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week8 - Fixed Exchange Rates and Foreign Exchange...

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Fixed Exchange Rates and Foreign Exchange Interventions Viktoria Hnatkovska week 8 1
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Preview ° Balance sheets of central banks ° Intervention in the foreign exchange markets and the money supply ° How the central bank °xes the exchange rate ° Monetary and °scal policies under °xed exchange rates ° Financial market crises and capital ±ight ° Types of °xed exchange rates: reserve currency and gold standard systems ° Zero interest rates, de±ation, and liquidity traps 2
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Why study fixed exchange rates ° Many countries try to °x or ²peg³their exchange rate to a currency or group of currencies by intervening in the foreign exchange markets. ° Monetary system these days is a hybrid of "pure" °xed and ±oating exchange rate systems. ° Some countries belong to exchange rate unions - organizations whose members °x their mutual exchange rates, while allowing free ±oat against currencies of nonmember countries. ° Many developing countries practice pegs or a managed ±oating exchange rate. ° The central bank ²manages³the exchange rate from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility. ° Historically pegs were popular. Can we use some lessons from the past for the future? ° How do central banks intervene in the foreign exchange markets? 3
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Central bank balance sheet and the money supply ° To study the e/ects of central bank intervention in the foreign exchange markets, °rst construct a simpli°ed balance sheet for the central bank . ° Balance sheet records the assets and liabilities of a central bank. ° Balance sheets use double booking keeping: each transaction enters the balance sheet twice. ° Assets: ° Foreign assets ± Foreign government bonds (o¢ cial international reserves) ° Gold (o¢ cial international reserves) ° Domestic assets: claims on domestic citizens and institutions ± Domestic government bonds ± Loans to domestic banks (called discount loans in US) ° Liabilities: ° Deposits of domestic banks: banks are required to hold central bank deposits as partial backing of their own liabilities ° Currency in circulation (previously central banks had to give up gold when citizens brought currency to exchange) 4
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Central bank balance sheet and the money supply ° Assets = Liabilities + Net worth ° If we 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. ° Example: when central bank purchases an asset, it pays for it in one of the two ways: ° by cash, which raises the supply of currency in circulation ° by check, which, when deposited in the private bank, raises that bank claims on the central bank by the same amount ° the latter can typically be used by the private bank to make additional loans to cus- tomers, as a result, the amount of money in circulation increases.
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