THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 560

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PA R T V I

International Finance and Monetary Policy
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 depreciation 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
therefore have to sell the anchor currency and buy its own to keep its currency from
depreciating. The result of this foreign exchange intervention will then be a decline
in the smaller country s international reserves, a contraction of its monetary base, and
thus a decline in its money supply. Sterilization of this foreign exchange intervention
is not an option because this would just lead to a continuing loss of international
reserves until the smaller country was forced to devalue its currency. The smaller
country no longer controls its monetary policy, because movements in its money supply are completely determined by movements in the larger country s money supply.
Another way to see that when a country fixes its exchange rate to a larger country s currency it loses control of its monetary policy through the interest parity condition discussed in Web Appendix 19.1. There we saw that when there is capital
mobility, the domestic interest rate equals the foreign interest rate minus the
expected appreciation of the domestic currency. With a fixed exchange rate,
expected appreciation of the domestic currency is zero, so that the domestic interest rate equals the foreign interest rate. Therefore, changes in the monetary policy
in the large anchor country that affect its interest rate are directly transmitted to
interest rates in the smaller country. Furthermore, because the monetary authorities in the smaller country cannot make their interest rate deviate from that of the
larger country, they have no way to use monetary policy to affect their economy.

APP LI CAT IO N

How Did China Accumulate Nearly US$2 Trillion
of International Reserves?
By the end of 2008, China had accumulated nearly US$2 trillion of international
reserves. How did the Chinese get their hands on this vast amount of foreign
assets? After all, China is not yet a rich country.
The answer is that China pegged its exchange rate to the U.S. dollar at a fixed
rate of 8.28 yuan (also called renminbi) to the U.S. dollar in 1994. Because of
China s rapidly growing productivity and an inflation rate that is lower than in the
United States, the long-run value of the yuan has increased, leading to a higher
relative expected return for yuan assets and a rightward shift of the demand for
yuan assets. As a result, the Chinese have found themselves in the situation
depicted in panel (b) of Figure 20-2, in which the yuan is undervalued. To keep
the yuan from appreciating above Epar to E1 in the figure, the Chinese central bank
has been engaging in massive purchases of U.S. dollar assets. Today the Chinese
government is one of the largest holders of U.S. government bonds in the world.