International Finance: Theory & Policy,

12/e, Global Edition

Chapter 7
Fixed Exchange Rates
and Foreign Exchange
Intervention

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Learning Objectives
7.1 Understand how a central bank must manage
monetary policy so as to fix its currency’s value in the
foreign exchange market.
7.2 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.
7.3 Explain how monetary, fiscal, and sterilized
intervention policies affect the economy under a fixed
exchange rate.
7.4 Discuss causes and effects of balance of payments
crises.
7.5 Describe how alternative multilateral systems for
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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

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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?
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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.

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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.
– 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
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circulation increases.
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.
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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.
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• When the central bank sells domestic bonds or
Table 7.1 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
Sterilized foreign 0  $100 +$100
Negative $100

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

Sterilized foreign 0 +$100  $100

exchange sale
Negative $100

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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.

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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.

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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
R  R . until

• 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 E 0 but the level of output rises,
demand ofraising
at the
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 7.1 Asset Market Equilibrium With
0
a Fixed Exchange Rate, E E sub 0

To hold the exchange rate E 0 when output rises Y 1 to Y 2 , the

fixed at from central
bank must purchase foreign assets and thereby raise the money M 1 to M 2 .
supply from
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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 7.2 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 E 0 and an output level Y . Hoping to increase output
1

rate
Y 2 , the of
of central bank decides to increase the money supply to by buying domestic
shiftinassets
AA1 and
to AA2 . Because the central bank must E 0 , however, it has to
g
foreign assets for maintain sell the
domestic currency, an action that decreases
money supplyand
immediately AA2 back to AA1. The economy’s equilibrium therefore
returns
point 1, with output Y 1.
remains at
unchanged at Copyright © 2023 Pearson Education, Ltd.
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.
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Figure 7.3 Fiscal Expansion Under a
Fixed Exchange Rate

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

from
intervention that accompanies it (the AA1 to AA2 ) move
shift from from point 1 to
economy the
point 3. Copyright © 2023 Pearson Education, Ltd.
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
EP  
a real
expensive:  falls  .
 P 
appreciation
– 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.

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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.

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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 7.4 Effect of a Currency
Devaluation

When a currency is devalued E 0 to E 1, the

from economy’s
equilibrium moves from point 1 to point 2 as both output and
the money supply expand.

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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
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.

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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.

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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.

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Figure 7.5 Capital Flight, the Money
Supply, and the Interest Rate

To hold the exchange rate E 0 after the market decides it will be

fixed devalued
to E 1at
, the central bank must use its reserves to finance a private
financial
outflow that shrinks the money supply and raises the home
interest rate.
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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.
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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 replenish 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. Copyright © 2023 Pearson Education, Ltd.
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.

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Figure 7.6 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.
Source: Swiss National Bank.
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Interest Rate Differentials (1 of 3)
• For many countries, the expected rates of return are
not E e
 E
the 
R R  . Why?
E
same:
• 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.
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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.
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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

needed toamount
compensate investors for investing in
risky domestic assets.
• The risk could be caused by default risk or
exchange rate risk.
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 
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
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the peso and reduced exchange rate risk.
Figure 7.7 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 E 1 to E 2 .
from
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Types of Fixed Exchange Rate Systems
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.

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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 360 ¥ US$1
rate at
and the Bank of France fixed the exchange 5Ffr US$1.
rate at
 360 ¥ 
 US$1  72 ¥
  = .
– The yen/franc rate  5Ffr  1Ffr
was  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.
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Gold and Silver Standard
• Bimetallic standard: the value of currency is based on
both silver and gold.
• The United States used a bimetallic standard from 1837 to
1861.
• Banks coined specified amounts of gold or silver into the
national currency unit.
– 371.25 grains of silver or 23.22 grains of gold could be
turned into a silver or a gold dollar
– So gold was 371.25 / 23.22 16 times as much as
worth silver.
– Se www.micheloud.co for a fun description of the
e m bimetallic
standard, the gold standard after 1873, and the Wizard of
Oz!

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Figure 7.8 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.
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 Figure 7.9 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:
(C OFER), International Monetary Fund, Currency Composition of
at http://www.imf.org/external/np/sta/cofer/eng/ind Foreign
. These Exchange
data
Reserves ex.htm cover
only the countries that report reserve composition to the
IMF.
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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.

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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.

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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.
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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.

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Figure 7A1.1 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.
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Figure 7A2.1 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 E 0.
exchange rate
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