Financial Markets and Institutions (2-downloads)

sell domestic currency to keep the exchange rate fixed, but as a result, it

gains international reserves.

As we have seen, if a country’s currency is overvalued, its central bank’s attempts

to keep the currency from depreciating will result in a loss of international reserves.

If the country’s central bank eventually runs out of international reserves, it cannot

keep its currency from depreciating, and a devaluation must occur, in which the par

exchange rate is reset at a lower level.

If, by contrast, a country’s currency is undervalued, its central bank’s interven-

tion to keep the currency from appreciating leads to a gain of international reserves.

As we will see shortly, the central bank might not want to acquire these interna-

tional reserves, and so it might want to reset the par value of its exchange rate at a

higher level (a revaluation).

If there is perfect capital mobility—that is, if there are no barriers to domestic

residents purchasing foreign assets or foreigners purchasing domestic assets—then

a sterilized exchange rate intervention cannot keep the exchange rate at E

par

because,

as we saw earlier in the chapter, the relative expected return of domestic assets is

unaffected. For example, if the exchange rate is overvalued, a sterilized purchase

of domestic currency will leave the relative expected return and the demand curve

unchanged—so pressure for a depreciation of the domestic currency is not removed.

If the central bank keeps purchasing its domestic currency but continues to sterilize,

it will just keep losing international reserves until it finally runs out of them and is

forced to let the value of the currency seek a lower level.

One important implication of the foregoing analysis is that a country that ties its

exchange rate to an anchor currency of a larger country loses control of its monetary

policy. If the larger country pursues a more contractionary monetary policy and

decreases its money supply, this would lead to lower expected inflation in the larger

country, thus causing an appreciation of the larger country’s currency and a depreci-

ation of the smaller country’s currency. The smaller country, having locked in its

exchange rate to the anchor currency, will now find its currency overvalued and will

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