Chapter 2 (b) The Duel Role of Central banks

n The major role of a Central Bank is to The Determination of maintain the value of its currency. It Exchange Rates: can do this two ways. n 1) Domestic monetary policy: the role of Central Banks controlling domestic inflation and interest rates. n 2) International policy: helping to maintain ‘stable’ exchange rates.

The Role of Central Banks The Role of Central Banks n n The central bank is, in theory, the only government 2) The central bank may, if it doesn’t wish private-sector agency that can “print” new money. New money is interest rates to rise, purchase some of the Treasury’s usually ‘transmitted’ to the private sector through outstanding debt. a process called monetization. n 3) The bank pays the seller or issuer of those bonds n Monetization is what happens when a government with what is essentially new money (fiat money). bond is converted to currency in circulation. n 4) Clearly, if the Central bank buys up a lot of the debt, it n The process of monetization: will be essentially “printing” a lot of new money. The n 1) If the Treasury needs to borrow to fund a budget monetary base balloons and domestic inflation may deficit, it issues new Treasury debt. If the Treasury increase. issues too much, interest rates could rise sharply, “crowding out” private borrowers.

The Role of Central Banks The Role of Central Banks n A Central Bank that is closely-linked to the ruling n The government has to borrow, issuing bonds, to raise government may have a tendency to monetize deficits the difference between spending and tax revenues. w for political reasons. n n As the Central Bank often ends up being the only buyer Weak governments usually have a severe problem with of the government bonds, these weak governments excessive money creation. usually have a severe problem with excessive money n Weak governments have trouble collecting taxes creation. n Weak governments resort to excess spending on n Argentina (earlier Hong Kong) dispensed with its government jobs, a large military, lavish pensions to irresponsible central bank and tried to use a currency maintain popularity. n board: Argentine pesos were backed (one to one) by Thus, the budget goes deeply into deficit. USDs held by the Board. The board wasn’t supposed to “print” more pesos than it had dollars.

1 The Role of Central Banks Central Banks & Currency Boards

n n The currency board solution is fairly rare. There are two advantages of a central bank over a currency board: n The major trend has been a recent gain in central bank n independence, with the clear mission that of preserving 1) liquidity crisis: the central bank can act as lender of the value of the nation’s currency. the last resort to the domestic banking system during a loss of confidence (or panic). Remember, banks n In practice, independence means the bank can’t be borrow short-term and lend long-term. If depositors influenced into funding the ruling government’s budget panic and want their money back all at once the banks deficits. will fail. But the central bank can (and usually will) n In the past, the central banks with the greatest print enough new money to cover these rare events. independence were the most successful in controlling n What about Y2K? inflation, and also had the best reputation. Ex: Bundesbank, Swiss National Bank.

Central Banks & Currency Boards Currencies and Seigniorage n The second advantage of a central bank over a currency n A third approach: use some other currency. Panama board is the ability to conduct monetary policy. uses the USD, and the dollar circulates in many n When the economy is in recession, the central bank can countries with unstable governments. monetize more government debt, allowing the Treasury n When the central bank monetizes government debt, spend more without crowding out private borrowing the Treasury now pays the interest to the CB, rather (Japan is doing this). than to private investors. Usually, the CB returns n Inflation may not result as prices are often falling this interest to the Treasury. This “free ride” for the during recession government - not having to pay interest is called seigniorage. n The role of price stability works both ways. Don’t want inflation or deflation.

Currencies and Seigniorage The Role of Central Banks n the interest a government avoids paying when it n Under fixed (pegged) exchange rates, central banks issues currency, is a major issue in the had a major secondary role of managing the Dollarization” debate. Some countries, (the citizens county’s exchange rate - usually through increasing at least) tired of their own unstable currency, would or decreasing the supply of it’s currency on the like to replace theirs with the USD (or maybe the forex markets. Euro). n Even, now, with floating rates, central banks n The U.S. taxpayer would gain from the additional sometimes intervene on currency exchanges if they monetization required to print the new required view an exchange rate shift as too extreme. specie. Argentina, now partly dollarized, has Extreme depreciation or appreciation can harm the expressed a wish to use only the USD, but collect economy. some seigniorage.

2 Impact of currency depreciation Intervention

- Exports: more competitive. n To Defend or Support a Currency: Buy - Imports: less attractive back the currency on the Foreign Exchange Benefit: easier to export, domestic prices fall Market, using up Foreign Reserves. Ex: relative to foreign prices. The Brazilian Central bank used $ reserves to buy back Reals. However, the bank Disadvantage: higher cost imports (especially failed to save the peg as forex reserves ran commodities such as oil) can spur inflation. too low. Foreign investors may start to panic and pull n funds from the country - causing a runaway The CB may borrow reserves from other devaluation. Central Banks or intervene in concert with other Central Banks.

Impact of currency appreciation Intervention

Benefit: imports should be cheaper, lower n Easier to push down one's currency. inflation. Japan’s managed float Disadvantages: Exports: less competitive. n Trade surplus often means a shortage of Export oriented countries often Yen to buy Japanese goods. Yen could rise intervene to keep the currency from and make Japanese goods less competitive. rising. Many are Asian countries; n Bank of Japan can "Print money" and buy Taiwan, China, Japan. foreign exchange. This “printing” is how central banks build up reserves.

Sterilized Intervention: Mexico The case of Mexico

n A case conducting foreign intervention and an n Mexico wished to keep the Peso from falling opposing domestic monetary policy. against the dollar, but (as this was during a n Example in 1994-5: Mexico was running a presidential election year) also wanted to keep large trade deficit and investors (both foreign the local economy growing at the same time. and Mexican!) had decided that they no n In essence, the “solution”: less Pesos abroad longer wished to invest in Mexico, and started but the same (or more) Pesos at home. pulling funds out, selling peso assets for dollars. The supply of pesos rose on the forex markets, pushing the peso exchange rate down.

3 The case of Mexico Sterilized Intervention: Mexico n Money creation: world peso supply rises. n The Bank of Mexico bought up the excess pesos, spending its foreign reserves (mostly n Domestic: Central Bank buys government debt, dollars). What happened to these peso? pays with new money. n As pesos were removed from the economy, n Foreign: none, too many pesos already. Mexican interest rates rose. To offset the n Money destruction: world peso supply falls. shrinking domestic peso supply, the central n Domestic: none, BdM wants economy to grow. monetized more the government’s debt, and n Foreign: Bank of Mexico sells foreign currency added to the domestic supply of pesos. reserves, The pesos purchased are removed from circulation.

Sterilized Intervention (skip) Sterilized Intervention (skip) n n Case of opposing loose foreign intervention The intervention strategy: The Bank of Japan and tight domestic monetary policies: creates new Yen, then sells them on the forex markets. n Example: Japan wishes to keep the Yen from n rising but wishes to fight inflation at the same New Problem: foreigners use the new money time. Wants domestic money to be stable but to buy Japanese goods, thus Yen return to the increased supply outside country. local economy and helps cause domestic inflation. n New solution: Central bank buys up the new Yen as they come into the country, by selling (Japanese) T-Bills from its government securities portfolio.

Sterilized Intervention (skip) n Money creation: world yen supply rises. n Domestic: none, BOJ doesn’t want inflation. n Foreign: Bank of Japan buys foreign currencies, pays with new money n Money destruction: world yen supply falls. n Domestic: BOJ sells government debt from portfolio, to pay for the yen that returns to Japan. The yen purchased are removed from circulation. n Foreign: none, BOJ wants Yen to stop rising on forex market.

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