What this lesson teaches
I can explain fiscal, monetary and supply-side policy and judge how well each works.
Syllabus 9570, 3.2.3(b). Macroeconomic Policies: Policy measures and their effectiveness in achieving macroeconomic objectives:; Fiscal policy - How discretionary fiscal policy can influence the level of economic activities and living standards through government spending and taxation; Monetary policy - How monetary policy can influence the level of economic activities and living standards through the management of exchange rates (case of Singapore) and interest rates; Supply-side policies - How supply-side policies can improve quantity, quality and mobility of factors of production to increase the productive capacity of an economy and hence affect living standards
Make a guess
Hong Kong pegs its dollar to the US dollar and lets money move freely. Can it set its interest rates far below US rates?
- Yes, as long as its economy is strong.
- Yes. A peg fixes the exchange rate, not interest rates.
- No. Money would flow out and attack the peg.
Show the answer
No. Money would flow out and attack the peg.
With free capital flows, savers would move money to the US for higher returns. To keep the peg, Hong Kong's rates must follow US rates.
A country that fixes its exchange rate must buy its own currency with reserves when money flows out, and reserves can run out.
Countries manage their currencies in different ways. A floating exchange rate is set by demand and supply, as with the US dollar. A managed float, like Singapore's band, lets the rate move but steers it. A peg fixes the rate against another currency.
Hong Kong has pegged its dollar to the US dollar since 1983, and since 2005 it has kept the rate between HK$7.75 and HK$7.85 per US$. When the HK dollar weakens to HK$7.85, the Hong Kong Monetary Authority buys HK dollars and sells US dollars from its reserves, which raises demand for HK dollars and holds the rate.
A peg holds only while the central bank has reserves to sell. If investors expect a devaluation, they sell the currency and move their money abroad. This is capital flight, and it adds to the selling pressure. In 1997 Thailand spent much of its reserves defending the baht's peg, then let it float on 2 July. The baht lost about half its value within months.
The impossible trinity, or trilemma, explains the trade-offs. A country cannot have all three of a fixed or managed exchange rate, free movement of capital and its own interest rate policy. Hong Kong keeps the peg and free capital, so its interest rates follow US rates. China has long limited capital flows, so it can manage the yuan and still set its own interest rates.
- Peg
- Fixed against another currency; held by buying and selling with reserves.
- Capital flight
- Money leaves when investors expect a devaluation.
- Trilemma
- Choose two: fixed rate, free capital, own interest rates.
- Thailand 1997
- Reserves ran low defending the baht; it floated on 2 July.
Worked example: How long can the reserves last?
Suppose Country X pegs its currency to the US dollar and holds US$60 billion of reserves. Investors expect a devaluation and start moving money out at US$5 billion a month.
- To hold the peg, the central bank must buy the currency being sold, paying US$5 billion a month from its reserves.
- At that pace, the reserves would last 60 / 5 = 12 months, and less if the outflow speeds up as the reserves shrink.
- It can also raise interest rates to make holding its currency more attractive, but higher rates cut C and I and slow the economy.
- If the outflow does not stop, the peg must go. The currency falls sharply, and import prices and foreign-currency debts jump.
Watch out for this
A country with a fixed exchange rate can still set whatever interest rate it wants.
Not if capital moves freely. If its rates fall below those of the anchor country, money flows out and the peg comes under attack. To keep the peg, it must either follow the anchor's rates or restrict capital flows.
Check your understanding
Investors start moving money out of a country that pegs its currency. What must the central bank do to hold the peg?
- Print more of its own currency so there is enough to go round.
- Buy its own currency using foreign reserves.
- Cut interest rates to support the economy.
Show the answer
Buy its own currency using foreign reserves.
Right. Buying its currency raises demand for it, offsetting the extra supply from the outflow.