The Evolving Role of Central Banks

4 Foreign Exchange Management and Monetary Policy

Patrick Downes, and Reza Vaez-Zadeh
Published Date:
June 1991
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The paper is in four sections. The first defines what is meant by exchange rate policy. As will be seen, three types of policy directly affect exchange rates: (1) the choice of fixed versus flexible exchange rates (with and without managed floating), (2) monetary policy, and (3) intervention policy. The second section discusses the choice of fixed versus flexible exchange rates in broad brush fashion. The third section discusses in more detail the conduct of monetary policy and of intervention policy. The fourth discusses sterilization of reserve changes in a system of fixed exchange rates or a managed float. The paper concludes with a short addendum on intervention in the forward market.

Some Definitions

The term exchange rate policy is somewhat slippery because it focuses on the variable being affected by a variety of policies, rather than on the policies themselves. As such it differs from terms like monetary policy, fiscal policy, or commercial policy, which tend to focus on the “instrument” of policy (money or interest rates, taxes and transfers, government expenditures, tariffs, or quotas). Hence, rather than talking about exchange rate policy it is more useful to talk about the elements of policy that have a direct influence on exchange rates—choice of exchange rate system, monetary policy, and intervention policy. This is not to argue that other policies, as well as exogenous shocks, do not affect exchange rates, for example, fiscal policy, commercial policy, exogenous change in the world relative price of raw materials. They do, but it is the three policies that are under the control of the authorities and that have a more direct effect on exchange rates that are typically encompassed in the term exchange rate policy. The choice of exchange rate system is the fundamental decision; it has crucial implications for the scope of monetary policy. Intervention policy is the least important of the three and is much less powerful than monetary policy.

Fixed Versus Flexible Exchange Rates

Voluminous literature exists on the subject of fixed versus flexible exchange rates. Most applies to developed countries, but some applies to developing countries. The relative potency of monetary and fiscal policy under fixed and flexible exchange rates with various levels of capital mobility and asset substitutability,1 the mechanism through which policies have their effects in the two regimes, the insulation properties of the different exchange rate regimes in response to various kinds of shocks, and the role of policy coordination and concerted intervention by the Group of Seven countries are among the important topics in the literature.2

Broadly speaking, a worldwide system of irrevocably fixed exchange rates (i.e., one currency) would have significant efficiency benefits. Most notably, transactions costs and the need to expend resources on coping with the risk of exchange rate changes would be eliminated. The advantages of flexible exchange rates arise from macroeconomic and adjustment considerations, in particular the ability of a country under a flexible exchange rate regime to achieve a better inflationary performance than its potential partners, and its enhanced ability to respond to real shocks that are specific to it.

In a world of fixed exchange rates, perfect asset substitutability, and no exchange controls, a small country has virtually no autonomy in monetary policy. This has two principal implications. First, a small country that fixes its exchange rate to the currency of a single large country or to a basket of currencies of a number of countries ties its inflation rate to that of its partner or a weighted average of its partners. Second, in the face of real shocks to the terms of trade, the real exchange rate adjusts through differential price movements rather than through nominal exchange rate changes.

A country that fixes its exchange rate (permanently) trades off its ability to influence domestic nominal variables in return for the rate of inflation of its larger partner. The greater the confidence a country has in the central bank of the country to which it is tying its currency and the greater the similarity of the shocks faced by the two countries, the more sensible is the decision. In the case of the European Monetary System (EMS), for example, other countries have been able to import the credibility of the Deutsche Bundesbank by tying their currencies to the deutsche mark. And, indeed, inflation rates have converged over time among those European countries (although with some lag as credibility is established). Another example is the francophone African countries that have maintained their ties to the French currency area.

Note that to obtain the full credibility benefit of the fixed rate in such circumstances, the country has to convince the market that the fixed rate is close to irrevocable. Having a fixed but adjustable exchange rate, in my view, does not yield the benefit of an irrevocably fixed rate—the country does not get the full advantage of the credibility, and it may be faced periodically with attacks on the currency followed by large discrete adjustments of the exchange rate peg with concomitant effects on prices of traded goods (or subsidies).

Choosing an irrevocably fixed exchange rate means that in the face of real shocks to the terms of trade, adjustment of the real exchange rate must take place through differential price movements rather than through changes in nominal exchange rates. A country should, then, tie its currency to that of a large credible country facing similar shocks to those it faces. This will permit its currency to float against those of other countries with differing external shocks.

Suppose such a match does not exist. That is, suppose a country faces sizable external shocks that are specific to it and that do not affect its potential partners, for example, a shift in raw materials prices relative to manufactured goods prices. In such a case, the movement in the exchange rate can act to offset in part the resulting changes in aggregate demand, to spread the costs and benefits of the change in raw materials prices throughout the economy, and to facilitate the movement in the real exchange rate toward its equilibrium. Of course, even with flexible exchange rates the adjustment is not easy. The risk always exists that a currency depreciation in response to a negative terms of trade shock will feed into a wage-price spiral. And flexible exchange rates will sometimes move away from equilibrium, not toward it. Indeed, misaligned exchange rates have prompted considerable discussion of currency zones, concerted intervention, EMS, and other ways of moving back toward the fixed exchange rate regime. Nonetheless, in a country subject to sizable periodic external shocks that are specific to it and do not affect its potential partners, it is difficult to argue that fixed exchange rates will dominate flexible exchange rates.

In this connection, it is worth noting the literature on optimal currency areas, where mobility of labor, the size and openness of the economy, the nature of shocks, and the flexibility of real wages are the focus. This reminds us that the decision regarding fixed versus flexible exchange rates is a multifaceted one, particularly for small countries.

I argued earlier that if there is perfect asset substitutability and no exchange controls, a country choosing fixed exchange rates will have no monetary policy autonomy. I now turn to the situation in a fixed exchange rate world with imperfect substitutability or exchange controls, or both.

Imperfect substitutability does permit a country to have some degree of autonomy in monetary policy even though its currency is fixed to another country’s currency. The same holds true for exchange controls. Under these circumstances, a central bank can follow a some-what different policy in the short run from its partner, but it has little longer-run autonomy unless it adjusts its exchange rate from time to time.

Consider, for example, a situation where small Country A chooses to follow a laxer monetary policy than large Country B to which its currency is tied. The lower interest rates in Country A can co-exist with higher interest rates in Country B since the capital outflow is not overwhelmingly large (because of imperfect substitutability or exchange controls). Over time, however, if Country A’s inflation rate is higher than Country B’s, its currency becomes more and more over-valued. This will induce capital outflows from Country A, as the public becomes more and more convinced of the inevitability of a future devaluation. Even if Country A’s government is successful in preventing the outflow by using controls,3 the overvalued currency will depress returns in the tradable goods sector, artificially increase the real wage rate (by keeping import prices low), make the inevitable adjustment harder to absorb, and raise the value of the rationed foreign exchange (raising the return to rent-seeking behavior).

In sum, the pure logic of the arguments thus far tends to lead one to support either an irrevocably fixed exchange rate (or one close enough to irrevocable so as to enable the authorities to obtain all the credibility benefits) or a flexible exchange rate (with or without management of the float), rather than an adjustable peg. The latter seems on the surface to have a variety of disadvantages without many compensating advantages. This particular judgment is stronger, the greater is asset substitutability and the less the reliance on controls. Having said this, I recognize that many countries have opted for this intermediate outcome. There are a number of reasons for such a result. Political considerations (in particular, concern about the perceptions of independence) may prevent a country from entering into a monetary union, while economic considerations (its lack of credibility) may lead it away from exchange rate flexibility. Also, experience under flexible exchange rates has made some countries wary of this structure. The second-best outcome in such a case might be to try to mimic monetary union by fixing the currency to that of a credible partner and holding tightly to that link. Moreover, a country may be nervous about tying irrevocably to another currency because the country to which it is tying may become less responsible in the future. Monetary union also precludes the adjustment of the exchange rate in case of a severe shock. Finally, the desire to capture the seigniorage tax may prevent monetary union.

Monetary Policy and Intervention Policy

In this section I consider more closely the conduct of monetary policy and intervention policy under fixed and flexible exchange rates.

Fixed Exchange Rate Regime

Consider first the short-run situation in a fixed exchange rate world. Continuing to use our example of small Country A and large Country B, let us suppose that Country A decides to relax its monetary policy and ease interest rates. What will be the effects on international reserves? The direct effect will be through capital outflows generated by the change in interest rate differentials (through transactions of both residents and nonresidents); the indirect effects will be through a deterioration of the current account as output and prices rise in Country A. The higher the degree of asset substitutability the larger will be the change in international reserves (i.e., the larger the amount of intervention needed) for a given change in interest rates. In the limit, with perfect asset substitutability, even a small change in interest rates results in an extremely large change in reserves, a reflection of the general point that there can be no autonomous monetary policy in a fixed exchange rate system with perfect substitutability.

Returning to the case of imperfect substitutability, I would repeat and amplify the point made previously that although a somewhat autonomous policy is possible in the short run, it is not possible in the long run without a parity adjustment. The easier monetary policy in Country A results in a capital outflow and a current account deterioration. If Country A persists in a more expansionary monetary policy, there will probably be further capital outflows (because of lagged adjustment to the earlier interest rate change) and the current account will continue to deteriorate, as domestic price inflation exceeds foreign inflation.

Domestic competitiveness will thus continually decline. The continuing and growing current account deficit will eventually exhaust the finite amount of international reserves available to Country A. Moreover, well before this occurs, the market will recognize that Country As policies are not viable and that future devaluation is inevitable if they are not changed. The capital outflow driven by the expectation of a devaluation of Country As currency can be considerably larger than the interest-rate-driven capital outflow, because the expected net returns from shedding investments in a currency that one expects will be devalued can be very high (since the discrete changes tend to be very large). In addition, if there is concern that the authorities will impose capital or exchange controls in such circumstances, the outward movement of capital will be even greater.4 Experience suggests that residents play a prominent role in such capital outflows, and it is not just foreign investors that react.

In sum, in a fixed exchange rate structure a small country’s monetary policy has to converge with that of its partner country in the long run even if asset substitutability is low, and in the short run if asset substitutability is high.

Flexible Exchange Rate Regime

I turn now to the case of a small country with flexible exchange rates. Monetary policy can be used autonomously by the authorities of the country. In the long run, autonomy enables the country to choose its own inflation rate and facilitates adjustment to real (terms of trade) shocks. At times, however, the market pushes flexible exchange rates too far in one direction or the other; adjustment costs for the tradable goods sector result. These erratic effects and bandwagon effects on the exchange rate provide the principal rationale for intervention in a flexible exchange rate system.

How does monetary policy get transmitted in a flexible exchange rate world? In a small open economy with flexible exchange rates, monetary policy is transmitted through changes in both interest rates and exchange rates. As economies become more open to foreign trade and foreign financial influences, the greater is the importance of the exchange rate channel. In the typical closed economy model, the tightening of monetary policy increases interest rates, and the higher interest rates, in turn, reduce interest-sensitive expenditures. Typically, the focus is on investment expenditures, residential construction, and consumer durables. In addition, spending on other forms of consumer goods is reduced via the wealth effect, at least in a world where long-term fixed-rate assets predominate. (In a world with Regulation-Q types of ceilings there would be disintermediation and credit rationing by financial institutions.) In the corresponding open economy model with flexible exchange rates, the tightening of monetary policy tends to increase the value of the domestic currency as well as to raise interest rates. The result is to reduce expenditures by foreigners on home goods and to shift expenditures by domestic residents from domestically produced goods to imports. In addition, the currency appreciation has a direct effect on prices, particularly in the case of the small open economy, where the prices of both exportable and importable products respond fairly directly to exchange rate changes.

It is important to note that the central bank has little influence on the split between interest rates and exchange rates of a given change in policy stance. Thus, a given tightening of policy may produce a significant interest rate increase and little appreciation, or relatively little interest rate change and a sharp appreciation. In large part, the split depends on expectations in the foreign exchange market, including expectations regarding the length of time the tighter policy and higher interest rates are expected to last and induced effects on expectations of future inflation. To assist them in the conduct of policy in these circumstances the authorities can use a “monetary conditions index,” which tries to weight both interest rate and exchange rate changes in terms of their relative effect on aggregate demand.

Beyond the concern with its effect on aggregate demand, the exchange rate is also important in the conduct of monetary policy for a couple of other reasons. At a time of inflationary pressure, one would want to avoid a sharp depreciation of the currency, because it would feed into price changes fairly rapidly and have deleterious effects on expectations of future rates of inflation. And there is sometimes concern that markets will overshoot and push exchange rates too far, especially if they believe the authorities are taking a hands-off attitude to the exchange rate (“benign neglect”). Both monetary policy and intervention policy can be used to influence the exchange rate in such circumstances, although the former is clearly by far the more powerful influence.

I would emphasize, however, the distinction between responding in the short run to changes in the exchange rate and having an implicit or explicit target level of the exchange rate. The latter is not consistent (except by chance) with achieving a target value for some domestic nominal variable; the former, however, may assist the authorities in reaching the goal for the domestic variable.

More generally, in a world of flexible exchange rates with high asset substitutability, exchange market intervention is not likely to have long-run or even medium-run influence on the exchange rate although it may be useful in the short run. Thus, for example, the Canadian authorities tend to think of intervention as, first and foremost, a tool for promoting orderly markets and moderating exchange rate movements in response to shocks and temporary disruptions. The technique of leaning against the wind is used to dampen short-run volatility and to offset random movements. Even in the case of more persistent shocks and more fundamental pressures, intervention is used as a means of buying time in order to permit monetary policy to go to work. The Jurgensen report, prepared some years ago for the Group of Seven, also reached the conclusion that intervention policy could have some short-run effect on exchange rates but could not be expected to have any lasting influence.5 Intervention can be sporadic or more continuous, the latter being the case in Canada.

Exchange market intervention could also be used to signal forthcoming monetary policy action, either automatic (in the case of unsterilized intervention), or discretionary (in the case of sterilized intervention). This role for intervention can be of particular importance when a belief has developed in the market that speculative forces have resulted in a considerable overshooting of the exchange rate. If market participants are already concerned about the viability of the currency at the prevailing exchange rate, strong intervention, which signals that the authorities hold the view that the currency is overpriced or underpriced and that they are likely to engage in more fundamental actions to move the rate, is likely to have a direct effect on market behavior. Without clear evidence of speculative overshoot, the signaling aspect will be less effective.

Sterilization of Changes in International Reserves

This penultimate section of the paper deals with the technical issue of sterilization of reserve changes. The details of sterilization will differ from country to country depending on the institutional structure (which, itself, is usually the result of the historical development of markets and institutions). The basic principle is, nonetheless, simple. Sterilization involves action (or no action in certain cases) by the authorities to prevent changes in international reserves from having secondary effects on domestic monetary conditions via their influence on the cash reserves of the domestic banking system.

Consider the following simple example. Suppose that international reserves are held on the books of the central bank (not a universal practice, as we shall see). The other asset of the central bank is domestic bonds, and the central bank liabilities are currency, the deposits of the banking system (bank reserves), and government deposits. Suppose that foreigners increase their desired holdings of domestic currency assets and that the authorities intervene to prevent an appreciation of the domestic currency. The central bank issues a check upon itself in return for the foreign currency (typically a check on a foreign bank). Whether the foreigner buys a bond from a resident or holds a deposit in a domestic bank, the domestic bank will obtain the claim on the central bank and its reserves at the central bank will rise. This will lead to downward pressure on short-term interest rates as the banks with excess reserves act to expand their portfolio of interest-bearing assets, and this downward pressure may be inappropriate.

There are a number of options available to the authorities to prevent the secondary effects: (1) The central bank can sell domestic assets on the domestic bill or bond market. (2) It can sell the foreign exchange to the domestic banks on a swap arrangement. (3) It can shift government deposits from the banks to the central bank. (4) The government can issue debt instruments and deposit the proceeds in the central bank. (5) The reserve-requirement ratio can be adjusted upward. Note that the first and fourth options assume the existence of a reasonably well-developed market for domestic instruments, while options two, three, and five do not.

It is sometimes argued that if the central bank or the government sells domestic instruments to sterilize the capital inflow, there will be upward pressure on domestic interest rates, further capital inflows, further need for open market sales for sterilization purposes, further upward pressure on interest rates, etc. This argument is fallacious because it does not take into account the destination of the original capital inflow. One possibility is that the foreign investor wants to hold domestic interest-bearing assets, with the result that the central bank indirectly ends up trading its own holdings of, say, treasury bills, to the foreign investor in return for foreign currency. A second possibility is that the foreign investor wishes to hold a deposit in a domestic bank. The central bank or government can then supply an interest-bearing asset for the bank to hold (treasury bill or swapped foreign exchange), or it can reduce other (i.e., government) deposits at the bank, or it can force the bank to hold more required reserves (either interest-bearing or non-interest-bearing), all of which actions prevent secondary repercussions. It is also possible for a country to impose a secondary reserve requirement, which would force banks to hold certain assets such as domestic treasury bills, in order to influence the demand by banks for the type of assets used in the sterilization operation.

In some countries, such as Canada, international reserves are held on the books of the government or a governmental entity and not on the books of the central bank. This does not change the logic of the above discussion but rather makes sterilization automatic rather than discretionary. In Canada, for example, international reserves are an asset in the Government’s Exchange Fund Account and are financed in the short run by a reduction in government deposits at the banks and in the long run by an increase in treasury bills outstanding. The Bank of Canada acts as an agent. Note that if a government financed its increased holdings of international reserves by borrowing from the central bank, we would be right back to the earlier example.

I would note in conclusion that sterilization prevents certain automatic responses from taking place. Thus the autonomous capital inflow just discussed would, if unsterilized, have led to an expansion of the balance sheets of the banks, put downward pressure on interest rates, and, hence, induced a partly offsetting capital outflow. By engaging in sterilization, the authorities are trying to prevent the secondary repercussions on the interest rate and hence insulate the domestic economy from the capital inflow. Similarly, if the capital inflow were the result of a tightening of monetary policy, the sterilization tries to prevent downward pressure on interest rates, which would offset the original action. Recall, however, that in the limit in a fixed exchange rate system with perfect substitutability, fully sterilized intervention is not possible because of the infinite interest rate elasticity of capital flows, and unsterilized intervention simply reverses the original central bank tightening action (leaving the central bank with more foreign exchange and less domestic assets on its balance sheet).

An Addendum on Forward Exchange Market Intervention

Intervention in the forward market is virtually identical in its effects to intervention in the spot market. The only differences are first, that the authorities do not need foreign exchange to intervene in the forward market and hence are not limited by size of the stock of international reserves or the capacity to borrow and, second, that bank reserves are not affected by forward market intervention and therefore sterilization is not required. However, forward exchange market intervention may permit the authorities to take on too much risk since there is no obvious limit to intervention. One could argue that the authorities could always hold the exchange rate at a given level by an infinite amount of intervention in the forward market. At some point, however, the counterparties in such transactions would probably no longer be willing to transact with the central bank, because of the risk element.

*The author is Deputy Governor at the Bank of Canada. The views expressed in the paper are those of the author and no responsibility for them should be attributed to the Bank of Canada.
1Capital mobility is defined as the absence of policy restrictions on the movement of funds between countries. Asset substitutability is defined as the willingness of investors and borrowers to shift between instruments denominated in different currencies in response to minute differences in expected returns.
2The Group of Seven countries comprise the major industrial countries: the United States, Japan, Germany, France, the United Kingdom, Italy, and Canada.
3I would note that no controls are perfect. For example, black markets develop, and there are leads and lags in current account transactions.
4Foreign borrowing by the authorities can provide more reserves, but market forces will eventually dominate.
5In a world with imperfect substitutability, intervention can have lasting effects but these are quantitatively small.

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