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Lecture Money, banking, and financial markets (3/e): Chapter 19 - Stephen G. Cecchetti, Kermit L. Schoenholtz

Chapter 19 - Exchange-rate policy and the central bank. In this chapter, students will be able to understand: When capital flows freely across a country's borders, fixing the exchange rate means giving up domestic monetary policy; central banks can intervene in foreign exchange markets; the decision to fix the exchange rate has costs, benefits, and risks; there are a number of examples of exchange-rate systems. | Chapter Nineteen 19- Introduction We need to examine the mechanics of how a central bank manages its country’s exchange rate. Both the U.S. and Europe are huge and largely self-contained economies. For the most part, these economies produce what they consume and invest. They can focus on domestic economy and let their exchange rates take care of themselves. 19- Introduction In small countries, however, imports and exports are sometimes more than 50 percent of GDP. Central banks in these countries do not have the luxury of leaving their exchange rates to take care of themselves. These countries are more exposed to what goes on in the rest of the world. Change in their exchange rates can have dramatic impact on them. 19- Introduction If exchange-rate policy is inseparable from interest-rate policy, we have left something out of our analysis. Why is a country’s exchange rate linked to its domestic monetary policy? Are there circumstances when exchange-rate . | Chapter Nineteen 19- Introduction We need to examine the mechanics of how a central bank manages its country’s exchange rate. Both the U.S. and Europe are huge and largely self-contained economies. For the most part, these economies produce what they consume and invest. They can focus on domestic economy and let their exchange rates take care of themselves. 19- Introduction In small countries, however, imports and exports are sometimes more than 50 percent of GDP. Central banks in these countries do not have the luxury of leaving their exchange rates to take care of themselves. These countries are more exposed to what goes on in the rest of the world. Change in their exchange rates can have dramatic impact on them. 19- Introduction If exchange-rate policy is inseparable from interest-rate policy, we have left something out of our analysis. Why is a country’s exchange rate linked to its domestic monetary policy? Are there circumstances when exchange-rate stabilization becomes the overriding objective of central bankers? Should central bankers try to fix their exchange rate? Should a country consider giving up its currency entirely? 19- Linking Exchange-Rate Policy with Domestic Monetary Policy Exchange-rate policy is integral to any monetary policy regime. When capital flows freely across a country’s borders, a fixed exchange rate means giving up domestic monetary policy. 19- Linking Exchange-Rate Policy with Domestic Monetary Policy There are two ways to see the connection between exchange rates and monetary policy. We can think about the market for goods and purchasing power parity. Capital market arbitrage shows us how short-run movements in exchange rates are tied to the supply and demand in the currency markets. 19- Inflation and the Long-Run Implications of Purchasing Power Parity In Chapter 10 we discussed the law of one price: Ignoring transportation costs, this says that identical goods should sell for the same price