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Chapter 18: Fixed Exchange Rate and Foreign Exchange Intervention - Coggle…
Chapter 18: Fixed Exchange Rate and Foreign Exchange Intervention
Why Do Central Banks Intervene in FX Markets?
Boosting Investor Confidence
Preventing Currency Crises
Inflation Control
Encouraging Economic Integration
Stability for Trade & Investment
Enforcing Policy Discipline
Challenges of Pegging a Currency
Speculative Attacks
High Foreign Reserve Requirements
Loss of Monetary Independence
How Do Central Banks Intervene?
Managed Floating: central banks may buy/sell currency to stabilize or influence exchange rates.
Regional Currency Arrangement: Some countries join exchange rate unions to fix mutual exchange rates while floating against outsiders.
Central Bank Intervention and the Money Supply
Central bank interventions in the foreign exchange market directly influence the money supply through their balance sheet operations — by changing either assets (like foreign reserves) or liabilities (like money in circulation).
If a central bank buys foreign assets to weaken the domestic currency, it increases the money supply.
If it sells foreign assets to strengthen the currency, it reduces the money supply.
Assets, Liabilities, and the Money Supply
When the Central Bank buys assets, increases money supply injecting money into the economy.
When the Central Bank sells assets decreases money supply taking it out of circulation
Transactions always affect the central bank's balance sheet symmetrically:
➕ Asset side ↔️ ➕ Liability side (and vice versa)
Sterilization is when a central bank offsets the impact of its foreign exchange interventions on the domestic money supply by conducting opposite transactions in domestic assets.
Foreign exchange intervention affects the money supply
Buying foreign bonds/currency → Money supply ↑
Selling foreign bonds/currency → Money supply ↓
To neutralize this effect the central bank conducts an opposite transaction in domestic bonds
If it buys foreign bonds, it sells domestic bonds ➝ sterilization.
If it sells foreign bonds, it buys domestic bonds ➝ sterilization.
The purpose is to
Avoid monetary expansion or contraction caused by foreign exchange actions
Support exchange rate goals without compromising monetary policy
Maintain control over inflation and interest rates
Sterilization allows a central bank to intervene in FX markets while keeping the money supply and inflation stable.
Foreign Exchange Markets
By trading in foreign bonds, central banks can manage exchange rates and help stabilize their economies, especially in a managed or pegged exchange rate regime.
Fixed Exchange Rates
The goal is to maintain the exchange rate (E) at a fixed level by ensuring Domestic interest rate (R) = Foreign interest rate (R*)
To fix E The central bank intervenes by
Trading foreign and domestic assets until R=R* (FX market)
Adjusting the domestic money supply (Ms) until R=R* (money market)
This ensures Money market equilibrium and foreign exchange market equilibrium → No pressure for currency appreciation or depreciation.
If Output Increases (Y ↑) → Real money demand increases: L(R,Y) ↑ → Causes excess demand for money → Interest rate (R) increases: R > R* → Pressure for domestic currency appreciation (E ↓)
To prevent appreciation and maintain R = R:, the central bank buys foreign assets → This injects domestic currency into the economy → Money supply (Ms) increases → R decreases back to R → E stays fixed
Alternatively by buying foreign currency and selling domestic currency, the value of domestic currency drops, which also helps maintain the fixed exchange rate.
Under a fixed exchange rate, the central bank loses monetary policy independence because it must adjust the money supply to maintain R = R* and keep E constant, regardless of domestic conditions like inflation or output growth.
Figure: Asset Market Equilibrium With a Fixed Exchange Rate, E0