Financial Markets and Institutions (2-downloads)

1

D

1

E

par

2

(b) Intervention in the case of an undervalued exchange rate

S

Exchange Rate, E

t

(foreign currency/

domestic currency)

Quantity of

Domestic Assets

E

1

D

2

1

D

1

E

par

2

(a) Intervention in the case of an overvalued exchange rate

F I G U R E   1 6 . 2

Intervention in the Foreign Exchange Market Under a Fixed Exchange 

Rate Regime

In panel (a), the exchange rate at 

E

par

is overvalued. To keep the exchange rate at 

E

par

(point 2), the central bank

must purchase domestic currency to shift the demand curve to 

D

2

. In panel (b), the exchange rate at 

E

par

is under-

valued, so the central bank must sell domestic currency to shift the demand curve to 

D

2

and keep the exchange

rate at 

E

par

(point 2).

relative to an anchor currency at E

par

, while the demand curve has shifted left to D

1

,

perhaps because foreign interest rates have risen, thereby lowering the relative

expected return of domestic assets. At E

par

the exchange rate is now overvalued: The

demand curve D

1

intersects the supply curve at exchange rate E

1

, which is lower than

the fixed (par) value of the exchange rate E

par

. To keep the exchange rate at E

par

,

the central bank must intervene in the foreign exchange market to purchase domes-

tic currency by selling foreign assets. This action, like an open market sale, means that

both the monetary base and the money supply decline, driving up the interest rate

on domestic assets, i

D

.

5

This increase in the domestic interest rate raises the rela-

tive expected return on domestic assets, shifting the demand curve to the right. The

central bank will continue purchasing domestic currency until the demand curve

reaches D

2

and the equilibrium exchange rate is at E

par

at point 2 in panel (a).

We have thus come to the conclusion that when the domestic currency is