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the government has the right to print unlimited quantities of its own currency. However, supplies of foreign currency must be held in reserve and the government does not have the option of increasing its supply. The possibility of running out of foreign currency and being unable to keep the currency from depreciating is one of the reasons that many nations have given up fixed exchange-rate regimes. Fixed exchange rates have been used by a large number of countries and for a large portion of modern economic history. Following World War II, the major industrialized countries agreed to fix the value of their currencies with respect to each other. This agreement was known as the Bretton-Woods agreement, and the IMF was established in 1949 to monitor this system of exchange rates. To a greater or lesser degree, this system remained in place until the early 1970s, when countries began to allow their exchange rates to drift. Following the breakdown of the Bretton-Woods agreement, the Western European nations joined together in a fixed exchange-rate regime. After suffering several major exchange-rate crises, 12 of the European nations preferred so strongly to maintain a fixed exchange rate that they agreed to give up their national currencies and the euro area was established. By giving up their national currencies and forming a monetary union, the member nations hope to avoid future crises. While the euro area is still relatively young (it was formally established in 1999), the currency union has not yet suffered a major crisis.

The Links Between Monetary and Exchange-Rate Policies A nation’s choice of exchange-rate policy is tightly linked to a nation’s choice of monetary policy. They are tightly linked because exchange-rate policy is a form of monetary policy. Monetary policy, broadly defined, is the policy that controls the growth rate of the money supply. In order to fix the exchange rate, a government must use its ability to control the money supply to sustain a fixed level of the exchange rate. If the supply of money is dedicated to controlling the level of the exchange rate, it cannot simultaneously be dedicated to controlling inflation. Given the earlier discussion of interest rate parity, the choice of monetary target is essentially a choice between stabilizing domestic prices and stabilizing the exchange rate. If the exchange rate is fixed, then domestic prices, both asset prices and goods prices, must do all of the adjusting. The increase in the number of economies preferring floating exchange rates and the rise of independent central banks with mandates to maintain price stability is not a coincidence. An increasing number of countries have come to desire central banks charged with maintaining low and stable inflation. To achieve this goal, central banks need a nominal target to automatically stabilize the money supply. Most modern central banks have chosen a domestic short-term interest rate for the nominal target. The short-term 162 | Economic Report of the President

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policy rate allows the central bank complete autonomy over choosing the rate of domestic inflation. The short-term policy rate is not the only nominal anchor available to the central bank, however. The central bank could choose to fix the domestic price of gold or any other commodity. The use of the gold standard has a long and reputable history. A nation’s exchange rate with another country can also be used as the nominal anchor for monetary policy. By fixing the value of the domestic currency against another currency, a country essentially adopts the monetary policy of the foreign country; one of the problems of using a strict fixed exchange rate is that the monetary policy of the foreign country may differ from what the central bank would have chosen given complete autonomy. That is, the bank could be forced to print either more or less currency than it would have otherwise chosen. Thinking through a specific example will help clarify the relationship between exchange-rate policy and overall monetary policy. For a long time, China had a fixed exchange rate with the United States. To maintain its fixed exchange rate, the Chinese government had to stand ready to buy or sell yuan, China’s domestic currency, for U.S. dollars at a fixed price. From 2000 to July 2005, this price was set at approximately 8.28 yuan per dollar. Over this time period, Chinese productivity growth was much higher than U.S. productivity growth and Chinese prices on average grew much more slowly than U.S. prices. High productivity growth implies a high return to investment in China relative to the United States. The slow growth of Chinese prices implies that, holding the exchange rate constant, Chinese goods were becoming cheaper relative to goods in the United States. Therefore, both in terms of maintaining interest rate parity and in terms of maintaining PPP, there was pressure for the yuan to appreciate relative to the U.S. dollar. How did the Chinese authorities prevent the appreciation? The Chinese authorities prevented the appreciation by buying U.S. dollars and exchanging these dollars for yuan. The pressures for appreciation of the yuan implied that the yuan was facing higher demand—that more goods could be purchased for dollars converted to yuan, and investments in China delivered, on average, a higher return. To offset the increase in demand, the Chinese government effectively increased the supply of Chinese assets and decreased the supply of U.S. assets. Chinese foreign-exchange reserves increased from around $150 billion in early 2000 to almost $1 trillion by September 2006, a truly remarkable increase. In other words, the Chinese prevented an appreciation of the exchange rate by effectively printing yuan and using those yuan to accumulate U.S. dollar assets. By fixing the exchange rate, the Chinese monetary authority is unable to use monetary policy for any other goal. By printing yuan, the Chinese raise the amount of currency in the country, which in turn, holding all else equal, raises the domestic price level, thus raising the economy’s inflation rate. Chapter 7

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But if they are just printing enough to buy and hold U.S. assets, from where does the domestic price pressure arise? The price pressure arises as the yuan, which are used to purchase the dollar assets, flow back into the Chinese economy. In other words, the prices increase because of foreign demand for Chinese goods. On the surface, this foreign demand appears to arise as a result of the Chinese exchange-rate regime; however, this demand is the same demand which was originally putting pressure on the Chinese exchange rate. At the old prices, there was not enough supply of Chinese goods to meet all of the demand. Because the exchange rate was unable to adjust, the price of Chinese goods had to adjust. Could the Chinese conduct a monetary operation to lower inflation? To lower inflation, the Chinese would need to remove yuan from circulation, perhaps by selling domestic bonds. This transaction is sometimes referred to as sterilization. The action, however, will tend to raise the value of the currency: the currency would become scarcer as a result of the reduction in supply. As the currency becomes more valuable the foreign-exchange value of the currency would tend to appreciate. Any monetary action the Chinese undertake to reduce domestic inflation tends to undo their exchange-rate intervention (see Box 7-4). This example also illustrates why the Chinese intervention does not systematically change the relative real prices between the United States and China. Had the Chinese government not intervened, Chinese domestic prices would have remained the same in terms of yuan and become more expensive in terms of dollars through a change in the exchange rate. With the intervention, Chinese domestic prices rose in terms of yuan and became more expensive in terms of dollars even though the value of the nominal exchange rate was unchanged. This outcome occurs any time a country takes actions to fix its exchange rate: fixing the nominal exchange rate does not necessarily have any impact on the relative prices between two countries. In other words, fixing the nominal exchange rate does not tend to move countries away from purchasing power parity. The only effect is that domestic goods prices have to do all of the adjustment since the exchange rate is fixed. In the end, central banks that choose to fix the value of their exchange rate relative to another currency and central banks that choose to set a short-term interest rate are each choosing a different tool to conduct monetary policy. Economic theory does not dictate a clear preference between the two tools; however, by 2006 no central bank from any major industrialized nation has opted to use a fixed exchange rate, while maintaining their own domestic currency, as a monetary policy instrument. These central banks understandably believe that interest rate targeting, in practice, is a preferred tool in the conduct of monetary policy.

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Box 7-4: The Impossible Trinity A fixed exchange-rate regime forces a country to choose between allowing free flows of assets in and out of the country or restricting the flows in order to preserve independent monetary policy. This choice is forced on countries because only two of the following three policies— free asset flows, a fixed exchange rate, and an independent monetary policy—can be maintained at any point in time. The underlying reason for this restriction is that free asset flows and monetary policy operations may yield a foreign-exchange value of the currency which is inconsistent with the fixed rate that the government is trying to maintain. The United States, for example, allows free asset flows and maintains an independent monetary policy. As a result, the U.S. central bank, the Federal Reserve Board, can influence domestic interest rates relative to foreign rates. If the Federal Reserve elects to raise domestic rates, however, then the United States becomes a more attractive investment environment relative to other countries, and assets flow into the U.S. economy. Because this shift in asset flows raises demand for the U.S. dollar, the exchange rate appreciates. Since the U.S. government lets the market determine the dollar’s foreignexchange value, the dollar’s appreciation can occur without any active intervention by the Federal Reserve. In this example, the only way to break the direct link between the exchange rate and the interest rate would be for the United States to restrict asset flows. If assets cannot flow into the United States, demand for the dollar does not rise with the increase in interest rates, and the exchange rate does not necessarily appreciate. In other words, one of the key assumptions of interest rate parity—that assets can flow to the location with the highest return—is broken. Denmark, on the other hand, effectively pegs its domestic currency to the euro and allows free flows of assets, as evidenced by the nearly 632 billion kroner of foreign direct investment in Denmark in 2005 (over 40 percent of Denmark’s GDP). By pegging its currency and allowing free asset flows, Denmark essentially loses the ability to independently determine its domestic inflation rate. If Denmark were to alter interest rates so that they deviated from world rates, assets would flow in or out of the Danish economy and lead to a shift in the exchange rate. To correct this shift and maintain its fixed exchange rate with the euro, Denmark would then have to buy or sell kroner, thus negating the interest rate changes it achieved through its monetary policy. In this sense, free asset flows and a fixed exchange rate make an independent monetary policy virtually impossible. continued on the next page

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Box 7-4 — continued In the middle of the spectrum are countries such as China, which has pegged its exchange rate to the U.S. dollar. China can, to a limited extent, operate an independent monetary policy, however, because it restricts the ability of its residents to move capital out of the country. In China’s case, world and domestic interest rates can differ since restrictions on the flow of funds out of the domestic economy limit the resulting changes in the money supply and the corresponding pressures on the exchange rate.

Conclusion Currency markets facilitate global trade and investment by making it easy for firms and investors to buy or sell the currencies they need to do business globally. In the absence of global currency markets, the benefits of international openness would be nearly impossible to realize—international trade would effectively be reduced to barter arrangements. The growing importance of international trade and investment has been accompanied by an increasing number of transactions in the foreign-exchange markets. The value of a nation’s currency is determined like any other good, service, or asset. The more people demand the currency and the scarcer the supply of the currency, the higher the currency’s value. The value of a currency is measured by its purchasing power relative to other currencies. In other words, the value of a currency is measured by its exchange rate with other currencies. Exchange-rate policy is a form of monetary policy. When a country fixes its exchange rate relative to another country, that country must use its monetary policy to maintain the exchange rate. A country with a fixed exchange rate does not have the ability to use monetary policy for any other purpose, just as a nation which sets a short-term interest rate must devote its monetary policy to achieving that goal. In addition, the value of a country’s currency is in large part determined by the value of that country’s goods, services, and assets and the ability of people and firms to freely trade these items across national borders. Any policy that restricts the free flow of these items will lower the value of the currency, in addition to lowering the value of the restricted asset. The value of a nation’s currency is tied to people’s ability to move assets and goods. Small changes in a nation’s openness to trade and investment will likely have a small impact on the value of the currency; however, every movement towards more protectionist policies is likely to be associated with a lower value of a nation’s currency than would have been true otherwise. 166 | Economic Report of the President