Lecture 16.1
FIXED EXCHANGE RATES

1. The central bank's balance sheet

• Assets
  • Foreign assets: Foreign-exchange reserves, gold holdings
  • Domestic assets: Govt securities, loans to private banks

• Liabilities
  • Deposits held by private banks
  • Currency in circulation

• Net worth
  • Net worth = Assets - Liabilities
  • Assume that net worth stays the same

2. Money supply

• Increase in money supply if:
  (a) Central bank's liabilities increase
  (b) Central bank purchases assets

3. Foreign-exchange intervention

• Central bank sells foreign-exchange reserves (say)
• Decline in central bank's assets
• Corresponding decrease in liabilities
• Result: Decrease in domestic money supply

4. Sterilization

• Offsetting transactions in domestic and foreign assets
  • Say, central bank buys $100 of f.e. reserves
  • Money supply increases (why?)
  • To counter this, central bank sells $100 of domestic assets
  • Result: No change in money supply

5. Balance of payments and the money supply

• Recall definition of BP:
  BP = CA + KA

• If BP > 0:
  • What is the sign of ORT?
  • Central bank is acquiring f.e. reserves
  • Money supply increases

• If BP < 0:
  • Central bank is selling f.e. reserves
  • Money supply falls

  
  

6. Asset market eqbm under fixed exchange rates

• Interest parity condition:
  r = r*

Money market eqbm

• Assume that the world interest rate r* is given (exogenous)
• Money supply becomes endogenous!!!!!!

  WHAT? WHAT? WHAT DOES THAT MEAN??

  • Say, GDP increases
  • Real money demand increases
  • Domestic interest rate rises
  • Inflow of foreign capital occurs
  • Domestic currency tends to appreciate
  • To prevent currency appreciation, the central bank will have to BUY foreign-exchange reserves
  • Results:
    Increase in money supply!
    Domestic interest rate remains unchanged