Reserve Country Monetary Policy under Fixed Exchange Rates

Suppose the US fixes its exchange rate to the British pound. In this circumstance the exchange rate system is a reserve currency standard in which the British pound is the reserve currency. The US government is the one that fixes its exchange rate and will hold some quantity of British pounds on reserve so it is able to intervene on the FOREX to maintain the credible fixed exchange rate.

It is worth noting that since the US fixes its exchange rate to the pound, the British pound is, of course, fixed to the US dollar as well. However, since the pound is the reserve currency, it has a special place in the monetary system. The Bank of England, Britain’s central bank will never need to intervene in the FOREX market. It does not need to hold dollars. Instead all market pressures for the exchange rate to change will be resolved by US intervention, that is by the non-reserve currency country.

Expansionary Monetary Policy by the Reserve Country

Now let’s suppose that the reserve currency country, Britain, undertakes expansionary monetary policy. We will consider the impact of this change from the vantage point of the US, the non-reserve currency country. Suppose the US is originally in a super-equilibrium at point F in the adjoining diagram with the exchange rate fixed at Ē_$/£. An increase in the British money supply will cause a decrease in British interest rates, i_£.

As shown in section 60-4, foreign interest rate changes cause a shift in the AA-curve. More specifically, a decrease in the foreign interest rate will cause the AA curve to shift downward (i.e., ↓i_£ is an AA-downshifter). This is depicted in the diagram as a shift from the red AA to the blue A’A’ line.

The money supply decrease puts downward pressure on the exchange rate in the following way. When British interest rates fall it will cause i_£ < i_$, and interest rate parity will be violated. Thus, international investors will begin to demand more dollars in exchange for pounds on the private FOREX to take advantage of the relatively higher rate of return on US assets. In a floating exchange system excess demand for dollars would cause the dollar to appreciate and the poundto depreciate. In other words, the exchange rate E_$/£ would fall. In the diagram this would correspond to a movement to the new A’A’ curve at point G.

However, because the country maintains a fixed exchange rate, excess demand for dollars on the private FOREX will automatically be relieved by US FED intervention. The FED will supply the excess dollars demanded by buying pounds in exchange for dollars at the fixed exchange rate. As we showed in Section 70-x, FED purchases of foreign currency results in an increase in the US money supply. This is because when the FED sells dollars in the private FOREX, these dollars are entering into circulation and thus become a part of the money supply. Since an increase in the money supply causes AA to shift up, the AA curve will return to its original position to maintain in order to maintain the fixed exchange rate. This is shown as the up and down movement of the AA curve in the diagram. Thus, the final equilibrium is the same as the original equilibrium at point F.

Remember that in a fixed exchange rate system, interest rate parity requires equalization of interest rates between countries. When the British interest rates fell, they fell below the rates in the US. However, when the US FED intervenes on the FOREX, the US money supply rises and US interest rates are pushed down. Pressure for the exchange rate to change will cease only when US interest rate become equal to British interest rates and interest rate parity (i_£ = i_$) is again satisfied.

Thus, after final adjustment occurs, expansionary monetary policy by the foreign reserve currency country in a fixed exchange rate system causes no effects on US GNP or the exchange rate. Also since the economy returns to the original equilibrium, there is also no effect upon the current account balance. However, FED intervention in the FOREX, to maintain the fixed exchange rate, will cause US interest rates to fall to maintain interest rate parity with the lower reserve country interest rates.

Contractionary Monetary Policy by the Reserve Country

Contractionary monetary policy corresponds to a decrease in the British money supply which would lead to an increase in British interest rates. In the AA-DD model, an increase in foreign interest rates shifts the AA-curve upward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.

The quick effects however, are as follows. Expansionary monetary policy by the foreign reserve currency country in a fixed exchange rate system causes no effects on US GNP or the exchange rate.Also since the economy returns to the original equilibrium, there is also no effect upon the current account balance.Howe ver, FED intervention in the FOREX, to maintain the fixed exchange rate, will cause US interest rates to rise to maintain interest rate parity with the higher reserve country interest rates.

International Finance Theory and Policy - Chapter 90-4: Last Updated on 4/7/05