1.2 Flashcards
why would countries fix ERs
reduce exchange rate uncertainty (+ve impact on trade and investment flows),
make exports more competitive (gain from undervalued currency),
import credibility of foreign central bank’s monetary policy,
achieve quick reduction in inflation (hyper inflation requires)
what can fixed ERs be vulnerable to
speculative attacks and currency crises
what are a central banks assets
official international reserves - foreign government bonds and gold,
domestic credit - domestic government bonds and loans to domestic banks
what are a central banks liabilities
currency (notes and coins in circulation),
deposits of domestic banks at CB
equation for balance sheet of central bank
assets = liabilities + net worth, dt + rt = ht + nwt, ht high-powered money dt domestic credit rt international reserves nwt net worth
equation for balance sheet of central bank with constant net worth
∆liabilities = ∆assets, ∆ht = ∆dt + ∆rt, ht high-powered money dt domestic credit rt international reserves
what happens to the central banks balance sheet when the cb buys domestic government bonds with fresh money (∆liabilities = ∆assets,
∆ht = ∆dt + ∆rt)
increase in assets leads to equal increase in liabilities, dt up, pays with fresh money ht up,
ht high-powered money
dt domestic credit
what happens to the central banks balance sheet when the cb sells domestic government bonds (∆liabilities = ∆assets,
∆ht = ∆dt + ∆rt)
decrease in assets decrease in liabilities, dt down, it takes money out of the economy ht down
what happens to the central banks balance sheet when the cb buys (sells) foreign government bonds (∆liabilities = ∆assets,
∆ht = ∆dt + ∆rt)
increase (decrease) in assets leads to equal increase (decrease) in liabilities, cb buys (sells) foreign bonds rt up (rt down) (international reserves denominated in foreign currency) pays for these (receives payment) with domestic money ht up
what is the difference between normal interventions by the central bank and sterilized interventions
normal: CB buying/selling international reserves,
sterilized: CB buying/selling international reserves and
CB selling/buying domestic gov. bonds such that ∆dt=-∆rt and therefore ∆ht=0
why would a central bank do a sterilized intervention
keep ht the same therefore interest rates the same,
(sterilized: CB buying/selling international reserves and
CB selling/buying domestic gov. bonds such that ∆dt=-∆rt and therefore ∆ht=0)
what does a credible fixed exchange rate regime require
Etst+1=Etst+2=st=sbar,
FOREX market equilibrium requires it=i*,
cb no longer have control over it,
(look at forex equation if Etst+1=st)
what is one negative of fixed exchange rates
home cb must follow what foreign cb does,
if foreign cb raises it* by contracting money supply mt*… home cb must do the same irrespective of other policy goals
what is normally the fundamental cause of crises
unsustainable fiscal policy,
the gov. has a deficit every period which must be financed by domestic credit creation
what is the relationship between mt and ht
mt = Xht,
X=money multiplier and ht high-powered money
what is the shadow exchange rate
floating ER that would prevail if speculators purchased all remaining reserves rt and the peg were abandoned after a successful attack, st=stildat
what is the shadow exchange rate used for
crucial concept when evaluating profit opportunities of currency speculators, gives price at which they will be able to sell the reserves they bought from cb
what is the gradient of the shadow exchange rate
stildat a line with gradient μ bec once peg abandoned, the floating rate must depreciate at rate μ
what is the basic idea of the currency crisis and speculators p1
cause gov deficit every period (μ),
gov cannot print money (mt fixed) so must borrow every period by issuing bonds rate μ (cb buys, issues domestic credit ∆d=μ)
speculators understand that fixed rate s incompatible with draining FOREX reserves every period
what is the basic idea of the currency crisis and speculators p2
CB dt up (domestic credit up) normally ht up but not compatible with fixed so increase in dt matched by decrease in rt (forex reserves),
attack takes place once forex reserves exhausted rt=0,
ER peg abandones st float,
deficit now financed by printing money ht=dt, ∆h=∆d=μ
how do the speculators make money in currency crises
see that international reserves can only go down so far,
sell home currency short at fixed s rate,
when s goes flexible and depreciates buy back and settle position
why is speculating for a currency crisis harder in reality
uncertainty about rate of domestic credit growth over time or about level of reserves r at which the peg is abandoned, some agents (domestic banks, rich asset holders) have informational advantage
do currency speculators always win
no, plenty of times markets sell currency and CB defends currency and peg remains
what do cbs sometimes do when markets become suspicious the peg is not sustainable and start selling
CBs rather than lose a lot of foreign exchange reserves will just increase interest rates by enough to compensate
