Re: International Economics Krugman Test Bank Zip 1
Malka Crickenberger
A second criterion for classifying exchange market intervention is the extent to which the intervention is allowed to affect the domestic money supply. At one extreme, the purchase of foreign exchange leads to an increase of exactly the same amount of the domestic money stock. At the other extreme, the intervention policy is accompanied by an open market operation in domestic assets that completely sterilizes the effect of the change in reserves on the domestic money supply. These two types of intervention policy are likely to have substantially different effects, as will be seen later on.
This paper will focus on the effectiveness of medium- to long-run intervention. It will furthermore concentrate on policies that are combined with open market operations in such a way that the domestic money supply is unaffected by them. Effectiveness is finally defined solely in terms of the ability of the policies to influence the exchange rate and not in terms of the broader questions concerning their ultimate effects on other policy targets.
Against this background, the following section of the paper turns to the theoretical aspects of the problem, while Section II reviews the existing empirical evidence on the effectiveness of intervention. The paper ends with a discussion of national and international policy implications of the study.
Recent emphasis on asset market equilibrium and the capital account in models of exchange rate determination suggests that the degree of substitutability between assets denominated in different currencies and the degree of capital mobility1 are crucial for the effectiveness of intervention. The three types of model discussed here rely on different assumptions in this regard. The monetary and the portfolio balance models both assume perfect capital mobility but differ in that the former assumes perfect substitutability between domestic and foreign assets while the latter does not. The balance of payments model does not assume perfect capital mobility but instead assumes that capital movements take place over time in response to interest rate differentials. This model can be consistent with either perfect substitutability between domestic and foreign assets (in the long run) or with imperfect substitutability. The implications for the effectiveness of intervention of each of these three views on exchange rate determination will be discussed in turn.
Whether of the variety that relies on instantaneous purchasing power parity or not, the monetary models, by assuming perfect substitutability between domestic and foreign assets and perfect capital mobility, imply that intervention policy not affecting either the domestic or the foreign money supply will have no influence on the exchange rate. This can be shown formally by looking at the equation that Bilson (1979), for instance, derives for the exchange rate. With s indicating the natural logarithm of the exchange rate (the domestic currency price of foreign exchange), m (m*) the natural logarithm of the domestic (foreign) money supply, y(y*) the natural logarithm of domestic (foreign) real output, and fd the forward discount on domestic currency, Bilson derives
By explicitly expressing the current value of the exchange rate as a function of future policy variables, equation (2) points to the possibility that intervention might be effective because it alters current expectations about the future course of the economy. Thus, if a current sale of foreign exchange by the central bank signals future monetary contraction, then the home currency will appreciate immediately even if the intervention is fully sterilized so that the money supply did not change in the current period. This constitutes the only possible channel through which intervention-cum-sterilization could be effective within this framework.
In contrast to the monetary model, the portfolio balance model3 does not assume that domestic and foreign interest-bearing assets are perfect substitutes. The reasons for imperfect substitutability may be many, but some of the most quoted include exchange risk, differential political and default risks, imperfect information about foreign assets, and government regulation of international capital flows.
Thus, a purchase of foreign bonds for domestic bonds would lead to a depreciation of the domestic currency unless the demand for domestic money was completely interest-inelastic or unless domestic bonds were considered perfect substitutes for foreign bonds. Alternatively, if the current spot rate were determined elsewhere, the portfolio balance model could be solved for the expected rate of depreciation as a function of asset stocks and wealth.
In general, S and λ will be determined jointly once some hypothesis concerning the future spot rate is formulated.4 Given that our knowledge of what determines expectations is fairly limited, it may make a great deal of difference to econometric application of the portfolio balance model whether it is solved for the spot rate or the expected rate of depreciation. This point will be elaborated in the discussion of empirical evidence in Section II.
The notion that the degree of substitutability between domestic and foreign assets depends on the length of time agents can take to adjust their portfolios may seem plausible if one draws an analogy with conventional consumer demand theory. One way to capture this idea is to specify the reallocation of portfolios in response to changes in interest rates as stock adjustment processes leading to international capital flows in response to interest differentials.5 These capital flows would, together with the other items in the balance of payments, determine the exchange rate in such a manner that balance of payments equality would be maintained at all times. The resulting model, referred to here as the balance of payments model, thus uses the balance of payments equality as an equilibrium condition in the foreign exchange market.6 Letting CA stand for the current account surplus, NCI for the private net capital inflow, and ΔRES for the purchase of foreign exchange reserves by the domestic monetary authorities (all three of which are dependent on the current spot exchange rate), we can write
Within this framework, where private capital flows result from a stock adjustment process, it is evident that intervention by the central bank would always succeed in influencing the exchange rate. Whether or not a temporary intervention (corresponding to a permanent exchange of foreign securities for domestic securities by the central bank) would have any lasting effect on the exchange rate would depend on the degree of substitutability between domestic and foreign assets. Under perfect substitutability, once the process of stock adjustment in the demand for foreign assets has run its course, we would be back in the world of the monetary model with no long-run effect on the exchange rate. With imperfect substitutability, the effect derived from the balance of payments model would, over time, approach that of the portfolio balance model with imperfect substitutability between domestic and foreign assets. As far as the effectiveness of intervention is concerned, therefore, a low speed of adjustment in asset markets has the same short-run implications as imperfect substitutability between assets. In the longer run, the only factor that matters is the degree of substitutability.
Expectations effects owing to intervention activity may arise for two distinct reasons. One possibility is that intervention will be interpreted as a signal of future changes in monetary policy (or, more generally, changes in any policy affecting exchange rates). Such changes in policy will, in turn, alter expectations concerning the future equilibrium exchange rate and, through the channels discussed in the previous section, the current spot rate. Another possibility is that, by modifying the net foreign asset position of the economy, intervention will affect the structure of the balance of payments and hence the equilibrium real exchange rate. The current nominal exchange rate will then be affected through the process linking current exchange rate changes with future long-run equilibria. Each of these two possibilities will be discussed in turn.
By intervening in the foreign exchange market, a central bank may be signaling its intentions to pursue policies that will move the exchange rate in the desired direction. An efficient way to do so is to let the intervention be fully reflected in the domestic money supply, thus backing the desired exchange rate adjustment with an appropriate monetary policy. If this is prevented by sterilization operations, the effectiveness of the intervention is reduced, but to the extent that the commitment to future policy actions ensuring the desired exchange rate movement is believed by the public to be genuine, expectations effects will ensure at least partial success of the intervention policy. This will be the case regardless of the degree of substitutability between domestic and foreign assets. If this substitutability is perfect, the discussion of the monetary model shows that the expectation of future monetary ease or tightening will have the same qualitative effect on the current spot exchange rate as current policy of the same type. The same would be true for the portfolio balance and the balance of payments models, since future policy would affect the expected yield differential between domestic and foreign assets.7
It is evident that for the expectations effects to have the influence just described, it is necessary that the motive behind the intervention be credible and that the exchange rate target implied by the intervention not conflict with other policy goals. The latter condition is particularly important in view of the fact that some countries also have targets for money supply growth or for their international reserve position. Insofar as a central bank does allow a purchase, say, of foreign exchange to increase the domestic money supply in the short run but is bound by other constraints to follow a previously announced path of money supply growth in the longer run, the effect of the current intervention on the exchange rate will be largely offset by the implied future reversal of the policy implied by the money growth rule.8 A similar problem will occur if the central bank has a target for its holdings of international reserves. An intervention purchase of foreign exchange to stabilize the exchange rate will create a divergence from this target and, hence, necessitate a reversal of the policy some time in the future. This reversal will, in turn, offset some of the effect of the intervention in the current period.
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