Central Banks, macroeconomic adjustments.

1. Central Banks
Macro - Adjustment Strategies

2. Central Banks & Exchange
Rate Regimes
 Flexible
 Fixed
 Managed Floating

3. Flexible Exchange Rate
 Exchange rates are freely determined
by the demand & supply of currencies.

4. Increase in Demand for £
Under Flexible Exchange Rate
e$/£
S£
e’
e
D£’
D£
Q£

5. Fixed Exchange Rate
 Gold standard (up to 1914)
 Peg currency to gold at a mint parity.
($20.67/ounce of gold, £4.25/ounce
of gold).

6. Fixed Exchange Rate
 Gold standard
 Pegged rate system
 Peg is the central value of exchange rate
around which the government maintains
narrow limits. (Haitian Gourde = $.20 since
1907 for a long period of time).
 Government intervenes in foreign exchange
markets to maintain the exchange rate
within prescribed limits.

7. Increase in Demand for £
Under Pegged Rate System
e$/£
S£
S£’
ē
D£’
D£
Q£

8. Fixed Exchange Rate
 Devaluation
 Peg is increased.
• £ was devalued in Nov. 1967 from $2.80/£ to
$2.40/£ .
 Revaluation
 Peg is decreased.

9. Managed Floating
 Government intervenes in the foreign
exchange market to influence the
exchange rate, but does not commit
itself to maintain a certain fixed rate or
some narrow limits around it.

10. Goods Market Equations
 Y = C + I + G0 + NX (Equim condition)
 C = C0 + cYd (Consn function)
 Yd = Y – T + R0 (Disposable income)
 T = T0 + tY (Tax function)
 I = I0 – br (Investment function)

11. Goods Market Equations
Endogenous Variables Parameters
 Y: National Income  c: MPC
 C: Consumption  t: Personal Tax Rate
 Yd: Disposable Income  b: Interest Sensitivity of I
 T : Personal Tax Revenue  C0 : Exogenous Component of C
 I : Investment
 I0 : Exogenous Component of I
 G0 : Government Expenditure
 R0 : Transfer Payments
 T0 : Fixed personal tax revenue

12. Goods Market Equilibrium:
IS Curve (General form)
 Goods market equilibrium condition:
AS = AD
Sn – I = NX
- A0 + br + sY = NX0 – mY
r = (A0 + NX0)/b – (s + m)/b*Y
= (A0 + NX0)/b – 1/αb*Y where
A0 = C0 + c(R0 – T0) + I0 + G0
NX0 = X0 – Q0 + (g + j)eP*/P
α = 1/[1 – c(1 – t) + m]

13. Goods Market Equilibrium:
IS Curve (Particular form)
 r=
A0 =
Open economy multiplier 1/(s+m) =

14. IS Curve
r
[A0 + NX0/b I
-1/ b
S
Y

15. Assets Markets
 Markets in which money, bonds, stocks,
real estate & other forms of wealth or
stores of value are exchanged.
 We consider two types of assets
 domestic bonds
 domestic money

16. Total Real Wealth in the Economy
 Supply of real wealth
 W/P = M/P + VS where
W : Nominal wealth
P : General price level
VS: Stock of bonds
 Demand for real wealth
 W/P = L + V
L: Demand for money
V: Demand for bonds
 In equilibrium
 L + V = M/P + VS
 Or (L - M/P) + (V - VS) = 0

17. Walras law
 As long as money market is in
equilibrium (i.e. L = M/P), bond market
will also be in equilibrium.

18. Money Market Equations
L = M/P (Money market equim condition)
 L = L0 + kY – hr (Money demand)
 M = uH (Money supply)
 H = IR + CBC0 (High Powered Money)
 IR = IR-1 + BP-1 (Int. Reserves adjustment)

19. Money Market Equations
Endogenous Variables Exogenous Variables
 L: Liquidity Demand  k: Income Sensitivity of L
 r: Real interest Rate  h: Interest Sensitivity of L
 M: Nominal Money Supply  u: Money Multiplier
 H: High-Powered Money  L0: Exogenous component of L
 IR: International Reserves
 P: General Price Level
 CBC0: Central Bank Credit

20. Demand for Money
 The demand for money can be linearized
to:
L = L0 + kY – hr

21. Supply of Money
 MS = Cp + CD
Cp: Currency (coin, dollar notes) in the
hand of the public
CD: Checkable deposits
 M = H where
 : the money multiplier
 H: the high powered money (monetary base)

22. Central Bank’s Balance Sheet
 Assets = IR + CBC
 Liabilities = Cp + RE
 IR + CBC = Cp + RE = H
 H is created when the Central Bank acquires
assets in the form of international reserves, IR
(foreign exchange & gold), & Central Bank
credit, CBC (loans, discounts & government
bonds).

23. Simplified
Central Bank Balance Sheet
Assets Claims
International Reserves $100b Currency $240 b
Central Bank Credit $200b Cash in vaults $20 b
Currency in the hand of the public $220b
Deposits at the central bank $60 b
High Powered Money $300b High Powered Money $300 b

24. Effects of Open Market Purchase
on Central Bank’s Balance Sheet
 Central bank purchase of securities (increase in
CBC).
 Central bank check is deposited in the
commercial bank.
 If the commercial bank decides to convert the
check into cash, the currency in vault (RE)
increases.
 If commercial bank deposit the check at the
central bank, commercial bank deposit (RE)
increases.

25. Effects of a Drain of International Reserves
on Central Bank’s Balance Sheet
 IR decreases & Commercial bank
deposit decreases. A BP deficit (surplus)
decreases (increases) H &, therefore,
tends to decrease (increase) MS.

26. Money Market Equilibrium:
The LM Curve
 MS/P = L0 + kY – hr
 r = (L0 - MS/P)/h + k/h Y
 Particular:
r=

27. LM Curve
r
M
L k/h
Y
[L0-MS/p]/h

28. Immediate-run Equilibrium
 Immediate-run equilibrium is obtained when
both the product & the money markets are in
simultaneous equilibrium.
 It occurs for a given level of fixed MS.

29. Immediate-run Equilibrium
r
M
I
rE
L S
Y
YE

30. Foreign Trade Equations
 BP = 0 (Foreign sector equim condition)
 BP = NX + CF (Balance of Payments)
 NX = X – Q (Net Export function)
 X = X0 + gePW/P (Export function)
 Q = Q0 + mY – jePW/P (Import function)
 e = e-1 – qBP (Exchange Rate adjustment)
 CF = f(r – rW) (Capital Flow equation)

31. Foreign Trade Equations
Endogenous Variables Exogenous Variables
 NX : Net Exports (Trade Surplus)  g : Exchange Rate Sensitivity of X
 X : Value of Exports
 Q : Value of Imports  m : Marginal Propensity to Imp.
 BP : Balance of Payments  j : Exch. Rate Sensitivity of Q
Surplus  f : Capital Mobility Coefficient
 CF : Capital Flow (KAB Surplus)
 e : Exchange Rate  q : Exchange Rate Coefficient
(Domestic/Foreign Currency)  rW : World Interest Rate
 X0 : Exogenous Component of X
 Q0 : Exogenous Component of Q

32. Foreign Trade Sector Equilibrium:
The BP Curve
 BP = 0 => NX + f (r – rW) = 0
 With no capital mobility (f = 0)
 NX = NX0 - mY = 0
 Y = NX0/m
 With perfect capital mobility
 r = rW
 With imperfect capital mobility
NX0 – mY + f (r – rW) = 0
=> r = [rW - NX0/f] + m/f * Y

33. BP with No Capital Mobility
 Y = NX0/m
 In particular form:
Y=

34. BP Curve with
No Capital Mobility
r BP
Y
NX0/m

35. BP Curve with
Perfect Capital Mobility
r
r = rW BP
Y

36. BP Curve with
Imperfect Capital Mobility
r
BP
Y

37. Short-run Equilibrium
 An immediate-run equilibrium sustaining a BP
deficit & losses of international reserves leads
to a decline in MS & a leftward shift of the LM
curve.
 A short-run equilibrium exists when all the
three markets are in equilibrium.

38. Short-run Equilibrium with
No Capital Mobility
r BP
M
I
rE
L S
Y
YE

39. Short-run Equilibrium with
Perfect Capital Mobility
r
M
I
rE BP
L S
Y
YE

40. Short-run Equilibrium with
Imperfect Capital Mobility
r
M
I BP
rE
L S
YE Y

41. Sterilization Operations
Operations carried out by the Central
Bank in order to neutralize the effects
that its intervention in foreign exchange
markets has on H.
 H = IR + CBC = 0
or CBC = - IR