Lecture 6_Central Bank Intervention

8/9/2019 Lecture 6_Central Bank Intervention

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Lecture 6

CENTRAL BANKINTERVENTION

By Preeti Singh


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Introduction

• How do central banks intervene in the foreignexchange market?

• Many countries try to x or “peg” their exchangerate to a currency or group of currencies by

intervening in the foreign exchange market.

• Many with a exible or “oating” exchange rate infact practice a managed foating exchangerate.

– !he central bank “manages” the exchange ratefrom time to time by buying and sellingcurrency and assets" especially in periods of

exchange rate volatility.


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#. $%&'(M)&!(*+ ,$ -)&!(*/(&0 #&!)1)&!#,&

(. ole of )xchange ates2

*#&0+ /)!3))& !H) ',M)+!#-(&' !H) 3,*'

)-,&,M4

THE ROLE OF CENTRAL BANKS


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/. !H) #M5(-! ,$ )6-H(&7) (!) -H(&7)+

8.-urrency (ppreciation2

9domestic prices increase relative to foreignprices.

9 )xports2 less price competitive9 #mports2 more attractive

:.-urrency 'epreciation9 domestic prices fall relative to foreign prices.

9 )xports2 more price competitive.

9 #mports2 less attractive

THE ROLE OF CENTRAL BANKS


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-. $oreign )xchange Market #ntervention

8. 'enition2 the o;cial purchases and salesof currencies through the central bank toinuence the home exchange rate.

:. 7oal of #ntervention2 to alter the demand forone currency by changing the supply of

another.'. !he )


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Central Bank Interentionand the !one" #u$$l"

• !o study the e


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Central Bank%& Balance#heet

• A&&et&

– $oreign government bonds =o;cial internationalreserves>

– 7old =o;cial international reserves> – 'omestic government bonds

– *oans to domestic banks =called discount loans in %+>

• Lia'ilitie& – 'eposits of domestic banks

– -urrency in circulation =previously central banks hadto give up gold when citiens brought currency>


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Central Bank%& Balance#heet (cont)*

• A&&et& + Lia'ilitie& , Net -orth

– #f we assume that net worth of the central bankalways e@uals ero then assets A liabilities.

– (n increase in assets leads to an e@ual increasein liabilities.

– ( decrease in assets leads to an e@ual decreasein liabilities.

• -hanges in the central bankBs balance sheet leadto changes in currency in circulation or changes inbank deposits" which lead to changes in themoney supply.


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A&&et&. Lia'ilitie&and the !one" #u$$l"

• ( purchase of any asset will be paid for with currencyor a che@ue from the central bank"

– both of which are denominated in domestic currency" and

– both of which increase the supply of money in circulation.

– !he transaction leads to e@ual increases of assets andliabilities.

• 3hen the central bank buys domestic bonds or foreign bonds" the domestic money supply increases.


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• ( sale of any asset will be paid for with currencyor a che@ue given to the central bank"

– both of which are denominated in domestic currency.

– !he central bank puts the currency into its vault orreduces the amount of bank deposits"

– causing the supply of money in circulation to shrink. – !he transaction leads to e@ual decreases of assets

and liabilities.

• 3hen the central bank sells domestic bonds or

foreign bonds" the domestic money supplydecreases.


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/oreign Exchange!arket&

• -entral banks trade foreign governmentbonds in the foreign exchange markets.

– $oreign currency deposits and foreign

government bonds are often substitutes2 bothare fairly li@uid assets denominated in foreigncurrency.

– Cuantities of both foreign currency deposits

and foreign government bonds that are boughtand sold inuence the exchange rate.


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#terili0ation

• /ecause buying and selling of foreign bondsin the foreign exchange market a


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$inancial -risis and -apital$light

• 3hen a central bank does not haveenough o;cial international reserve assetsto maintain a xed exchange rate" a

'alance o1 $a"ment& cri&i& results. – !o sustain a xed exchange rate" the central

bank must have enough foreign assets to sellin order to satisfy the demand for them at the

xed exchange rate.


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$inancial -risis and -apital $light

• #nvestors may expect that the domesticcurrency will be devalued" causing them towant foreign assets instead of domestic

assets" whose value is expected to fallsoon.

8. !his expectation or fear only makes thebalance of payments crisis worse2

– investors rush to change their domestic assetsinto foreign assets" depleting the stock of o;cialinternational reserve assets more @uickly.


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:. (s a result" nancial capital is @uickly moved fromdomestic assets to foreign assets2 ca$ital fight.

– !he domestic economy has a shortage of nancial capitalfor investment and has low aggregate demand.

E. !o avoid this outcome" domestic assets must o.

F. (s a result" the domestic economy may face high

interest rates" reduced money supply" lowaggregate demand" low output and lowemployment.


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• )xpectations of a balance of payments crisisonly worsen the crisis and hastendevaluation.

– 3hat causes expectations to change? – )xpectations about the central bankBs ability andwillingness to maintain the xed exchange rate.

– )xpectations about the economy2 shrinkingdemand for domestic products relative to foreign

products means that the domestic currencyshould become less valuable.

• #n fact" expectations of devaluation cancause a devaluation2 &el121ul3lling cri&i&.


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3hat happens if the central bank runs out of o;cialinternational reserves =foreign assets>?

• #t must devalue the domestic currency so that it takesmore domestic currency =assets> to exchange for

8 unit of foreign currency =asset>. – !his will allow the central bank to replenish its foreign assets

by buying them back at a devalued rate"

– increasing the money supply"

– reducing interest rates" – reducing the value of domestic products"

– increasing aggregate demand" output" employment overtime.


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$inancial -rises and -apital $light

• #n a balance of payments crisis"

– the central bank may buy domestic bonds andsell domestic currency =to increase the money

supply> to prevent high interest rates" but thisonly depreciates the domestic currency more.

– the central bank generally can not satisfy thegoals of low interest rates and xed exchange

rates simultaneously.


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-(+) +!%'42 !he Mexican 5eso -risis" 8GGF8GGI

• #n late 8GGF" the Mexican central bankdevalued the value of the peso relative tothe %+ dollar.

• !his action was accompanied by highinterest rates" capital ight" lowinvestment" low production and high

unemployment.• 3hat happened?


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-(+) +!%'42 !he Mexican 5eso -risis"8GGF8GGI =cont.>

Source: Saint Louis Federal Reserve


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%nderstanding the -risis

• #n the early 8GGJs" Mexico was an attractive placefor foreign investment" especially from &orth(merican $ree !rade (greement =&($!(> partners.

• 'uring 8GGF" political developments caused anincrease in MexicoBs risk premium = > due toincreases in default risk and exchange rate risk2

– peasant uprising in -hiapas

– assassination of leading presidential candidate from 5#

• (lso" the $ederal eserve raised %+ interest ratesduring 8GGF to prevent %+ ination. =+o" RK L >


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• !hese events put downward pressure on thevalue of the peso.

• MexicoBs central bank had promised to

maintain the xed exchange rate.• !o do so" it sold dollar denominated assets"

decreasing the money supply andincreasing interest rates.

• !o do so" it needed to have ade@uatereserves of dollar denominated assets. 'idit?


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%+ 'ollar 'enominated #nternationaleserves of the Mexican -entral /ank

January 1994 ……………… $27 billion

ctober 1994 …………………$17 billion

!ove"ber 1994 ………##…… $1 billion

%ece"ber 1994 ………##……$ & billion

January 1994 ……………… $27 billion

ctober 1994 …………………$17 billion

!ove"ber 1994 ………##…… $1 billion

%ece"ber 1994 ………##……$ & billion

During 1994, Mexico’s central bank hid the fact that its

reserves were being depleted. Wh!

Source: 'anco de ()*ico+ ,tt-:..///#ban*ico#or0#"*


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• :J 'ec 8GGF2 Mexico devalues the peso by 8E. #txes E at F.J pesosNdollar instead of E.FpesosNdollar.

• #nvestors expect that the central bank has depleted

its reserves.• ρ ! further due to exchange rate risk2 investors

expect that the central bank to devalue again andthey sell Mexican assets" putting more downwardpressure on the value of the peso.

• :: 'ec 8GGF2 with reserves nearly gone" the centralbank abandons the xed rate.

• #n a week" the peso falls another EJ to about I.OpesosNdollar.


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!he escue 5ackage2educing ρ

• !he %+ P #M$ set up a QIJ billion fund toguarantee the value of loans made to MexicoBsgovernment"

– reducing default risk"

– and reducing exchange rate risk" since foreign loanscould act as o;cial international reserves to stabilie theexchange rate if necessary.

• (fter a recession in 8GGI" Mexico began a

recovery from the crisis. – Mexican goods were relatively cheap.

– +tronger demand for Mexican products reduced negativee


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T"$e& o1 /ixed Exchange Rate#"&tem&

4) Re&ere currenc" &"&tem2 one currencyacts as o;cial international reserves.

– !he %+ dollar was the currency that acted aso;cial international reserves from under thexed exchange rate system from 8GFF8GOE.

– (ll countries but the %+ held %+ dollars as themeans to make o;cial international payments.

5) old &tandard2 gold acts as o;cialinternational reserves that all countriesuse to make o;cial internationalpayments.


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Re&ere Currenc"#"&tem

• $rom 8GFF8GOE" each central bank xed the valueof its currency relative to the %+ dollar by buying orselling domestic assets in exchange for dollarassets.

• (rbitrage ensured that exchange rates between anytwo currencies remained xed.

– +uppose /ank of Rapan xed the exchange rate atESJTN%+Q8 and the /ank of $rance xed the exchange rateat I $frN%+Q8

– !he yenNfranc rate would be ESJTN%+Q8 N I$frN%+Q8 AO:TN8$fr

– #f not" then currency traders could make an easy prot bybuying currency where it is cheap and selling it where itis expensive.


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eserve -urrency +ystem

• /ecause most countries maintained xedexchange rates by trading dollardenominated =foreign> assets" they hadine


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eserve -urrency +ystem

• #n fact" the monetary policy of the %+ inuencedthe economies of other countries.

• +uppose the %+ increased its money supply.

– !his would lower %+ interest rates" putting downwardpressure on the value of the %+ dollar.

– #f other central banks maintained their xed exchangerates" they would have needed to buy dollar denominated=foreign> assets" increasing their money supplies.

– #n e

Lecture 6_Central Bank Intervention

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