chap019 - Chapter 19 Exchange-Rate Policy and the Central...

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Chapter 19 Exchange-Rate Policy and the Central Bank Chapter Overview In this chapter we turn to a discussion of exchange rate regimes and consider the link between a country’s exchange rate policy and its domestic monetary policy. We will also examine instances in which exchange rate stabilization becomes the overriding objective of central bankers, so much so that a decision to fix the exchange rate may be made. Finally, we turn our attention to instances where a country might give up its currency entirely. Reading this chapter will prepare students to: assess the options countries face with regard to their exchange rate policy; explain how and why central banks intervene in foreign exchange markets; evaluate the costs, benefits, and risks of fixed exchange rates; and describe a number of different exchange rate systems. Important Points of the Chapter On most days, policymakers at the Fed and the ECB concentrate on the domestic economy and let their exchange rates take care of themselves. In small countries, where exchange rates can have a dramatic impact, central bankers do not have that luxury. Domestic policy and exchange rate policy are connected, particularly because exchange rate policy is linked to interest rate policy. Application of Core Principles Principle #4: Markets (page 456) Arbitrage will cause prices (and interest rates) to equalize across markets. As a result, free movements of capital across a country’s borders means that if it wants a fixed exchange rate it must give up domestic monetary policy. Principle #5: Stability (page 460) In developing countries, government officials may try to avert the crises caused by large movements of capital by imposing inflow controls or outflow controls. Principle #4: Markets (page 463) In a foreign exchange intervention when the Fed buys foreign bonds, the supply of dollars changes and U.S. interest rates fall, decreasing the demand for the dollar. The demand and supply shifts together drive the value of the dollar down. Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 13
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Chapter 19 Exchange-Rate Policy and the Central Bank Principle #5: Stability (page 465) Central bank officials in small, emerging market countries may feel that the best policy is to maintain a predictable value for their currency, and so they fix the exchange rate. Principle #4: Markets (page 467) In the summer of 1997, a speculative attack on the Thai currency (the baht) occurred driving down its value. Principle #5: Stability (page 471) The alternative to flexible, market determined exchange rates are “hard-peg” systems. However, given the possibility for speculative attack, pegs must indeed be hard to be sustainable. Teaching Tips/Student Stumbling Blocks This chapter focuses on the conditions under which the government might intervene in the market for foreign currency to influence the exchange rate, which may enhance economic stability and improve economic welfare. That is, Core
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