FIXED EXCHANGE RATES and Foreign Exchange Intervention Central

FIXED EXCHANGE RATES and Foreign Exchange Intervention Central Bank Balance Sheet Assets Liabilities (1) Foreign Assets (1) Deposits held by Private Banks (2) Domestic Assets (2) Currency in circulation H = Base Money Foreign Assets Sale Base Money contracts Foreign Assets Purchase Base Money Expands 1

2 Fixed Exchange Rate S = fixed exchange rate 1, 2 return 1 2 output shock Automatic increase in M following CB intervention in the foreign exchange market. Result: Base Money is endogenous

The Sustainability of Fixed Exchange Rate Regime 3 demand for money (1) interest parity (2)

Purchasing Power Parity (3) Substitute (2) & (3) into (1): (4) 4

Fixed Exchange Rate 5 money supply is totally endogenous A Simple Model (Krugman 1979) fixed exchange rate flexible exchange rate

International Reserves 6

7 Central Bank Balance Sheet Domestic Credit Expands Indefinitely rate of expansion “Shadow” Exchange Rate

Logarithmic Approximation +f(x 0( 8

9 The “Shadow” exchange rate is: a market-based exchange rate when the central bank has no international reserves:

10 Implications: (1) Instantaneous Collapse s time 0 (2) Calculations:

11 s T’ T T i T T T” time

12 Sustainability of Fixed Exchange Rate fixed “shadow” (1) time no budget deficit ( =0) (2) imperfect asset substitutability (a) regulating capital inflows (b) risk premium is a function of external debt

13 if is a function of external debt (B) minus domestic assets (A) a sterilized intervention which keeps M constant switches reserves (negative external debt) for domestic assets would change the risk premium, and change domestic interest rate. Sales of reserves accompanied by purchase of domestic bonds will raise and i.