's reserves are depleted due to speculative attacks?

    <p>The exchange rate may fall further from its pegged value.</p> Signup and view all the answers

    What is the result of increasing interest rates (r) to defend an overvalued peg?

    <p>The demand for domestic currency assets increases while supply decreases.</p> Signup and view all the answers

    What happens to the exchange rate when there is an increase in the real interest rate?

    <p>The exchange rate appreciates and net exports decrease.</p> Signup and view all the answers

    How does a decrease in the real interest rate affect the exchange rate?

    <p>It increases supply of local currency assets.</p> Signup and view all the answers

    Which of the following statements is true about monetary policy in an open economy?

    <p>Monetary policy effects are amplified through the exchange rate channel.</p> Signup and view all the answers

    What type of exchange rate regime did Australia adopt after 1983?

    <p>Floating exchange rate regime.</p> Signup and view all the answers

    What is the primary concern with fixed exchange rate regimes?

    Signup and view all the answers

    How does an increase in the real interest rate affect the demand for local currency in an open economy?

    <p>It increases demand for local currency assets.</p> Signup and view all the answers

    What is the effect of a decrease in the real interest rate on net exports in an open economy?

    <p>It increases net exports due to a weaker local currency.</p> Signup and view all the answers

    What does a fixed exchange rate regime typically require from a central bank?

    <p>Sufficient international reserves to defend the peg.</p> Signup and view all the answers

    In relation to monetary policy effectiveness, what assumption is made about exchange rates in an open economy?

    <p>Exchange rates are flexible and can change.</p> Signup and view all the answers

    What occurs when an economy has a fixed exchange rate and experiences an excess supply of its currency?

    <p>The central bank will sell its foreign reserves to maintain the peg.</p> Signup and view all the answers

    What is a likely consequence of a speculative attack on a currency under a fixed exchange rate regime?

    <p>Depletion of the central bank's foreign reserves.</p> Signup and view all the answers

    How did Australia's exchange rate regime change after 1983?

    <p>It transitioned to a floating exchange rate regime.</p> Signup and view all the answers

    What is one of the factors that can amplify the effects of monetary policy in an open economy?

    <p>Changes in net exports via the exchange rate channel.</p> Signup and view all the answers

    The Thai baht was pegged to the US dollar at a rate of 20 baht to 1 USD before 1997.

    <p>False</p> Signup and view all the answers

    The excessive foreign investment in Thailand was primarily due to low real interest rates.

    <p>False</p> Signup and view all the answers

    A speculative attack on the baht led to its immediate appreciation.

    <p>False</p> Signup and view all the answers

    If investors borrowed funds in the US with low interest rates, they could potentially make high returns in Asia if the exchange rate remained stable.

    <p>True</p> Signup and view all the answers

    The collapse of baht-denominated assets caused a localized economic crisis limited to Thailand.

    <p>False</p> Signup and view all the answers

    An increase in the real interest rate decreases the demand for local currency assets.

    <p>False</p> Signup and view all the answers

    In a fixed exchange rate regime, the central bank must maintain the exchange rate by managing the supply of its currency.

    <p>True</p> Signup and view all the answers

    Monetary policy is always more effective in an open economy than in a closed economy.

    <p>False</p> Signup and view all the answers

    A decrease in the real interest rate leads to a currency appreciation and a decrease in net exports.

    <p>False</p> Signup and view all the answers

    Australia adopted a floating exchange rate regime after 1983.

    <p>True</p> Signup and view all the answers

    Speculative attacks on currencies can occur more frequently in countries with fixed exchange rates.

    <p>True</p> Signup and view all the answers

    In an open economy, changes in the real interest rate do not affect net exports.

    <p>False</p> Signup and view all the answers

    The policy trilemma states that a central bank can achieve all three goals of a fixed exchange rate, free capital flows, and an independent monetary policy simultaneously.

    <p>False</p> Signup and view all the answers

    A central bank can maintain a fixed exchange rate without using its international reserves.

    <p>False</p> Signup and view all the answers

    If the pegged exchange rate is lower than the fundamental value, the currency is considered overvalued.

    <p>False</p> Signup and view all the answers

    An overvalued exchange rate occurs when the pegged rate is greater than the fundamental value.

    <p>True</p> Signup and view all the answers

    Maintaining a fixed exchange rate can increase volatility in the macroeconomy due to fixed monetary policy.

    <p>True</p> Signup and view all the answers

    A central bank sells its currency when there is excess supply to maintain its currency peg.

    <p>False</p> Signup and view all the answers

    International reserves serve as a tool for a central bank to defend an undervalued currency by selling its local currency.

    <p>True</p> Signup and view all the answers

    Fixed exchange rate regimes give a central bank complete independence in monetary policy decisions.

    <p>False</p> Signup and view all the answers

    A fixed exchange rate may not always reflect the economic fundamentals, leading to misalignments.

    <p>True</p> Signup and view all the answers

    Central banks can maintain an overvalued exchange rate indefinitely without risking depletion of reserves.

    <p>False</p> Signup and view all the answers

    Speculative attacks often occur when investors expect a future devaluation of a currency.

    <p>True</p> Signup and view all the answers

    The 'policy trilemma' states a central bank can achieve all three goals of independent monetary policy, fixed exchange rate, and free international capital flows at the same time.

    <p>False</p> Signup and view all the answers

    Depleting international reserves increases the likelihood that a central bank will have to devalue its currency.

    <p>True</p> Signup and view all the answers

    Increasing the interest rate (r) can be a strategy to defend a fixed exchange rate during selling pressure.

    <p>True</p> Signup and view all the answers

    In a scenario where the central bank faces selling pressure, it can still effectively use monetary policy to manage domestic economic issues like unemployment.

    <p>False</p> Signup and view all the answers

    Speculative attacks can be seen as a form of a self-fulfilling prophecy for currency devaluation.

    <p>True</p> Signup and view all the answers

    A central bank's ability to defend an overvalued exchange rate is not limited by its international reserves.

    <p>False</p> Signup and view all the answers

    Australia had a fixed exchange rate system before 1983.

    <p>True</p> Signup and view all the answers

    Raising interest rates can help manage a devaluation in a fixed exchange rate regime.

    <p>True</p> Signup and view all the answers

    The policy trilemma states that a country can achieve all three of fixed exchange rate, independent monetary policy, and free capital flows simultaneously.

    <p>False</p> Signup and view all the answers

    During the East Asian Crisis, many countries maintained a fixed exchange rate pegged to the GBR.

    <p>False</p> Signup and view all the answers

    An independent monetary policy allows a central bank to control inflation effectively under a fixed exchange rate regime.

    <p>False</p> Signup and view all the answers

    Speculative attacks can lead to the forced devaluation of a currency under pressure.

    <p>True</p> Signup and view all the answers

    Capital controls can be used to support a fixed exchange rate by limiting the flow of currency across borders.

    <p>True</p> Signup and view all the answers

    Lowering interest rates while maintaining a fixed exchange rate will always increase a currency's value.

    <p>False</p> Signup and view all the answers

    How does an increase in the real interest rate affect net exports in an open economy?

    <p>An increase in the real interest rate appreciates the exchange rate, which reduces net exports.</p> Signup and view all the answers

    What role does the exchange rate channel play in monetary policy effectiveness in an open economy?

    <p>The exchange rate channel amplifies the effects of monetary policy by influencing net exports alongside domestic demand.</p> Signup and view all the answers

    What is one consequence of maintaining a fixed exchange rate when there is excess supply of currency?

    <p>Maintaining a fixed exchange rate during excess supply can lead to central bank depletion of reserves.</p> Signup and view all the answers

    Why is it assumed that monetary policy is more effective in an open economy?

    <p>Monetary policy is assumed more effective because changes in real interest rates also impact net exports through the exchange rate.</p> Signup and view all the answers

    What typically happens to a country's currency during a speculative attack under a fixed exchange rate regime?

    <p>During a speculative attack, a country's currency generally depreciates, challenging the fixed exchange rate.</p> Signup and view all the answers

    How does an increase in the real interest rate affect the demand for local currency in an open economy?

    <p>An increase in the real interest rate raises the demand for local currency as investors seek higher returns.</p> Signup and view all the answers

    What is the policy 'trilemma' in the context of exchange rates?

    <p>The policy trilemma states that a country cannot simultaneously maintain fixed exchange rates, free capital movement, and an independent monetary policy.</p> Signup and view all the answers

    What effect does a decrease in the real interest rate have on the exchange rate?

    <p>A decrease in the real interest rate typically depreciates the exchange rate.</p> Signup and view all the answers

    What is the role of a central bank in maintaining a fixed exchange rate when it is pegged too low?

    <p>The central bank must sell its currency to meet excess demand, thereby increasing its international reserves.</p> Signup and view all the answers

    How does an overvalued exchange rate affect a central bank's international reserves?

    <p>An overvalued exchange rate causes the central bank to buy back its currency, which depletes its international reserves.</p> Signup and view all the answers

    What happens to the exchange rate when the central bank runs out of international reserves?

    <p>The exchange rate can no longer be maintained, leading to potential devaluation or a shift in the exchange rate regime.</p> Signup and view all the answers

    In a fixed exchange rate regime, what may happen if a currency is pegged above its fundamental value?

    <p>There will be excess supply of the currency, leading the central bank to buy the currency to maintain the peg.</p> Signup and view all the answers

    What creates a challenge for a central bank that pegs its currency too low?

    <p>The challenge arises from the excess demand for the currency, requiring the central bank to frequently sell its currency.</p> Signup and view all the answers

    Why might a central bank choose to fix the exchange rate against a commodity like gold?

    <p>Fixing the exchange rate against a commodity can provide stability and reduce volatility in the economy.</p> Signup and view all the answers

    What is a potential risk of maintaining a fixed exchange rate in the context of global capital flows?

    <p>A major risk is that it can limit the central bank's monetary policy flexibility, leading to potential economic imbalances.</p> Signup and view all the answers

    What is the relationship between exchange rate pegging and international reserves?

    <p>Maintaining a pegged exchange rate requires active management of international reserves to address excess demand or supply.</p> Signup and view all the answers

    What event prompted the Thai central bank to float the baht in 1997?

    <p>A speculative attack on the baht due to investors realizing the peg was unsustainable.</p> Signup and view all the answers

    How did high real interest rates contribute to the economic challenges in Thailand prior to the 1997 crisis?

    <p>High real interest rates attracted excessive foreign investment, creating an asset bubble.</p> Signup and view all the answers

    What is the implication of the baht's peg to the US dollar for investors borrowing funds in the US?

    <p>Investors could generate high returns by investing in Thailand as long as the exchange rate remained stable.</p> Signup and view all the answers

    What was the relationship between Thailand's foreign reserves and its currency peg?

    <p>The central bank had to use its foreign reserves to maintain the baht's peg to the US dollar.</p> Signup and view all the answers

    Explain the potential consequences for investors if the baht experienced a 50% devaluation.

    <p>Investors would face significant losses, as their assets would be worth only half, making it hard to repay debts.</p> Signup and view all the answers

    What are the implications of removing capital controls in a fixed exchange rate and independent monetary policy scenario?

    <p>It would likely cause volatility in the exchange rate, as maintaining the peg becomes difficult without the capital controls in place.</p> Signup and view all the answers

    How did the speculative attack on the Thai baht affect its currency value during the East Asian crisis?

    <p>The speculative attack led to a significant devaluation of the baht, causing a loss of confidence among investors and further capital flight.</p> Signup and view all the answers

    Why might a central bank choose to raise interest rates to defend an overvalued exchange rate?

    <p>A central bank may raise interest rates to attract foreign capital and stabilize the currency, despite risking economic recession domestically.</p> Signup and view all the answers

    What role do international reserves play in supporting a fixed exchange rate system?

    <p>International reserves are used to buy or sell currency on the foreign exchange market, helping to stabilize the exchange rate.</p> Signup and view all the answers

    In the context of the policy trilemma, why is it challenging to maintain a fixed exchange rate with free capital flows and independent monetary policy?

    <p>It is difficult because attempting to stabilize the exchange rate requires sacrificing either monetary policy independence or allowing capital flows to be unrestricted.</p> Signup and view all the answers

    How can a central bank mitigate risks associated with maintaining an undervalued peg?

    <p>A central bank can implement policies that manage inflation and encourage economic stability to counteract the risks of capital flight and reduced confidence.</p> Signup and view all the answers

    What were the consequences of raising real interest rates in Thailand prior to the 1997 crisis?

    <p>The increase in real interest rates led to a domestic recession and exacerbated defaults, putting more downward pressure on the currency.</p> Signup and view all the answers

    What general economic condition is likely to prompt a speculative attack on a fixed exchange rate?

    <p>An economic condition characterized by rapid capital inflows combined with signs of potential currency overvaluation can prompt a speculative attack.</p> Signup and view all the answers

    What is a speculative attack and what causes investors to initiate one?

    <p>A speculative attack is a significant sell-off of domestic currency assets by investors who anticipate a devaluation of the currency.</p> Signup and view all the answers

    How does a central bank's choice to maintain an overvalued peg impact its reserves?

    <p>Maintaining an overvalued peg can drain the central bank's reserves over time, making a devaluation more likely.</p> Signup and view all the answers

    What are the three goals of the policy trilemma that a central bank must choose between?

    <p>The three goals are independent monetary policy, fixed exchange rate, and free international capital flows.</p> Signup and view all the answers

    In what way can changing interest rates (r) influence the demand for domestic currency assets?

    <p>Increasing the interest rate (r) can raise demand for domestic currency assets by making them more attractive to investors.</p> Signup and view all the answers

    What does it mean when an exchange rate is described as a 'self-fulfilling prophecy'?

    <p>A 'self-fulfilling prophecy' occurs when the expectation of a devaluation leads to behavior that causes the devaluation to happen.</p> Signup and view all the answers

    Why might a central bank be unable to use interest rates to stabilize the domestic economy while maintaining a fixed exchange rate?

    <p>The central bank's need to maintain a fixed exchange rate limits its ability to adjust interest rates freely.</p> Signup and view all the answers

    What happens to exchange rates when a central bank's international reserves deplete during a speculative attack?

    <p>When a central bank depletes its reserves during a speculative attack, the exchange rate is likely to fall further from the pegged level.</p> Signup and view all the answers

    How does increasing the real interest rate (r) in response to selling pressure affect the market?

    <p>Increasing the real interest rate (r) can shift the supply curve of currency left and the demand curve right, impacting currency values.</p> Signup and view all the answers

    An increase in the real interest rate r appreciates the exchange rate and reduces net ______.

    <p>exports</p> Signup and view all the answers

    In a fixed exchange rate regime, the central bank uses its foreign ______ to maintain the exchange rate.

    <p>reserves</p> Signup and view all the answers

    A speculative attack can lead to a rapid decline in the value of a ______.

    <p>currency</p> Signup and view all the answers

    The policy 'trilemma' suggests a limit to achieving an independent monetary policy, free capital flows, and a fixed ______.

    <p>exchange rate</p> Signup and view all the answers

    Australia adopted a floating exchange rate regime in ______.

    <p>1983</p> Signup and view all the answers

    A decrease in the real interest rate decreases demand for local currency assets and ______ the exchange rate.

    <p>depreciates</p> Signup and view all the answers

    Monetary policy impacts demand through the ______ rate channel in an open economy.

    <p>exchange</p> Signup and view all the answers

    In an open economy, an increase in the real interest rate can lead to increased demand for local currency assets and a ______ in net exports.

    <p>decrease</p> Signup and view all the answers

    Central banks may fix the nominal exchange rate either against some major ______ or against a commodity, like gold.

    <p>currency</p> Signup and view all the answers

    When the exchange rate is undervalued, it indicates that the pegged exchange rate Epeg is ______ than the fundamental value Efun.

    <p>less</p> Signup and view all the answers

    To maintain a peg, the central bank must be willing and able to buy or sell its currency to soak up excess ______ or supply.

    <p>demand</p> Signup and view all the answers

    An overvalued exchange rate occurs when the pegged rate Epeg exceeds the fundamental value Efun, leading to excess ______ of the currency.

    <p>supply</p> Signup and view all the answers

    The ability of a central bank to defend an overvalued exchange rate is limited by its stock of international ______.

    <p>reserves</p> Signup and view all the answers

    If a central bank experiences excess demand for its currency due to an undervalued exchange rate, it must sell its currency, thereby building up its international ______.

    <p>reserves</p> Signup and view all the answers

    When a central bank lowers interest rates while maintaining a fixed exchange rate, it risks ______ pressure on the currency.

    <p>selling</p> Signup and view all the answers

    In a fixed exchange rate regime, monetary policy is constrained because the central bank must prioritize maintaining the ______ over other economic goals.

    <p>exchange rate</p> Signup and view all the answers

    A speculative attack involves a massive selling of domestic currency ______.

    <p>assets</p> Signup and view all the answers

    Maintaining an overvalued exchange rate for a long time can eventually drain international ______.

    <p>reserves</p> Signup and view all the answers

    The policy trilemma indicates a central bank can only pursue two of three goals: independent monetary policy, fixed exchange rate, or free international ______.

    <p>capital flows</p> Signup and view all the answers

    Devaluations linked to speculative attacks can turn into a self-fulfilling ______.

    <p>prophecy</p> Signup and view all the answers

    To counteract selling pressure, a central bank could increase the real ______.

    <p>interest rate</p> Signup and view all the answers

    If the central bank depletes its reserves due to selling pressure, the exchange rate is likely to fall from E______ to Efun.

    <p>peg</p> Signup and view all the answers

    When the central bank chooses to maintain a fixed exchange rate, it can no longer use its ______ effectively to stabilize the domestic economy.

    <p>monetary policy</p> Signup and view all the answers

    Speculative attacks create extra ______ pressure on a currency.

    <p>selling</p> Signup and view all the answers

    The Thai baht was pegged to the US dollar at a rate of 25 baht to 1 ______.

    <p>USD</p> Signup and view all the answers

    Investors borrowed funds where interest rates were comparatively low in order to invest in ______ with high returns.

    <p>Asia</p> Signup and view all the answers

    The artificially high real interest rate led to an ______ bubble in Thailand.

    <p>asset</p> Signup and view all the answers

    The speculative attack on the baht resulted in a sharp ______ of the currency.

    <p>devaluation</p> Signup and view all the answers

    With dwindling foreign reserves, the Thai central bank was forced to ______ the Baht.

    <p>float</p> Signup and view all the answers

    In Australia before 1983 we had side ______, then since 1983 we have had side b.

    <p>a</p> Signup and view all the answers

    A fixed exchange rate and independent monetary policy, but no free ______ flows, is one scenario of the policy trilemma.

    <p>capital</p> Signup and view all the answers

    To stabilize the domestic economy, a central bank might lower the ______ rate in an independent monetary policy scenario.

    <p>interest</p> Signup and view all the answers

    In a speculative attack, investors sell off a currency, putting downward pressure on the ______ rate.

    <p>exchange</p> Signup and view all the answers

    The East Asian Crisis of 1997-98 was partly due to currencies being pegged to the ______ dollar for years.

    <p>USD</p> Signup and view all the answers

    Central banks raised real interest rates to mitigate the likelihood of ______, inadvertently causing domestic recession.

    <p>devaluation</p> Signup and view all the answers

    A central bank uses international reserves to support a fixed exchange rate system, maintaining ______ stability.

    <p>currency</p> Signup and view all the answers

    The policy trilemma suggests that it is impossible to maintain a fixed exchange rate with ______ capital flows and independent monetary policy.

    <p>free</p> Signup and view all the answers

    Study Notes

    Monetary Policy and the Exchange Rate

    • Monetary policy in open economies can influence exchange rates, creating an additional channel for monetary policy to impact the economy
    • An increase in the real interest rate (r) increases demand for local currency assets and decreases supply, leading to an appreciation of the exchange rate
    • An appreciation of the exchange rate reduces net exports, because imports become cheaper and exports more expensive

    Fixed Exchange Rate Regimes

    • A central bank can maintain a fixed exchange rate regime by buying and selling its currency to counter excess demand and supply, using international reserves.
    • An overvalued exchange rate, where the fixed rate is higher than the fundamental rate, leads to excess supply of the currency and depletion of international reserves
    • A fixed exchange rate can limit the effectiveness of monetary policy, as the central bank may need to adjust interest rates to defend the peg
    • An unsustainable fixed exchange rate can lead to a speculative attack.

    Speculative Attacks

    • Speculative attacks are a large-scale selling of a country's currency assets, motivated by expectations of devaluation.
    • They can deplete a country's foreign reserves, increasing the likelihood of devaluation and creating a self-fulfilling prophecy.

    The Policy Trilemma

    • The policy trilemma states that a country can only choose two of these three goals simultaneously:
      • Independent monetary policy (setting the real interest rate as needed to achieve domestic economic objectives)
      • A fixed exchange rate
      • Free international capital flows (no capital controls)
    • Maintaining a fixed exchange rate and free capital flows restricts the ability of a country to use monetary policy for domestic stabilization
    • Independent monetary policy and free capital flows generally require a flexible exchange rate
    • A fixed exchange rate and independent monetary policy require capital controls to limit capital flows.

    Case Study: Thailand

    • The Thai Baht was pegged to the USD, attracting large foreign investment due to high real interest rates in Thailand
    • The inflow of foreign capital led to an asset bubble
    • When investors realized that the peg was unsustainable, they sold their baht assets, leading to a speculative attack and depletion of the Thai central bank's foreign reserves.
    • The Baht was forced to float, causing a devaluation and cascading economic crisis.

    Monetary Policy and the Exchange Rate

    • Central bank changes demand using changes in real interest rate (r)
    • Changes in r also affect demand through the exchange rate channel
    • An increase in r increases demand for local currency assets and decreases supply of local currency assets, appreciating the exchange rate and reducing net exports
    • A decrease in r decreases demand for local currency assets and increases supply of local currency assets, depreciating the exchange rate and increasing net exports

    Fixed Exchange Rate Regimes

    • Central bank may fix exchange rate at a target level against a major currency or a commodity, like gold
    • Fixing exchange rate may reduce volatility in the macroeconomy driven by exchange rate fluctuations
    • Key concern: exchange rate may be fixed at a level that is too high or too low relative to fundamentals
    • The exchange rate is undervalued if Epeg < Efun. The exchange rate is overvalued if Epeg > Efun
    • To maintain the peg, central bank must buy/sell its currency to soak up excess demand/supply
    • Central banks have limited international reserves

    Speculative Attacks

    • A speculative attack is a massive selling of domestic currency assets
    • Investors sell domestic currency assets if they expect devaluation
    • Such selling requires the central bank to deplete international reserves
    • Depleting international reserves makes devaluation even more likely
    • Devaluations can be the result of a self-fulfilling prophecy

    The Policy 'Trilemma'

    • A central bank’s policy trilemma is that it can choose to pursue only two of the following three goals simultaneously:
      • Independent monetary policy (setting r as needed)
      • Fixed exchange rate
      • Free international capital flows (no capital controls)
    • Fixed exchange rate and free capital flows means no independent monetary policy.
    • Independent monetary policy and free capital flows means no fixed exchange rate
    • Fixed exchange rate and independent monetary policy means no free capital flows

    Case Study: Thailand

    • In Thailand, the baht was pegged to the US dollar at a rate of 25 baht to 1 USD
    • Thai central bank supported the peg by maintaining high real interest rates, attracting excessive foreign investment into Thailand
    • Investors borrowed funds in the US (low interest rates) and purchased assets in Asia at high rates, causing an asset bubble
    • When investors realized the baht’s peg was not sustainable, they triggered a speculative attack
    • The Thai central bank was forced to float the baht, causing a sharp devaluation, which led to a collapse in the value of baht-denominated assets and a region-wide economic crisis.

    Monetary Policy and the Exchange Rate

    • Central banks can manipulate demand through interest rates
    • Increased interest rates increase the demand for local currency assets, reducing the supply and appreciating the exchange rate
    • Decreased interest rates decrease the demand for local currency assets, increasing the supply and depreciating the exchange rate
    • Monetary policy is potentially amplified by changes in the exchange rate
    • Flexible exchange rates are key to the effectiveness of monetary policy

    Fixed Exchange Rate Regimes

    • Central banks can fix an exchange rate against another currency (like USD) or commodity (like gold)
    • Fixing the exchange rate can reduce macro-economic volatility caused by exchange rate fluctuations
    • Maintaining a fixed exchange rate constraints the central banks ability to manipulate interest rates
    • Exchange rates can be pegged at an unsustainable rate
    • An exchange rate is undervalued if the pegged level (Epeg) is below the fundamental value (Efun)
    • An exchange rate is overvalued if the pegged level (Epeg) is above the fundamental value (Efun)
    • Maintaining an overvalued exchange rate uses the central banks international reserves
    • An undervalued exchange rate uses the central banks international reserves by selling its own currency
    • An overvalued exchange rate drains the central banks international reserves by buying its own currency
    • Unsustainable exchange rate pegging invites speculative attacks

    Speculative Attacks

    • Speculative attacks occur when investors sell domestic currency assets in anticipation of devaluation
    • This selling pressure forces the central bank to use its international reserves
    • Depleting the central banks international reserves makes devaluation more likely
    • Devaluation can be the result of a self-fulfilling prophecy

    The Policy Trilemma

    • Central Banks can only simultaneously pursue two goals out of three:
      • Independent monetary policy
      • Fixed exchange rate
      • Free International capital flows (no capital controls)
    • Fixing an exchange rate and having free capital flows will prevent an independent monetary policy
    • Having an independent monetary policy and free capital flows will prevent a fixed exchange rate
    • Fixing an exchange rate and having an independent monetary policy will prevent free capital flows

    Case Study: Thailand

    • Thai baht was pegged to USD at a rate of 25 baht to 1 USD
    • The Thai central bank supported the peg by maintaining high real interest rates
      • This discouraged domestic borrowing and encouraged foreign investment
    • Foreign investors borrowed USD at low rates and invested them in Thai assets at high rates
    • When the Thai baht depreciated against the USD, investors were unable to pay back their loans
    • This forced the Thai central bank to float the baht
    • The depreciation led to a collapse in Baht-denominated assets
    • The Thai economic crisis contributed to the East Asian crisis of 1997-98

    Monetary Policy and the Exchange Rate

    • Changes in interest rates affect demand through the exchange rate channel in an open economy, amplifying its effects.
    • An increase in interest rate appreciates the exchange rate, reducing net exports as the demand for the local currency increases.
    • A decrease in interest rate depreciates the exchange rate, increasing net exports as the demand for the local currency decreases.

    Exchange Rate Regimes: Australia

    • Australian exchange rate was fixed to the UK pound until 1972.
    • It transitioned to a crawling peg against a basket of currencies until 1983.
    • Australia has had a floating exchange rate since 1983.

    Fixed Exchange Rate Regimes

    • Central banks may fix the exchange rate at a target level against a major currency or a commodity like gold.
    • This helps mitigate volatility driven by exchange rate fluctuations.
    • However, it constrains monetary policy as the central bank must maintain the peg by using its international reserves.

    Undervalued vs. Overvalued Exchange Rates

    • An undervalued exchange rate occurs when the pegged exchange rate (Epeg) is lower than the fundamental value (Efun) where supply and demand balance.
    • An overvalued exchange rate occurs when the Epeg is higher than the Efun.
    • The central bank must buy or sell its currency to maintain the peg, affecting its international reserves.

    Unsustainable Pegs and Speculative Attacks

    • Maintaining an overvalued exchange rate for a long time will drain reserves leading to a devaluation.
    • Expectations of a future devaluation can cause a crisis as investors sell domestic currency assets, leading to a speculative attack.
    • This selling pressure requires the central bank to deplete its reserves, making devaluation more likely.

    The Policy Trilemma

    • A central bank can only pursue two out of the three goals:
      • Independent monetary policy (setting interest rates as needed).
      • Fixed exchange rate.
      • Free international capital flows with no capital controls.
    • Choosing fixed exchange rates and free capital flows means the central bank loses monetary policy independence.
    • Choosing independent monetary policy and free capital flows means the central bank cannot fix the exchange rate.
    • Choosing fixed exchange rates and monetary policy independence requires capital controls to prevent international capital flows from influencing the exchange rate.

    Case Study: Thailand

    • Thailand had a fixed exchange rate pegged to the US dollar in the 1990s.
    • High interest rates attracted foreign investment and caused an asset bubble.
    • With declining foreign reserves, Thailand was forced to float the Baht in 1997, leading to a sharp devaluation and an economic crisis.
    • This case reflects the risks associated with maintaining unsustainable pegs and the potential for speculative attacks.

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    Introductory Macroeconomics Lecture 20: Exchange Rates II 2024 PDF

    Description

    Explore how monetary policy affects exchange rates in open economies. This quiz covers fixed exchange rate regimes, their implications on net exports, and the challenges faced by central banks. Test your understanding of currency appreciation and its impact on economic policy.

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