Podcast
Questions and Answers
What is a potential downside of fixing an exchange rate?
What is a potential downside of fixing an exchange rate?
If the exchange rate is undervalued, what must a central bank do to maintain the peg?
If the exchange rate is undervalued, what must a central bank do to maintain the peg?
What happens when the exchange rate is overvalued?
What happens when the exchange rate is overvalued?
In a fixed exchange rate regime, which factor does a central bank rely on to maintain the exchange rate?
In a fixed exchange rate regime, which factor does a central bank rely on to maintain the exchange rate?
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What does it indicate if the pegged exchange rate is less than its fundamental value?
What does it indicate if the pegged exchange rate is less than its fundamental value?
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What is a key concern regarding fixed exchange rates?
What is a key concern regarding fixed exchange rates?
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How does a central bank respond when there's excess supply of its currency in a pegged system?
How does a central bank respond when there's excess supply of its currency in a pegged system?
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What limits a central bank's ability to defend an overvalued exchange rate?
What limits a central bank's ability to defend an overvalued exchange rate?
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What was the primary reason the Thai central bank maintained high real interest rates before the 1997 crisis?
What was the primary reason the Thai central bank maintained high real interest rates before the 1997 crisis?
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What consequence did the speculative attack on the Thai baht have on the economy?
What consequence did the speculative attack on the Thai baht have on the economy?
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How did investors leverage low interest rates in the US before the crisis?
How did investors leverage low interest rates in the US before the crisis?
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What effect did the devaluation of the baht have on the value of assets purchased by investors?
What effect did the devaluation of the baht have on the value of assets purchased by investors?
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What was a significant consequence of the artificially high real interest rates in Thailand?
What was a significant consequence of the artificially high real interest rates in Thailand?
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What is the primary consequence of having a fixed exchange rate with free capital flows and an independent monetary policy?
What is the primary consequence of having a fixed exchange rate with free capital flows and an independent monetary policy?
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Which statement best describes the policy trilemma?
Which statement best describes the policy trilemma?
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What risk is associated with maintaining an undervalued peg in exchange rates?
What risk is associated with maintaining an undervalued peg in exchange rates?
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How can central banks use international reserves to support a fixed exchange rate system?
How can central banks use international reserves to support a fixed exchange rate system?
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During the East Asian Crisis, what was a common response by central banks facing downward pressure on their exchange rates?
During the East Asian Crisis, what was a common response by central banks facing downward pressure on their exchange rates?
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What is an effect of a speculative attack on a currency?
What is an effect of a speculative attack on a currency?
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What happens when a central bank lowers interest rates while maintaining a fixed exchange rate?
What happens when a central bank lowers interest rates while maintaining a fixed exchange rate?
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Why is maintaining an independent monetary policy incompatible with a fixed exchange rate and free capital flows?
Why is maintaining an independent monetary policy incompatible with a fixed exchange rate and free capital flows?
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What occurs during a speculative attack on a currency?
What occurs during a speculative attack on a currency?
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What is a potential outcome of maintaining an overvalued exchange rate for too long?
What is a potential outcome of maintaining an overvalued exchange rate for too long?
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How can central banks attempt to counteract selling pressure during a speculative attack?
How can central banks attempt to counteract selling pressure during a speculative attack?
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What is a 'self-fulfilling prophecy' in the context of currency devaluation?
What is a 'self-fulfilling prophecy' in the context of currency devaluation?
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What is constrained by the need to maintain a fixed exchange rate?
What is constrained by the need to maintain a fixed exchange rate?
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What are the three goals a central bank must choose between in the policy trilemma?
What are the three goals a central bank must choose between in the policy trilemma?
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What happens to the exchange rate when a central bank's reserves are depleted due to speculative attacks?
What happens to the exchange rate when a central bank's reserves are depleted due to speculative attacks?
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What is the result of increasing interest rates (r) to defend an overvalued peg?
What is the result of increasing interest rates (r) to defend an overvalued peg?
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What happens to the exchange rate when there is an increase in the real interest rate?
What happens to the exchange rate when there is an increase in the real interest rate?
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How does a decrease in the real interest rate affect the exchange rate?
How does a decrease in the real interest rate affect the exchange rate?
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Which of the following statements is true about monetary policy in an open economy?
Which of the following statements is true about monetary policy in an open economy?
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What type of exchange rate regime did Australia adopt after 1983?
What type of exchange rate regime did Australia adopt after 1983?
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What is the primary concern with fixed exchange rate regimes?
What is the primary concern with fixed exchange rate regimes?
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How does an increase in the real interest rate affect the demand for local currency in an open economy?
How does an increase in the real interest rate affect the demand for local currency in an open economy?
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What is the effect of a decrease in the real interest rate on net exports in an open economy?
What is the effect of a decrease in the real interest rate on net exports in an open economy?
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What does a fixed exchange rate regime typically require from a central bank?
What does a fixed exchange rate regime typically require from a central bank?
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In relation to monetary policy effectiveness, what assumption is made about exchange rates in an open economy?
In relation to monetary policy effectiveness, what assumption is made about exchange rates in an open economy?
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What occurs when an economy has a fixed exchange rate and experiences an excess supply of its currency?
What occurs when an economy has a fixed exchange rate and experiences an excess supply of its currency?
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What is a likely consequence of a speculative attack on a currency under a fixed exchange rate regime?
What is a likely consequence of a speculative attack on a currency under a fixed exchange rate regime?
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How did Australia's exchange rate regime change after 1983?
How did Australia's exchange rate regime change after 1983?
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What is one of the factors that can amplify the effects of monetary policy in an open economy?
What is one of the factors that can amplify the effects of monetary policy in an open economy?
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The Thai baht was pegged to the US dollar at a rate of 20 baht to 1 USD before 1997.
The Thai baht was pegged to the US dollar at a rate of 20 baht to 1 USD before 1997.
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The excessive foreign investment in Thailand was primarily due to low real interest rates.
The excessive foreign investment in Thailand was primarily due to low real interest rates.
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A speculative attack on the baht led to its immediate appreciation.
A speculative attack on the baht led to its immediate appreciation.
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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.
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.
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The collapse of baht-denominated assets caused a localized economic crisis limited to Thailand.
The collapse of baht-denominated assets caused a localized economic crisis limited to Thailand.
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An increase in the real interest rate decreases the demand for local currency assets.
An increase in the real interest rate decreases the demand for local currency assets.
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In a fixed exchange rate regime, the central bank must maintain the exchange rate by managing the supply of its currency.
In a fixed exchange rate regime, the central bank must maintain the exchange rate by managing the supply of its currency.
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Monetary policy is always more effective in an open economy than in a closed economy.
Monetary policy is always more effective in an open economy than in a closed economy.
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A decrease in the real interest rate leads to a currency appreciation and a decrease in net exports.
A decrease in the real interest rate leads to a currency appreciation and a decrease in net exports.
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Australia adopted a floating exchange rate regime after 1983.
Australia adopted a floating exchange rate regime after 1983.
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Speculative attacks on currencies can occur more frequently in countries with fixed exchange rates.
Speculative attacks on currencies can occur more frequently in countries with fixed exchange rates.
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In an open economy, changes in the real interest rate do not affect net exports.
In an open economy, changes in the real interest rate do not affect net exports.
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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.
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.
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A central bank can maintain a fixed exchange rate without using its international reserves.
A central bank can maintain a fixed exchange rate without using its international reserves.
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If the pegged exchange rate is lower than the fundamental value, the currency is considered overvalued.
If the pegged exchange rate is lower than the fundamental value, the currency is considered overvalued.
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An overvalued exchange rate occurs when the pegged rate is greater than the fundamental value.
An overvalued exchange rate occurs when the pegged rate is greater than the fundamental value.
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Maintaining a fixed exchange rate can increase volatility in the macroeconomy due to fixed monetary policy.
Maintaining a fixed exchange rate can increase volatility in the macroeconomy due to fixed monetary policy.
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A central bank sells its currency when there is excess supply to maintain its currency peg.
A central bank sells its currency when there is excess supply to maintain its currency peg.
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International reserves serve as a tool for a central bank to defend an undervalued currency by selling its local currency.
International reserves serve as a tool for a central bank to defend an undervalued currency by selling its local currency.
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Fixed exchange rate regimes give a central bank complete independence in monetary policy decisions.
Fixed exchange rate regimes give a central bank complete independence in monetary policy decisions.
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A fixed exchange rate may not always reflect the economic fundamentals, leading to misalignments.
A fixed exchange rate may not always reflect the economic fundamentals, leading to misalignments.
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Central banks can maintain an overvalued exchange rate indefinitely without risking depletion of reserves.
Central banks can maintain an overvalued exchange rate indefinitely without risking depletion of reserves.
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Speculative attacks often occur when investors expect a future devaluation of a currency.
Speculative attacks often occur when investors expect a future devaluation of a currency.
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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.
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.
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Depleting international reserves increases the likelihood that a central bank will have to devalue its currency.
Depleting international reserves increases the likelihood that a central bank will have to devalue its currency.
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Increasing the interest rate (r) can be a strategy to defend a fixed exchange rate during selling pressure.
Increasing the interest rate (r) can be a strategy to defend a fixed exchange rate during selling pressure.
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In a scenario where the central bank faces selling pressure, it can still effectively use monetary policy to manage domestic economic issues like unemployment.
In a scenario where the central bank faces selling pressure, it can still effectively use monetary policy to manage domestic economic issues like unemployment.
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Speculative attacks can be seen as a form of a self-fulfilling prophecy for currency devaluation.
Speculative attacks can be seen as a form of a self-fulfilling prophecy for currency devaluation.
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A central bank's ability to defend an overvalued exchange rate is not limited by its international reserves.
A central bank's ability to defend an overvalued exchange rate is not limited by its international reserves.
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Australia had a fixed exchange rate system before 1983.
Australia had a fixed exchange rate system before 1983.
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Raising interest rates can help manage a devaluation in a fixed exchange rate regime.
Raising interest rates can help manage a devaluation in a fixed exchange rate regime.
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The policy trilemma states that a country can achieve all three of fixed exchange rate, independent monetary policy, and free capital flows simultaneously.
The policy trilemma states that a country can achieve all three of fixed exchange rate, independent monetary policy, and free capital flows simultaneously.
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During the East Asian Crisis, many countries maintained a fixed exchange rate pegged to the GBR.
During the East Asian Crisis, many countries maintained a fixed exchange rate pegged to the GBR.
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An independent monetary policy allows a central bank to control inflation effectively under a fixed exchange rate regime.
An independent monetary policy allows a central bank to control inflation effectively under a fixed exchange rate regime.
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Speculative attacks can lead to the forced devaluation of a currency under pressure.
Speculative attacks can lead to the forced devaluation of a currency under pressure.
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Capital controls can be used to support a fixed exchange rate by limiting the flow of currency across borders.
Capital controls can be used to support a fixed exchange rate by limiting the flow of currency across borders.
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Lowering interest rates while maintaining a fixed exchange rate will always increase a currency's value.
Lowering interest rates while maintaining a fixed exchange rate will always increase a currency's value.
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How does an increase in the real interest rate affect net exports in an open economy?
How does an increase in the real interest rate affect net exports in an open economy?
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What role does the exchange rate channel play in monetary policy effectiveness in an open economy?
What role does the exchange rate channel play in monetary policy effectiveness in an open economy?
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What is one consequence of maintaining a fixed exchange rate when there is excess supply of currency?
What is one consequence of maintaining a fixed exchange rate when there is excess supply of currency?
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Why is it assumed that monetary policy is more effective in an open economy?
Why is it assumed that monetary policy is more effective in an open economy?
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What typically happens to a country's currency during a speculative attack under a fixed exchange rate regime?
What typically happens to a country's currency during a speculative attack under a fixed exchange rate regime?
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How does an increase in the real interest rate affect the demand for local currency in an open economy?
How does an increase in the real interest rate affect the demand for local currency in an open economy?
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What is the policy 'trilemma' in the context of exchange rates?
What is the policy 'trilemma' in the context of exchange rates?
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What effect does a decrease in the real interest rate have on the exchange rate?
What effect does a decrease in the real interest rate have on the exchange rate?
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What is the role of a central bank in maintaining a fixed exchange rate when it is pegged too low?
What is the role of a central bank in maintaining a fixed exchange rate when it is pegged too low?
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How does an overvalued exchange rate affect a central bank's international reserves?
How does an overvalued exchange rate affect a central bank's international reserves?
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What happens to the exchange rate when the central bank runs out of international reserves?
What happens to the exchange rate when the central bank runs out of international reserves?
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In a fixed exchange rate regime, what may happen if a currency is pegged above its fundamental value?
In a fixed exchange rate regime, what may happen if a currency is pegged above its fundamental value?
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What creates a challenge for a central bank that pegs its currency too low?
What creates a challenge for a central bank that pegs its currency too low?
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Why might a central bank choose to fix the exchange rate against a commodity like gold?
Why might a central bank choose to fix the exchange rate against a commodity like gold?
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What is a potential risk of maintaining a fixed exchange rate in the context of global capital flows?
What is a potential risk of maintaining a fixed exchange rate in the context of global capital flows?
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What is the relationship between exchange rate pegging and international reserves?
What is the relationship between exchange rate pegging and international reserves?
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What event prompted the Thai central bank to float the baht in 1997?
What event prompted the Thai central bank to float the baht in 1997?
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How did high real interest rates contribute to the economic challenges in Thailand prior to the 1997 crisis?
How did high real interest rates contribute to the economic challenges in Thailand prior to the 1997 crisis?
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What is the implication of the baht's peg to the US dollar for investors borrowing funds in the US?
What is the implication of the baht's peg to the US dollar for investors borrowing funds in the US?
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What was the relationship between Thailand's foreign reserves and its currency peg?
What was the relationship between Thailand's foreign reserves and its currency peg?
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Explain the potential consequences for investors if the baht experienced a 50% devaluation.
Explain the potential consequences for investors if the baht experienced a 50% devaluation.
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What are the implications of removing capital controls in a fixed exchange rate and independent monetary policy scenario?
What are the implications of removing capital controls in a fixed exchange rate and independent monetary policy scenario?
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How did the speculative attack on the Thai baht affect its currency value during the East Asian crisis?
How did the speculative attack on the Thai baht affect its currency value during the East Asian crisis?
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Why might a central bank choose to raise interest rates to defend an overvalued exchange rate?
Why might a central bank choose to raise interest rates to defend an overvalued exchange rate?
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What role do international reserves play in supporting a fixed exchange rate system?
What role do international reserves play in supporting a fixed exchange rate system?
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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?
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?
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How can a central bank mitigate risks associated with maintaining an undervalued peg?
How can a central bank mitigate risks associated with maintaining an undervalued peg?
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What were the consequences of raising real interest rates in Thailand prior to the 1997 crisis?
What were the consequences of raising real interest rates in Thailand prior to the 1997 crisis?
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What general economic condition is likely to prompt a speculative attack on a fixed exchange rate?
What general economic condition is likely to prompt a speculative attack on a fixed exchange rate?
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What is a speculative attack and what causes investors to initiate one?
What is a speculative attack and what causes investors to initiate one?
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How does a central bank's choice to maintain an overvalued peg impact its reserves?
How does a central bank's choice to maintain an overvalued peg impact its reserves?
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What are the three goals of the policy trilemma that a central bank must choose between?
What are the three goals of the policy trilemma that a central bank must choose between?
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In what way can changing interest rates (r) influence the demand for domestic currency assets?
In what way can changing interest rates (r) influence the demand for domestic currency assets?
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What does it mean when an exchange rate is described as a 'self-fulfilling prophecy'?
What does it mean when an exchange rate is described as a 'self-fulfilling prophecy'?
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Why might a central bank be unable to use interest rates to stabilize the domestic economy while maintaining a fixed exchange rate?
Why might a central bank be unable to use interest rates to stabilize the domestic economy while maintaining a fixed exchange rate?
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What happens to exchange rates when a central bank's international reserves deplete during a speculative attack?
What happens to exchange rates when a central bank's international reserves deplete during a speculative attack?
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How does increasing the real interest rate (r) in response to selling pressure affect the market?
How does increasing the real interest rate (r) in response to selling pressure affect the market?
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An increase in the real interest rate r appreciates the exchange rate and reduces net ______.
An increase in the real interest rate r appreciates the exchange rate and reduces net ______.
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In a fixed exchange rate regime, the central bank uses its foreign ______ to maintain the exchange rate.
In a fixed exchange rate regime, the central bank uses its foreign ______ to maintain the exchange rate.
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A speculative attack can lead to a rapid decline in the value of a ______.
A speculative attack can lead to a rapid decline in the value of a ______.
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The policy 'trilemma' suggests a limit to achieving an independent monetary policy, free capital flows, and a fixed ______.
The policy 'trilemma' suggests a limit to achieving an independent monetary policy, free capital flows, and a fixed ______.
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Australia adopted a floating exchange rate regime in ______.
Australia adopted a floating exchange rate regime in ______.
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A decrease in the real interest rate decreases demand for local currency assets and ______ the exchange rate.
A decrease in the real interest rate decreases demand for local currency assets and ______ the exchange rate.
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Monetary policy impacts demand through the ______ rate channel in an open economy.
Monetary policy impacts demand through the ______ rate channel in an open economy.
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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.
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.
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Central banks may fix the nominal exchange rate either against some major ______ or against a commodity, like gold.
Central banks may fix the nominal exchange rate either against some major ______ or against a commodity, like gold.
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When the exchange rate is undervalued, it indicates that the pegged exchange rate Epeg is ______ than the fundamental value Efun.
When the exchange rate is undervalued, it indicates that the pegged exchange rate Epeg is ______ than the fundamental value Efun.
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To maintain a peg, the central bank must be willing and able to buy or sell its currency to soak up excess ______ or supply.
To maintain a peg, the central bank must be willing and able to buy or sell its currency to soak up excess ______ or supply.
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An overvalued exchange rate occurs when the pegged rate Epeg exceeds the fundamental value Efun, leading to excess ______ of the currency.
An overvalued exchange rate occurs when the pegged rate Epeg exceeds the fundamental value Efun, leading to excess ______ of the currency.
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The ability of a central bank to defend an overvalued exchange rate is limited by its stock of international ______.
The ability of a central bank to defend an overvalued exchange rate is limited by its stock of international ______.
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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 ______.
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 ______.
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When a central bank lowers interest rates while maintaining a fixed exchange rate, it risks ______ pressure on the currency.
When a central bank lowers interest rates while maintaining a fixed exchange rate, it risks ______ pressure on the currency.
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In a fixed exchange rate regime, monetary policy is constrained because the central bank must prioritize maintaining the ______ over other economic goals.
In a fixed exchange rate regime, monetary policy is constrained because the central bank must prioritize maintaining the ______ over other economic goals.
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A speculative attack involves a massive selling of domestic currency ______.
A speculative attack involves a massive selling of domestic currency ______.
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Maintaining an overvalued exchange rate for a long time can eventually drain international ______.
Maintaining an overvalued exchange rate for a long time can eventually drain international ______.
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The policy trilemma indicates a central bank can only pursue two of three goals: independent monetary policy, fixed exchange rate, or free international ______.
The policy trilemma indicates a central bank can only pursue two of three goals: independent monetary policy, fixed exchange rate, or free international ______.
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Devaluations linked to speculative attacks can turn into a self-fulfilling ______.
Devaluations linked to speculative attacks can turn into a self-fulfilling ______.
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To counteract selling pressure, a central bank could increase the real ______.
To counteract selling pressure, a central bank could increase the real ______.
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If the central bank depletes its reserves due to selling pressure, the exchange rate is likely to fall from E______ to Efun.
If the central bank depletes its reserves due to selling pressure, the exchange rate is likely to fall from E______ to Efun.
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When the central bank chooses to maintain a fixed exchange rate, it can no longer use its ______ effectively to stabilize the domestic economy.
When the central bank chooses to maintain a fixed exchange rate, it can no longer use its ______ effectively to stabilize the domestic economy.
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Speculative attacks create extra ______ pressure on a currency.
Speculative attacks create extra ______ pressure on a currency.
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The Thai baht was pegged to the US dollar at a rate of 25 baht to 1 ______.
The Thai baht was pegged to the US dollar at a rate of 25 baht to 1 ______.
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Investors borrowed funds where interest rates were comparatively low in order to invest in ______ with high returns.
Investors borrowed funds where interest rates were comparatively low in order to invest in ______ with high returns.
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The artificially high real interest rate led to an ______ bubble in Thailand.
The artificially high real interest rate led to an ______ bubble in Thailand.
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The speculative attack on the baht resulted in a sharp ______ of the currency.
The speculative attack on the baht resulted in a sharp ______ of the currency.
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With dwindling foreign reserves, the Thai central bank was forced to ______ the Baht.
With dwindling foreign reserves, the Thai central bank was forced to ______ the Baht.
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In Australia before 1983 we had side ______, then since 1983 we have had side b.
In Australia before 1983 we had side ______, then since 1983 we have had side b.
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A fixed exchange rate and independent monetary policy, but no free ______ flows, is one scenario of the policy trilemma.
A fixed exchange rate and independent monetary policy, but no free ______ flows, is one scenario of the policy trilemma.
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To stabilize the domestic economy, a central bank might lower the ______ rate in an independent monetary policy scenario.
To stabilize the domestic economy, a central bank might lower the ______ rate in an independent monetary policy scenario.
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In a speculative attack, investors sell off a currency, putting downward pressure on the ______ rate.
In a speculative attack, investors sell off a currency, putting downward pressure on the ______ rate.
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The East Asian Crisis of 1997-98 was partly due to currencies being pegged to the ______ dollar for years.
The East Asian Crisis of 1997-98 was partly due to currencies being pegged to the ______ dollar for years.
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Central banks raised real interest rates to mitigate the likelihood of ______, inadvertently causing domestic recession.
Central banks raised real interest rates to mitigate the likelihood of ______, inadvertently causing domestic recession.
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A central bank uses international reserves to support a fixed exchange rate system, maintaining ______ stability.
A central bank uses international reserves to support a fixed exchange rate system, maintaining ______ stability.
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The policy trilemma suggests that it is impossible to maintain a fixed exchange rate with ______ capital flows and independent monetary policy.
The policy trilemma suggests that it is impossible to maintain a fixed exchange rate with ______ capital flows and independent monetary policy.
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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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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.
