1 Lecture 14 Pegging the Exchange Rate Econ 340 Econ 340, Deardorff, Lecture 14: Pegging 2 Lecture 14 Outline: Pegging the Exchange Rate • How It’s Done – Market Intervention – Bands of Fluctuation – Hybrids of Pegged and Floating • Who Pegs? • Mechanics of Intervention – Reserves – Money Supply – Sterilization • Effects of Pegging Econ 340, Deardorff, Lecture 14: Pegging 3 How It’s Done • What “Pegging” Means – To “fix” the exchange rate by intervening in the market – It does not mean just fixing it by law – making it illegal to exchange the currency at other than the official rate • Countries do that too, but that is not pegging, and it does not entirely work: gives rise to “black market” – “Intervention” means • Buying or selling foreign currency, so as to • Make up the difference between the market’s supply and demand • Normally done by the pegging country’s central bank Econ 340, Deardorff, Lecture 14: Pegging 4 • Example: If the Fed were to peg the $ to the € at rate E* (Note: it does not do this!) S€ D€ Q€ E = $/€ E* Fed buys the extra € How It’s Done OR S€ D€ E E* Fed sells the needed € Q€ Econ 340, Deardorff, Lecture 14: Pegging 5 How It’s Done • What “Pegging” Means – In practice, pegs are never exact – Central banks • Set a “par value” (= “central value”) • Intervene only if rate moves some distance (e.g., 1%) above or below this par value • This range of movement is called an “exchange rate band” – We will ignore this complication in drawing the market, and pretend that they peg the rate exactly Econ 340, Deardorff, Lecture 14: Pegging 6 How It’s Done • Hybrids of Pegged and Freely Floating Exchange Rates – Managed Float • Intervene to influence the rate • But do not announce a target rate or par value • And do not necessarily keep the rate constant – “Dirty Float” = same as Managed Float2 Econ 340, Deardorff, Lecture 14: Pegging 7 How It’s Done • Hybrids of Pegged and Freely Floating Exchange Rates – “Leaning Against the Wind” • Particular form of managed float that – Does not try to alter the level of the exchange rate, but – Does try to slow its rate of change • Purpose: to dampen fluctuations Econ 340, Deardorff, Lecture 14: Pegging 8 How It’s Done • Hybrids of Pegged and Freely Floating Exchange Rates – Crawling Peg • A pegged rate with a par value that moves – Slowly, and – Predictably • Example: Country might announce that the par value will appreciate by 0.01% each week as long as central bank is buying foreign exchange, and vice versa Note: All of these hybrids still do require intervention in the exchange market Econ 340, Deardorff, Lecture 14: Pegging 9 Lecture 14 Outline: Pegging the Exchange Rate • How It’s Done – Market Intervention – Bands of Fluctuation – Hybrids of Pegged and Floating • Who Pegs? • Mechanics of Intervention – Reserves – Money Supply – Sterilization • Effects of Pegging Econ 340, Deardorff, Lecture 14: Pegging 10 Who Pegs? • US? – No – But we did have a pegged exchange rate until 1973 • (Strictly speaking, it was other countries that pegged to us, not us to them) • In fact, from the late 1940s until 1973, virtually all countries pegged to the US dollar (exceptions were Canada, which sometimes floated, and several former colonies that pegged to the British pound or French franc) Econ 340, Deardorff, Lecture 14: Pegging 11 Who Pegs? • Europe? – No: the euro floats freely – Before the euro, after 1973, • Countries did not peg to currencies outside Europe • But they often did try to peg to each other – Denmark now pegs to the euro – Other EU countries outside the euro (UK, Sweden) and countries outside the EU (Switzerland, Norway) all have floating exchange rates Econ 340, Deardorff, Lecture 14: Pegging 12 Who Pegs? • Other Developed Countries? – No: Canada, Japan, Australia, New Zealand, Korea all have floating rates3 Econ 340, Deardorff, Lecture 14: Pegging 13 Who Pegs? • Developing Countries? – They are mixed – A sample (from IMF, 2008): • Argentina: pegged (to US dollar) • Brazil: float • Bulgaria: currency board (pegged to euro) • China pegged to dollar until summer 05 and July 08 to July 2010 • Costa Rica: crawling peg • India: managed float • Egypt: managed float • Nepal: pegged (to India’s rupee) – We’ll update this list in a later lecture. Econ 340, Deardorff, Lecture 14: Pegging 14 Lecture 14 Outline: Pegging the Exchange Rate • How It’s Done – Market Intervention – Bands of Fluctuation – Hybrids of Pegged and Floating • Who Pegs? • Mechanics of Intervention – Reserves – Money Supply – Sterilization • Effects of Pegging Econ 340, Deardorff, Lecture 14: Pegging 15 Mechanics of Intervention • Always: Buy or sell foreign currency in exchange for domestic currency • This has two effects, if nothing else is done: 1. Changes the level of reserves of foreign currency 2. Changes the level of the country’s own domestic money supply in circulation Econ 340, Deardorff, Lecture 14: Pegging 16 Mechanics of Intervention • Change in Central Bank’s Reserves of Foreign Currency – What they buy is added to reserves – What they sell is subtracted from reserves Econ 340, Deardorff, Lecture 14: Pegging 17 Mechanics of Intervention • Change in Country’s Domestic Money Supply – When US Central Bank (CB) buys € with $, those $ go into circulation • This adds to the US money supply • (Actually, it adds even more, due to “money multiplier” you learned about in Econ 102) – When CB sells € for $, those $ come out of circulation • Reducing the money supply Econ 340, Deardorff, Lecture 14: Pegging 18 Mechanics of Intervention • Sterilization – However, Central Bank has the option of preventing this change in the money supply by “sterilization” – Sterilization = Use of offsetting open market operations to keep the money supply unchanged – Example: To sterilize a $1 m.
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