THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 559

CHAPTER 20
Exchange Rate, Et
(foreign currency/
domestic currency)

The International Financial System

Exchange Rate, Et
(foreign currency/
domestic currency)

S

Epar

2

E1

1

D1 D2
Quantity of
Domestic Assets
(a) Intervention in the case of an overvalued exchange rate

FIGURE 20-2

527

S

E1

1

Epar

2

D2 D1
Quantity of
Domestic Assets
(b) Intervention in the case of an undervalued exchange

Intervention in the Foreign Exchange Rate Market Under a Fixed
Exchange Rate Regime

In panel (a), the exchange rate at Epar is overvalued. To keep the exchange rate at Epar (point 2),
the central bank must purchase domestic currency to shift the demand curve to D2. In panel (b),
the exchange rate at Epar is undervalued, so the central bank must sell domestic currency to
shift the demand curve to D2 and keep the exchange rate at Epar (point 2).

We have thus come to the conclusion that when the domestic currency is
overvalued, the central bank must purchase domestic currency to keep the
exchange rate fixed, but as a result it loses international reserves.
Panel (b) in Figure 20-2 describes the situation in which the demand curve has
shifted to the right to D1 because the relative expected return on domestic assets
has risen and hence the exchange rate is undervalued: The initial demand curve
D1 intersects the supply curve at exchange rate E1, which is above Epar. In this situation, the central bank must sell domestic currency and purchase foreign assets.
This action works like an open market purchase to increase the money supply and

lower the interest rate on domestic assets i D. The central bank keeps selling domestic currency and lowering i D until the demand curve shifts all the way to D2, where
the equilibrium exchange rate is at Epar point 2 in panel (b). Our analysis thus
leads us to the following result: When the domestic currency is undervalued,
the central bank must 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 intervention 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
international 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 Epar