FROM THE BALANCE OF PAYMENTS TO THE MONEY SUPPLY

If the country has an official settlements balance surplus, so that the exchange rate value of the country’s currency is experiencing upward pressure. The central bank must intervene to buy foreign currency and sell domestic currency. The result is an increase in official international reserve holdings and an increase in its liabilities.
First, intervention to defend the fixed rate alters monetary conditions in the country. Second, a fixed exchange rate and its defense constrain a country’s ability to pursue an independent monetary policy. Third, the effects of fiscal policy are also altered by a fixed exchange rate. Fourth, defending a fixed exchange rate without sterilization alters how different exogenous shocks affect the country’s macroeconomy in the short run.
Overall payments balance “worsens” Current account balance “worsens”
Price level increases. (in the long run)
FROM THE MONEY SUPPLY TO THE BALANCE OF PAYMENTS

Review: fractional banking money multiplier process money supply
FROM THE BALANCE OF PAYMENTS TO THE MONEY SUPPLY

If the country has an official settlements balance deficit, so that the exchange rate value of the country’s currency is experiencing downward pressure. The central bank must intervene to sell foreign currency and buy domestic currency.

STERILIZATION


Sterilization is taking an action to reverse the effect of official intervention on the domestic money supply. In a situation of payments surplus, the effects on the monetary base and the money supply of the combination of intervention and sterilization tend to cancel out. The net effects of the sterilized intervention are to alter the composition of the central bank’s assets (R increases and D decreases). In a situation of payments deficit, the effects on the monetary base and the money supply of the combination of intervention and sterilization tend to cancel out. The net effects of the sterilized intervention are to alter the

Internal and External Balance with Fixed Exchange Rate
Why study fixed rate? First, within the current system a substantial number of countries do fix their exchange rates. Second, in the current system a number of countries have floating rates in name, but the rates are so heavily managed by the government that they are closer to being fixed rates. Third, there are continuing discussions about returning to a system of fixed rates among the world’s major currencies.
FROM THE MONEY SUPPLY TO THE BALANCE OF PAYMENTS
Capital flows out (in the short run) Interest rate drops Real spending, production, and income rise.
An increase in the money supply

FROM THE MONEY SUPPLY TO THE BALANCE OF PAYMENTS

Expanding the money supply worsens the balance of payments with fixed rates.


The adjustment process in IS-LM-FE model.
The conclusion is that if an external imbalance exists, intervention to defend the fixed rate changes the domestic money supply. The money supply change causes adjustments that move the country back toward external balance.

The result is an decrease in official international reserve holdings and an decrease in its liabilities. The conclusion is that official intervention alters the central bank’s assets and liabilities, therefore, the country’s money supply, unless the central bank does
the defense of fixed exchange rate affects the country’s fiscal policies.
How
Internal and External Balance with Fixed Exchange Rate
Four implications of having a fixed exchange rate and defቤተ መጻሕፍቲ ባይዱnding it using official intervention.
i LM0 LM1 A i0 i1 E IS Y Y0 Y1 FE
FROM THE MONEY SUPPLY TO THE BALANCE OF PAYMENTS
What is the problem? First, the process is based on changes in the country’s holdings of international reserve assets. For a country that begins with a surplus, the monetary authority will acquire official international reserve assets. For a deficit, the authority will lose official reserves. Officials may view either change as undesirable. But this is not always true. Second, the adjustment toward external balance may not be consistent with internal balance.

FROM THE BALANCE OF PAYMENTS TO THE MONEY SUPPLY
Central bank Selected assets Domestic assets (D) Debt securities Loans to banks International reserve assets (R) Foreign – currency assets Selected liabilities Monetary base (MB) currency Deposits from banks