Table 18-1: Effects of a $100 Foreign Exchange Intervention: Summary TABLE 18-1 Effects of a $100 Foreign Exchange Intervention: Summary Effect on Effect on Effect on Domestic Central Domestic Central Bank’s Central Bank’s Bank's action Money Supply Domestic assets Foreign assets Nonsterilized foreign exchange purchase +S100 +$100 Sterilized foreign exchange purch S100 100 Nonsterilized foreign exchange sale -S100 $l00 Sterilized foreign exchange sale +S100 $100 Copyright 2012 Pearson Education. All rights reserved 18-11
Copyright © 2012 Pearson Education. All rights reserved. 18-11 Table 18-1: Effects of a $100 Foreign Exchange Intervention: Summary
Fixed Exchange rates To fix the exchange rate a central bank influences the quantities supplied and demanded of currency by trading domestic and foreign assets so that the exchange rate (the price of foreign currency in terms of domestic currency) stays constant. Foreign exchange markets are in equilibrium when R=RK +(ee-B/E When the exchange rate is fixed at some level eo and the market expects it to stay fixed at that level then R=Rk Copyright 2012 Pearson Education. All rights reserved 18-12
Copyright © 2012 Pearson Education. All rights reserved. 18-12 Fixed Exchange Rates • To fix the exchange rate, a central bank influences the quantities supplied and demanded of currency by trading domestic and foreign assets, so that the exchange rate (the price of foreign currency in terms of domestic currency) stays constant. • Foreign exchange markets are in equilibrium when R = R* + (Ee – E)/E • When the exchange rate is fixed at some level E0 and the market expects it to stay fixed at that level, then R = R*
Fixed Exchange Rates(cont) To fix the exchange rate the central bank must trade foreign and domestic assets in the foreign exchange market untilr=RK Alternatively we can say that it adjusts the quantity of monetary assets in the money market until the domestic interest rate equals the foreign interest rate given the level of average prices and real output MS/P=L(RK n Copyright 2012 Pearson Education. All rights reserved 18-13
Copyright © 2012 Pearson Education. All rights reserved. 18-13 Fixed Exchange Rates (cont.) • To fix the exchange rate, the central bank must trade foreign and domestic assets in the foreign exchange market until R = R*. • Alternatively, we can say that it adjusts the quantity of monetary assets in the money market until the domestic interest rate equals the foreign interest rate, given the level of average prices and real output: Ms/P = L(R*, Y)
Fixed Exchange Rates(cont) Suppose that the central bank has fixed the exchange rate at eo but the level of output rises raising the demand of real monetary assets This is predicted to put upward pressure on interest rates and the value of the domestic currency How should the central bank respond if it wants to fix exchange rates? Copyright G 2012 Pearson Education. All rights reserved 18-14
Copyright © 2012 Pearson Education. All rights reserved. 18-14 Fixed Exchange Rates (cont.) • Suppose that the central bank has fixed the exchange rate at E0 but the level of output rises, raising the demand of real monetary assets. • This is predicted to put upward pressure on interest rates and the value of the domestic currency. • How should the central bank respond if it wants to fix exchange rates?
Exchane ate. E Fig。18-1: Asset market Equilibrium with a fixed Exchange Rate, Domestic-currency retum R Domestic R interest rate, R Real money demand,L(R, r1) L(R, y2) Real money supply M2 Real domestic money holdings Copyright 2012 Pearson Education. All rights reserved 18-15
Copyright © 2012 Pearson Education. All rights reserved. 18-15 Fig. 18-1: Asset Market Equilibrium with a Fixed Exchange Rate, E0