Fixed Exchange Rates(cont) The central bank should buy foreign assets in the foreign exchange markets, thereby increasing the domestic money supply thereby reducing interest rates in the short run Alternatively, by demanding(buying) assets denominated in foreign currency and by supplying ( selling domestic currency, the price/value of foreign currency is increased and the price/value of domestic currency is decreased Copyright 2012 Pearson Education. All rights reserved 18-16
Copyright © 2012 Pearson Education. All rights reserved. 18-16 Fixed Exchange Rates (cont.) • The central bank should buy foreign assets in the foreign exchange markets, – thereby increasing the domestic money supply, – thereby reducing interest rates in the short run. – Alternatively, by demanding (buying) assets denominated in foreign currency and by supplying (selling) domestic currency, the price/value of foreign currency is increased and the price/value of domestic currency is decreased
Stabilization policies with a fixed Exchange Rate · Monetary policy ° Fiscal policy An abrupt change in exchange rates fixed level, eo · Analysis approaches DD-AA model Assumption the expected future exchange rate Ee equals the fixed rate eo Copyright G 2012 Pearson Education. All rights reserved
Copyright © 2012 Pearson Education. All rights reserved. Stabilization Policies with a Fixed Exchange Rate • Monetary policy • Fiscal policy • An abrupt change in exchange rate’s fixed level, E0 • Analysis approaches – DD-AA model – Assumption: the expected future exchange rate Ee equals the fixed rate E0
Monetary policy and Fixed Exchange Rates When the central bank buys and sells foreign assets to keep the exchange rate fixed and to maintain domestic interest rates equal to foreign interest rates, it is not able to adjust domestic interest rates to attain other goals, i. e. monetary policy is not independent In particular, monetary policy is ineffective in influencing output and employment. Copyright 2012 Pearson Education. All rights reserved 18-18
Copyright © 2012 Pearson Education. All rights reserved. 18-18 Monetary Policy and Fixed Exchange Rates • When the central bank buys and sells foreign assets to keep the exchange rate fixed and to maintain domestic interest rates equal to foreign interest rates, it is not able to adjust domestic interest rates to attain other goals, i.e., monetary policy is not independent. – In particular, monetary policy is ineffective in influencing output and employment
Fig 18-2: Monetary Expansion Is Ineffective Under a Fixed Exchange rate Exchange rate. E DD E AA2 utput, r Copyright 2012 Pearson Education. All rights reserved 18-19
Copyright © 2012 Pearson Education. All rights reserved. 18-19 Fig. 18-2: Monetary Expansion Is Ineffective Under a Fixed Exchange Rate
Fiscal Policy and Fixed Exchange Rates in the short run Changes in fiscal policy are more effective in influencing output and employment in the short run The rise in aggregate demand and output due to expansionary fiscal policy raises demand for real monetary assets, putting upward pressure on interest rates and on the value of the domestic currency To prevent an appreciation of the domestic currency, the central bank must buy foreign assets, thereby increasing the money supply and decreasing interest rates Copyright 2012 Pearson Education. All rights reserved 18-20
Copyright © 2012 Pearson Education. All rights reserved. 18-20 Fiscal Policy and Fixed Exchange Rates in the Short Run • Changes in fiscal policy are more effective in influencing output and employment in the short run: – The rise in aggregate demand and output due to expansionary fiscal policy raises demand for real monetary assets, putting upward pressure on interest rates and on the value of the domestic currency. – To prevent an appreciation of the domestic currency, the central bank must buy foreign assets, thereby increasing the money supply and decreasing interest rates