CHAPTER 20 Exchange Rate, Et (foreign currency/ domestic currency) The International Financial System Exchange Rate, Et (foreign currency/ domestic currency) S Epar E1 D1 D2 Quantity of Domestic Assets (a) Intervention in the case of an overvalued exchange rate FIGURE 20-2 527 S E1 Epar 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 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