The so-called managed float (aka dirty float) is perhaps the
most interesting attempt to, if not eliminate the impossible
trinity, at least to blunt its most pernicious characteristic, that
of locking countries into the disadvantages outlined in Figure 19.2
. Under a managed float, the central bank allows market forces
to determine second-to-second (day-to-day) fluctuations in exchange
rates but intervenes if the currency grows too weak or too
strong. In other words, it tries to keep the exchange rate
range bound, ostensibly to protect domestic economic interests
(exporters, consumers) who would be hurt by rapid exchange rate
movements. Those ranges or bands can vary in size from very wide to
very narrow and can change levels over time.
Central banks intervene in the
foreign exchange markets by exchanging international reserves,
assets denominated in foreign currencies, gold, and special drawing
rights (SDRs), for domestic
currency. Consider the case of Central Bank selling $10
billion of international reserves, thereby soaking up $10 billion
of MB (the monetary base, or currency in circulation and/or
reserves). The T-account would be:
Central Bank
Assets
Liabilities
International reserves −$10 billion
Currency in circulation or reserves −$10 billion
If it were to buy $100 million of
international reserves, both MB and its holdings of foreign assets
would increase:
Central Bank
Assets
Liabilities
International reserves +$100 million
Monetary base +$100 million
Such transactions are known in the biz as unsterilized
foreign exchange interventionsand they influence the FX
rate via changes in MB. Recall that increasing the money
supply (MS) causes the domestic currency to depreciate, while
decreasing the MS causes it to appreciate. It does so by
influencing both the domestic interest rate (nominal) and
expectations about Eef, the future exchange rate, via
price level (inflation) expectations. (There is also a direct
effect on the MS, but it is too small in most instances to be
detectable and so it can be safely ignored. Intuitively, however,
increasing the money supply leaves each unit of currency less
valuable, while decreasing it renders each unit more valuable.)
Central banks also sometimes engage
in so-called sterilized foreign exchange interventions when they
offset the purchase or sale of international reserves with a
domestic sale or purchase. For example, a central bank might
offset or sterilize the purchase of $100 million of international
reserves by selling $100 million of domestic government bonds, or
vice versa. In terms of a T-account:
Central Bank
Assets
Liabilities
International reserves +$100 million
Monetary base +$100 million
Government bonds −$100 million
Monetary base −$100 million
Because there is no net change in MB, a sterilized intervention
should have no long-term impact on the exchange rate. Apparently,
central bankers engage in sterilized interventions as a short-term
ruse (where central banks are not transparent, considerable
asymmetric information exists between them and the markets) or to
signal their desire to the market. Neither go very far, so for
the most part central banks that wish to manage their nation’s
exchange rate must do so via unsterilized interventions, buying
international reserves with domestic currency when they want to
depreciate the domestic currency, and selling international
reserves for domestic currency when they want the domestic currency
to appreciate.
The degree of float management can range from a hard peg,
where a country tries to keep its currency fixed to another,
so-called anchor currency, to such wide bands that intervention is
rarely undertaken. Figure 19.5 clearly shows that Thailand
used to maintain a hard peg against the dollar but gave it up
during the Southeast Asian financial crisis of 1997. That big spike
was not pleasant for Thailand, especially for economic agents
within it that had debts denominated in foreign currencies, which
suddenly became much more difficult to repay. (In June 1997, it
took only about 25 baht to purchase a dollar. By the end of that
year, it took over 50 baht to do so.) Clearly, a major downside of
maintaining a hard peg or even a tight band is that it simply is
not always possible for the central bank to maintain or defend the
peg or band. It can run out of international reserves in a
fruitless attempt to prevent a depreciation (cause an
appreciation). Or maintenance of the peg might require increasing
or decreasing the MB counter to the needs of the domestic
economy.
A graph, like the one in Figure 19.6 , might be useful here.
When the market exchange rate (E1) is equal to the
fixed, pegged, or desired central bank rate (Epeg)
everything is hunky dory. When a currency is overvalued (by the
central bank), which is to say that E1 is less than
Epeg (measuring E as foreign currency/domestic
currency), the central bank must soak up domestic currency by
selling international reserves (foreign assets). When a currency is
undervalued (by the central bank), which is to say that when
E1 is higher than Epeg, the central bank must
sell domestic currency, thereby gaining international reserves.
Stop and Think Box
In 1990, interest rates rose in Germany
due to West Germany’s reunification with formerly communist East
Germany. (When exchange rates are fixed, the interest parity
condition collapses to iD = iF because
Eef = Et.) Therefore, interest rates also
rose in the other countries in the ERM, including France, leading
to a slowing of economic growth there. The same problem could recur
in the new European currency union or euro zone if part of the zone
needs a high interest rate to stave off inflation while another
needs a low interest rate to stoke employment and growth. What does
this analysis mean for the likelihood of creating a single world
currency?
It means that the creation of a world
currency is not likely anytime soon. As the European Union has
discovered, a common currency has certain advantages, like the
savings from not having to convert one currency into another or
worry about the current or future exchange rate (because there is
none). At the same time, however, the currency union has reminded
the world that there is no such thing as a free lunch, that every
benefit comes with a cost. The cost in this case is that the larger
the common currency area becomes, the more difficult it is for the
central bank to implement policies beneficial to the entire
currency union. It was for that very reason that Great Britain
opted out of the euro.
key takeaways
Central banks influence the FX rate via unsterilized foreign
exchange interventions or, more specifically, by buying or selling
international reserves (foreign assets) with domestic
currency.
When central banks buy international reserves, they increase MB
and hence depreciate their respective currencies by increasing
inflation expectations.
When central banks sell international reserves, they decrease
MB and hence appreciate their respective currencies by decreasing
inflation expectations.