Chapter 18

Fixed Exchange Rates and

Foreign Exchange Intervention

Copyright © 2023 Pearson Education, Ltd.

Learning Objectives
18.1 Understand how a central bank must manage monetary
policy so as to fix its currency’s value in the foreign exchange
market.
18.2 Describe and analyze the relationship among the central
bank’s foreign exchange reserves, its purchases and sales in
the foreign exchange market, and the money supply.
18.3 Explain how monetary, fiscal, and sterilized intervention
policies affect the economy under a fixed exchange rate.
18.4 Discuss causes and effects of balance of payments crises.
18.5 Describe how alternative multilateral systems for pegging
exchange rates work

2
Preview
• Balance sheets of central banks
• Intervention in the foreign exchange markets and the
money supply
• How the central bank fixes the exchange rate
• Monetary and fiscal policies under fixed exchange rates
• Financial market crises and capital flight
• Types of fixed exchange rates: reserve currency and
gold standard systems

3
Introduction
• Many countries try to fix or “peg” their exchange rate to a
currency or group of currencies by intervening in the
foreign exchange markets.
• Many with a flexible or “floating” exchange rate in fact
practice a managed floating exchange rate.
– The central bank “manages” the exchange rate from
time to time by buying and selling currency and
assets, especially in periods of exchange rate
volatility.
• How do central banks intervene in the foreign exchange
markets?
4
FT: Exchange Rate Regimes
• Exchange rate regimes in 2010

5
FT: Exchange
Rate Regimes
(2010)

6
Exchange Rate Regimes of the World
• No separate legal tender
– No currency of their own (dollarized or currency union)
• Currency board
– Fixed regime that has special legal and procedural rules designed to
make the peg “harder”
• Other pegs
– Variations of less than 1%, fixed to a single or a basket of currencies
• Crawling pegs
– Depreciation/appreciation can happen gradually

7
Central Bank Intervention and the Money Supply

• To study the effects of central bank intervention in the foreign exchange

markets, first construct a simplified balance sheet for the central bank.
– This records the assets and liabilities of a central bank.
– Balance sheets use double-entry bookkeeping: each transaction enters
the balance sheet twice.

8
Central Bank’s Balance Sheet (1 of 2)

• Assets
– Foreign government bonds (official international reserves)
– Gold (official international reserves)
– Domestic government bonds
– Loans to domestic banks (called discount loans in United States)
• Liabilities
– Deposits of domestic banks
– Currency in circulation (previously central banks had to give up gold when
citizens brought currency to exchange)
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Central Bank’s Balance Sheet (2 of 2)
• Assets = Liabilities + Net Worth
– If assume that net worth is constant, then
▪ An increase in assets leads to an equal increase in
liabilities.
▪ A decrease in assets leads to an equal decrease in
liabilities.
• Changes in the central bank’s balance sheet lead to changes in
currency in circulation or changes in deposits of banks, which
lead to changes in the money supply (called monetary base).
– If their deposits at the central bank increase, banks are
usually able to use these additional funds to lend to
customers, so amount of money in circulation increases.
10
Central Bank’s Balance Sheet

• Selling foreign assets ($100)

• Paid with domestic currency

11
Assets, Liabilities, and the Money
Supply (1 of 2)

• A purchase of any asset by the central bank will be paid

for with currency or a check written from the central bank,
– both of which are denominated in domestic currency,
and
– both of which increase the supply of money in
circulation.
– The transaction leads to equal increases of assets and
liabilities.
• When the central bank buys domestic bonds or foreign
bonds, the domestic money supply increases.

12
 Assets, Liabilities, and the Money
Supply (2 of 2)

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

13
Foreign Exchange Markets
• Central banks trade foreign government bonds in the
foreign exchange markets.
– Foreign currency deposits and foreign government
bonds are often substitutes: both are fairly liquid
assets denominated in foreign currency.
– Quantities of both foreign currency deposits and
foreign government bonds that are bought and sold
influence the exchange rate.

14
Sterilization
• Because buying and selling of foreign bonds in the
foreign exchange markets affects the domestic money
supply, a central bank may want to offset this effect.
• This offsetting effect is called sterilization.
• If the central bank sells foreign bonds in the foreign
exchange markets, it can buy domestic government
bonds in bond markets—hoping to leave the amount of
money in circulation unchanged.

15
Sterilization

• Selling foreign assets ($100)

• Buying domestic assets ($100)

16
Table 18.1 Effects of a $100 Foreign Exchange
Intervention: Summary
Domestic Central Effect on Domestic Effect on Central Effect on Central
Bank’s Action Money Supply Bank’s Domestic Bank’s Foreign
Assets Assets
Nonsterilized foreign +$100 0 +$100
exchange purchase
$100
Negative $100

Sterilized foreign 0 +$100

exchange purchase
Nonsterilized foreign $100
Negative $100
0 $100
Negative $100

exchange sale
Sterilized foreign 0 +$100 $100
Negative $100

exchange sale

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Fixed Exchange Rates (1 of 4)
• To fix the exchange rate, a central bank influences the quantities
supplied and demanded of currency by trading domestic and
foreign assets, so that the exchange rate (the price of foreign
currency in terms of domestic currency) stays constant.
• Foreign exchange markets are in equilibrium when

RR 

 E e
E 
E

• When the exchange rate is fixed at some level E 0 and the

market expects it to stay fixed at that level, then

R R*
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Fixed Exchange Rates (2 of 4)
• To fix the exchange rate, the central bank must trade foreign
and domestic assets in the foreign exchange market until
R  R .

• Alternatively, we can say that it adjusts the quantity of

monetary assets in the money market until the domestic
interest rate equals the foreign interest rate, given the level
of average prices and real output:

MS
 L(R  ,Y )
P

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Fixed Exchange Rates (3 of 4)
• Suppose that the central bank has fixed the exchange
rate at E 0 but the level of output rises, raising the
demand of real monetary assets.

• This is predicted to put upward pressure on interest rates

and the value of the domestic currency.
• How should the central bank respond if it wants to fix
exchange rates?

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Fixed Exchange Rates (4 of 4)
• The central bank should buy foreign assets in the foreign
exchange markets,
– thereby increasing the domestic money supply,
– thereby reducing interest rates in the short run.
– Alternatively, by demanding (buying) assets
denominated in foreign currency and by supplying
(selling) domestic currency, the price/value of foreign
currency is increased and the price/value of domestic
currency is decreased.

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 Figure 18.1 Asset Market Equilibrium With a Fixed
0
Exchange Rate, E E sub 0

To hold the exchange rate fixed at E 0 when output rises

from Y 1 to Y 2 , the central bank must purchase foreign
assets and thereby raise the money supply from M 1 to M 2 .

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Monetary Policy and Fixed Exchange Rates

• When the central bank buys and sells foreign assets to

keep the exchange rate fixed and to maintain domestic
interest rates equal to foreign interest rates, it is not able
to adjust domestic interest rates to attain other goals.
– In particular, monetary policy is ineffective in
influencing output and employment.

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 Figure 18.2 Monetary Expansion Is Ineffective Under a
Fixed Exchange Rate

Initial equilibrium is shown at point 1, where the output and asset markets simultaneously clear at a fixed exchange rate of
E 0 and an output level of Y 1. Hoping to increase output to Y 2 , the central bank decides to increase the money supply by
buying domestic assets and shifting AA1 to AA2 . Because the central bank must maintain E 0 , however, it has to sell foreign
assets for domestic currency, an action that decreases the money supply immediately and returns AA2 back to AA1. The
economy’s equilibrium therefore remains at point 1, with output unchanged at Y 1.
24
Fiscal Policy and Fixed Exchange Rates in the Short
Run

• Temporary changes in fiscal policy are more effective in

influencing output and employment in the short run:
– The rise in aggregate demand and output due to
expansionary fiscal policy raises demand for real
monetary assets, putting upward pressure on interest
rates and on the value of the domestic currency.
– To prevent an appreciation of the domestic currency,
the central bank must buy foreign assets, thereby
increasing the money supply and decreasing interest
rates.

25
Figure 18.3 Fiscal Expansion Under a Fixed Exchange
Rate

Fiscal expansion (shown by the shift from DD1 to DD 2 ) and the

intervention that accompanies it (the shift from AA1 to AA2 ) move the
economy from point 1 to point 3.
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Fiscal Policy and Fixed Exchange Rates in the Long
Run (1 of 2)
• When the exchange rate is fixed, there is no real appreciation of the
value of domestic products in the short run.
• But when output is above its potential level, wages and prices tend
to rise in the long run.
• A rising price level makes domestic products more expensive:
 EP  
a real appreciation  falls  .
 P 
– Aggregate demand and output decrease as prices rise: DD
curve shifts left.
– Prices tend to rise until employment, aggregate demand, and
output fall to their normal (potential or natural) levels.

27
Fiscal Policy and Fixed Exchange Rates in the Long
Run (2 of 2)

• Prices are predicted to change proportionally to the

change in the money supply when the central bank
intervenes in the foreign exchange markets.
– AA curve shifts down (left) as prices rise.
– Nominal exchange rates will be constant (as long as
the fixed exchange rate is maintained), but the real
exchange rate will be lower (a real appreciation).

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Devaluation and Revaluation
• Depreciation and appreciation refer to changes in the value of a currency
due to market changes.
• Devaluation and revaluation refer to changes in a fixed exchange rate
caused by the central bank.
– With devaluation, a unit of domestic currency is made less valuable, so
that more units must be exchanged for 1 unit of foreign currency.
– With revaluation, a unit of domestic currency is made more valuable, so
that fewer units need to be exchanged for 1 unit of foreign currency.

29
Devaluation
• For devaluation to occur, the central bank buys foreign
assets, so that domestic monetary assets increase and
domestic interest rates fall, causing a fall in the rate
return on domestic currency deposits.
– Domestic products become less expensive relative to
foreign products, so aggregate demand and output
increase.
– Official international reserve assets (foreign bonds)
increase.

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Figure 18.4 Effect of a Currency Devaluation

When a currency is devalued from E 0 to E 1, the economy’s

equilibrium moves from point 1 to point 2 as both output and the money
supply expand.
31
Financial Crises and Capital Flight (1 of 6)

• When a central bank does not have enough official

international reserve assets to maintain a fixed exchange
rate, a balance of payments crisis (currency crisis)
results.
– To sustain a fixed exchange rate, the central bank
must have enough foreign assets to sell in order to
satisfy the demand of them at the fixed exchange
rate.

32
Financial Crises and Capital Flight (2 of 6)
• Investors may expect that the domestic currency will be
devalued, causing them to want foreign assets instead of
domestic assets, whose value is expected to fall soon.
1. This expectation or fear only makes the balance of
payments crisis worse:
– Investors rush to change their domestic assets into
foreign assets, depleting the stock of official
international reserve assets more quickly.

33
Financial Crises and Capital Flight (3 of 6)
2. As a result, financial capital is quickly moved from domestic assets
to foreign assets: capital flight.
– The domestic economy has a shortage of financial capital for
investment and has low aggregate demand.

3. To avoid this outcome, domestic assets must offer high interest

rates to entice investors to hold them.
– The central bank can push interest rates higher by reducing the
money supply (by selling foreign and domestic assets).

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

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

34
Figure 18.5 Capital Flight, the Money Supply, and the
Interest Rate

To hold the exchange rate fixed at E 0 after the

market decides it will be devalued to E 1, the central
bank must use its reserves to finance a private
financial outflow that shrinks the money supply and
raises the home interest rate.

35
Financial Crises and Capital Flight (4 of 6)

• Expectations of a balance of payments crisis only worsen the crisis and

hasten devaluation.
– What causes expectations to change?
▪ Expectations about the central bank’s ability and willingness to
maintain the fixed exchange rate.
▪ Expectations about the economy: shrinking demand of domestic
products relative to foreign products means that the domestic currency
should become less valuable.
• In fact, expectations of devaluation can cause a devaluation: a self-fulfilling
crisis.

36
Financial Crises and Capital Flight (5 of 6)
• What happens if the central bank runs out of official
international reserve assets (foreign assets)?
• It must devalue the domestic currency so that it takes more
domestic currency (assets) to exchange for 1 unit of foreign
currency (asset).
– This will allow the central bank to restore its foreign assets
by buying them back at a devalued rate,
– increasing the money supply,
– reducing interest rates,
– reducing the value of domestic products,
– increasing aggregate demand, output, and employment
over time.
37
Financial Crises and Capital Flight (6 of 6)

• In a balance of payments crisis,

– the central bank may buy domestic bonds and sell
domestic currency (to increase the money supply) to
prevent high interest rates, but this only depreciates
the domestic currency more.
– the central bank generally cannot satisfy the goals of
low domestic interest rates (relative to foreign interest
rates) and fixed exchange rates simultaneously.
• Markets can attack a strong currency as well.

38
Figure 18.6 The Swiss Franc’s Exchange Rate against the Euro and Swiss
Foreign Exchange Reserves, 2006–2016

The Swiss National Bank intervened heavily to slow the Swiss franc’s appreciation against the euro, setting a floor
under the price of the euro in September 2011 and abandoning that floor in January 2015.
39
Source: Swiss National Bank.
Interest Rate Differentials (1 of 3)
• For many countries, the expected rates of return are not

the same: R  R 

 E e
E .
Why?
E

• Default risk:
The risk that the country’s borrowers will default on their loan
repayments. Lenders therefore require a higher interest rate to
compensate for this risk.
• Exchange rate risk:
If there is a risk that a country’s currency will depreciate or be
devalued, then domestic borrowers must pay a higher interest
rate to compensate foreign lenders.

40
Interest Rate Differentials (2 of 3)
• Because of these risks, domestic assets and foreign assets are not treated the
same.
– Previously, we assumed that foreign and domestic currency deposits were
perfect substitutes: deposits everywhere were treated as the same type of
investment, because risk and liquidity of the assets were assumed to be the
same.
– In general, foreign and domestic assets may differ in the amount of risk that they
carry: they may be imperfect substitutes.
– Investors consider these risks, as well as rates of return on the assets, when
deciding whether to invest.

41
Interest Rate Differentials (3 of 3)
• A difference in the risk of domestic and foreign assets is
one reason why expected rates of return are not equal
across countries:

R R 

 E e
E 
E
where  is called a risk premium, an additional amount
needed to compensate investors for investing in risky
domestic assets.
• The risk could be caused by default risk or exchange rate
risk.
42
The Mexican Peso Crisis in 1994
• The Tequila crisis in 1994 (Mexico)
– Currency and banking crisis
• Background
– During the early 90s, Mexico attracted foreign investment
– Entered NAFTA (North American Free Trade Agreement) in 1994
– Crawling peg of the Mexican peso against USD
▪ Strong peso led to the current account deficits
– US raised the interest rate in 1994
– 1994 presidential election led to loose fiscal and monetary policy
– Assassination of the presidential candidate (political instability)

43
The Mexican Peso Crisis in 1994
• What happened
– Downward pressure on peso
– Mexico’s central bank used dollar reserves to maintain the exchange rate
– The peso devalued by 13% in December and the central bank was running
out of reserves. It abandoned the fixed exchange rate eventually.
– Investors pull their capital out of Mexico.
– Tightening of monetary and fiscal policies
• A recession in 1995
– Current account deficit: -5.8% to -0.5% from 1994 to 1995
– GDP: 4.8% to -6.2%
– Unemployment: 3.7% to 6.2%
– Inflation: 7% to 35.1%
44
The Rescue Package: Reducing 
rho

• The United States and IMF set up a $50 billion fund to guarantee the value of
loans made to Mexico’s government,
– reducing default risk,
– and reducing exchange rate risk, since foreign loans could act as official
international reserves to stabilize the exchange rate if necessary.
• After a recession in 1995, the economy began to recover.
– Mexican goods were relatively inexpensive, allowing production to
increase.
– Increased demand of Mexican products relative to demand of foreign
products stabilized the value of the peso and reduced exchange rate risk.

45
Peso vs. USD

46
Capital Flow and Reserves

47
Bond Yields in Selected
Countries
• Sovereign debt securities denominated in
USD
– The principal is backed by US treasury
bonds.

48
The Mexican Peso Crisis in 1994
• What caused the crisis?
• Can be several factors
• IMF listed three major views
– Adverse domestic political and external economic shocks
– An unsustainable external position
– Domestic policy slippages

49
Types of Fixed Exchange Rate Systems
• So far, we focused on a single country that fixes its
exchange rate in terms of a single foreign currency. In
reality, there are many currencies. Two systems in
history.
1. Reserve currency system: one currency acts as
official international reserves
– The U.S. dollar was the currency that acted as official
international reserves from under the fixed exchange rate
system from 1944 to 1973.
– All countries except the United States held U.S. dollars as
the means to make official international payments.
2. Gold standard: gold acts as official international reserves
that all countries use to make official international payments.
50
Reserve Currency System
• From 1944 to 1973, central banks throughout the world fixed the value of
their currencies relative to the U.S. dollar by buying or selling domestic
assets in exchange for dollar denominated assets.

• Arbitrage ensured that exchange rates between any two currencies

remained fixed.

– Suppose Bank of Japan fixed the exchange rate at 360 ¥ US$1

and the Bank of France fixed the exchange rate at 5Ffr US$1.

 360 ¥ 
 US$1  72 ¥
 =
– The yen/franc rate was  5Ffr  1Ffr
.
 US$1 
 

– If not, then currency traders could make an easy profit by buying

currency where it was cheap and selling it where it was expensive.
51
Figure 18.8 Growth Rates of International Reserves

Annualized growth rates of international reserves did not decline sharply after the early 1970s. Recently,
developing countries have added large sums to their reserve holdings, but their pace of accumulation has
slowed starting with the crisis years of 2008–2009. The figure shows averages of annual growth rates.
Source: International Monetary Fund. 52
FT: Reserve Accumulation, 1997-2012

53
 Figure 18.9 Currency Composition of Global Reserve
Holdings

While the euro’s role as a reserve currency increased during the first decade of its existence, it has taken a hit after the
euro crisis. The dollar remains the overwhelming favorite.
Source: International Monetary Fund, Currency Composition of Foreign Exchange Reserves (COFER), at
http://www.imf.org/external/np/sta/cofer/eng/index.htm . These data cover only the countries that report reserve
composition to the IMF.
54
FT: Do Fixed Exchange Rates Promote Trade?

55
FT: Output Costs of Fixed Exchange Rates

56
FT: Inflation Performance and the Exchange Rate
Regime

57
Summary (1 of 4)
1. Changes in a central bank’s balance sheet lead to
changes in the domestic money supply.
– Buying domestic or foreign assets increases the
domestic money supply.
– Selling domestic or foreign assets decreases the
domestic money supply.

2. When markets expect exchange rates to be fixed,

domestic and foreign assets have equal expected
returns if they are treated as perfect substitutes.

58
Summary (2 of 4)
3. Monetary policy is ineffective in influencing output or
employment under fixed exchange rates.
4. Temporary fiscal policy is more effective in influencing
output and employment under fixed exchange rates,
compared to under flexible exchange rates.

59
Summary (3 of 4)
5. A balance of payments crisis occurs when a central
bank does not have enough official international
reserves to maintain a fixed exchange rate.
6. Capital flight can occur if investors expect a
devaluation, which may occur if they expect that a
central bank can no longer maintain a fixed exchange
rate: self-fulfilling crises can occur.
7. Domestic and foreign assets may not be perfect
substitutes due to differences in default risk or due to
exchange rate risk.

60
Summary (4 of 4)
8. Under a reserve currency system, all central banks but
the one that controls the supply of the reserve currency
trade the reserve currency to maintain fixed exchange
rates.
9. Under a gold standard, all central banks trade gold to
maintain fixed exchange rates.

61
Figure 18A1.1 The Domestic Bond Supply and the Foreign Exchange Risk
Premium Under Imperfect Asset Substitutability

An increase in the supply of domestic currency bonds that the private sector
must hold raises the risk premium on domestic currency assets.

62
Figure 18.7 Effect of a Sterilized Central Bank Purchase of Foreign Assets
Under Imperfect Asset Substitutability

A sterilized purchase of foreign assets leaves the money

supply unchanged but raises the risk-adjusted return that

domestic currency deposits must offer in equilibrium. As

a result, the return curve in the upper panel shifts up and

to the right. Other things equal, this depreciates the

domestic currency from E 1 to E 2 .

63
 Figure 18A2.1 How the Timing of a Balance of Payments Crisis
Is Determined

The market stages a speculative attack and buys

the remaining foreign reserve stock FT at time T,

which is when the shadow floating exchange rate
ETS just equals the pre-collapse fixed exchange
rate E 0 .

64