week9 - Fixed Exchange Rates and Foreign Exchange...

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Unformatted text preview: Fixed Exchange Rates and Foreign Exchange Interventions (cont.) Viktoria Hnatkovska week 9 1 managed floating and sterilized interventions & Under managed &oating monetary policy is in&uenced by exchange rate changes, but is not completely subordinate to the objective of the xed rate. & Instead, the Central Bank (CB) has to balance out domestic objectives (employment, in- &ation) and exchange rate stability. & How? Suppose CB tries to ght o/ domestic unemployment by using expansionary mone- tary policy. This implies that it will _____ domestic assets and increase M s . & To prevent currency from depreciating, CB ______ foreign assets. This will tend to reduce domestic M s ; hindering the CBs attempt to reduce unemployment. & In reality CB practice sterilized interventions under both &exible and xed ER regimes. & If sterilized foreign exchange interventions leave domestic M s unchanged, what is the ra- tionale for such policy? 2 Ineffectiveness of sterilization & A rationale for sterilized foreign exchange interventions is di cult to &nd using the model we developed previously & Consider an example of &scal expansion we studied before. & G " = ) E # : So CB has to expand M s to prevent currency from appreciating by ____ foreign assets. & Such policy raises Y in the short run, but eventually also causes ination, which CB may try to avoid by sterilizing the increase in M s that its &scal policy has induced. & But as soon as CB _____ domestic assets to # M s ; it will have to _____ foreign assets to prevent its currency from appreciating. & So, sterilization is a self-defeating policy. 3 Perfect asset substitutability & What was the key feature of our model that generated the results above? It is the assump- tion of perfect asset substitutability. & We assumed that forex market is in equilibrium only when expected return on domestic and foreign assets are equalized. The exchange rate is pinned down by this parity condition. & In this world, forex market participants only care about expected rates of return and these rates are determined by the monetary policy. Therefore, actions such as sterilization, by leaving M s unchanged, also have no e/ect on E: & In contrast, when assets are imperfect substitutes, factors such as risk start to matter. In general, foreign and domestic assets may di/er 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. In this case, expected returns may di/er in equilibrium. & Since both return and risk matter, the CB actions that alter the riskiness of domestic currency assets can move E; even if M s does not change....
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This note was uploaded on 01/28/2011 for the course ECON 304 taught by Professor Michaelpeters during the Spring '10 term at The University of British Columbia.

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week9 - Fixed Exchange Rates and Foreign Exchange...

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