Currency Management and Economic Stability PDF

Currency Management and Economic Stability
Author(s): Slobodan Djajić

Source: The Economic Journal, Vol. 94, No. 374 (Jun., 1984), pp. 324-339
Published by: Wiley on behalf of the Royal Economic Society
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The EconomicJournal, 94 (June I984), 324-339
Printedin GreatBritain
CURRENCY MANAGEMENT AND

ECONOMIC STABILITY
SlobodanDjajic*
The sudden change in the course of American monetary policy at the beginning
of this decade has created an interesting policy problem for its trading partners.
A restrictive monetary policy in the United States, which over prolonged
periods of time proved to be tighter than anticipated, has led to a substantial
rise in interest rates on dollar-denominated securities and a sharp increase in
the foreign-currency value of the dollar. The policy problem for other developed
economies is whether to ignore the events in the United States and hope that
the flexible exchange rate system will insulate them from foreign disturbances, or
to try and stabilise the exchange rate by following America's example of monetary
restraint. What makes the problem difficult is that neither of these alternatives
appears attractive. Allowing their currencics to depreciate is inconsistent
with the goal of maintaining a stable price level, while tight monetary policy
seems even less desirable given the depressed state of their economies.'
The purpose of the paper is to examine this policy dilemma in the context of
a simple macro model of a small-open economy in a world of perfect capital
mobility. In the market for goods, the economy is assumed to specialise in the
production of a unique domestic commodity which is consumed at home or
exported, and to import another commodity whose foreign-currency price is
taken as given. Following Dornbusch (1976), the price of domestic goods is
postulated to adjust slowly in response to excess demand. Demand is a function
of income, the rate of interest, and the terms of trade, while supply is deter-
mined according to a well-behaved production function with capital and labour
as arguments. I assume that the capital stcck is fixed, but that the supply of
labour is perfectly elastic at a given real wage defined in terms of a bundle of
domestic and imported commodities. On the financial side of the model
residents have a choice of holding either domestic currency or internationally
traded domestic and foreign short-term securities. Expectations regarding the
future course of the exchange rate are formed rationally2 and economic agents
are assumed to be risk neutral. The foreign real rate of interest (which is equal
to the nominal rate, given the assumption that the foreign price level is con-
stant) is exogenous from the point of view of our economy.
In the context of this simple model I analyse the effects of an unanticipated
permanent increase in the foreign rate of interest on our economy under two
alternative assumptions regarding the behaviour of the central bank. In one
* I wish to thank Russell Boyer, Jon Harkness, Martin Prachowny, Douglas Purvis, John Stapleton,
an Associate Editor and an anonymous referee of the JOURNAL for helpful comments.
1 The policy response of the West German Bundesbank has been examined by Obstfeld (I983).
2 The role of rational expectations in models of exchange rate dynamics has been analysed by Calvo
and Rodriguez (I977), Dornbusch (I976), Frenkel (I976), Kouri (I976) and Mussa (I976), to name
just a few.
[ 324 ]

JUNE I984] CURRENCY MANAGEMENT AND ECONOMIC STABILITY 325
case the exchange rate is perfectly flexible and the monetary authority is
assumed to take no action; in the other, the domestic money supply is reduced
by the amount necessary to restore equality between the domestic and the
foreign nominal rate of interest. If the policy goal is to achieve stable employ-
ment and prices, I show that neither the passive nor the contractionary policy
response is satisfactory. In both cases the price level rises and employment
declines. The contractionary monetary response is preferable, however, since
it reduces fluctuations in employment along the adjustment path and also
results in a more stable price level. The cause of greater real and nominal
fluctuations which cccur in the absence of intervention is the inflexibility of
domestic prices. Lack of price flexibility, however, can be compensated for with
greater flexibility of the nominal money supply. On the basis of this result
I present an argument in favour of currency management.
The extent to which the central bank should intervene in the currency market
in response to an increase in the foreign rate of interest depends, of course, on
the cost of adjustment associated with each of the potential adjustment paths.
This problem is studied under two alternative assumptions regarding adjust-
ment costs. In one case, deviations of macroeconomic variables from their
steady-state values are perceived to be costly; in the other, it is assumed that
jumps in the time paths of the crucial real variables of the model are undesirable.
It is found that intervention in the currency market should be designed to
prevent overshootingof the exchange rate in the first case, and any exchange rate
jumps in the second. In terms of interest-rate policy, intervention in the first
case entails an increase in the domestic rate of interest which matches the
increase in the foreign rate. In the second case the monetary authority should
intervene more aggressively to raise the domestic rate of interest even further.
The policy of maintaining a constant level of employment and prices requires,
however, that currency management be accompanied by an appropriate fiscal
measure.
The paper also examines the dynamics of adjustment of an increase in the
foreign rate of interest under the fixed exchange rate regime. At this point I
compare the various policies that were considered in terms of levels of use of
foreign-exchange reserves. Although long-run reserve use is found to be most
extensive under fixed exchange rates, short-runuse of reserves in implementing
the 'crawling peg' regime is greater than that required to keep the exchange
rate absolutely fixed. This result may be helpful in explaining why reserve use
increased in some countries as they moved from fixed rates to managed floating.
The paper is organised as follows: section I presents the model. Section II
analyses the effects of an unanticipated permanent increase in the foreign real
rate of interest under various policy responses. Finally, section III states some
conclusions.
I. THE MODEL
Our economy is assumed to specialise in the production of a single commodity

which is produced according to a well-behaved function of capital and labour.
Assuming that the capital stock is fixed, output is an increasing function of

326 THE ECONOMIC JOURNAL [JUNE
employment. Firms hire labour up to the point where the product wage is equal
to the marginal physical product of labour. Since the latter is inversely related
to the level of employment, we can express output y as a decreasing function of
the product wage
y =f(W/P), f'(.) < o, (I)
where W and P denote the nominal wage and the price of domestic goods,
respectively.
In order to highlight the implications of the practice of wage indexation for
the process of macroeconomic adjustment in small-open economies, I proceed
under the extreme assumption that the supply of labour is perfectly elastic at
a given real consumption wage wf.In other words, I assume that, due to strong
labour unions or social custom, the nominal wage is fully indexed such that at
any instant the real consumption wage is insulated from commodity price
changes.' Defining units of foreign goods such that their foreign currency price is
equal to i, each unit's domestic currency price is equal to E, the nominal
exchange rate. The consumer price index [I is a weighted average of the two
commodity prices. For convenience I use the Cobb-Douglas specification
[I = EY'P-Y, where y is the share of foreign goods in consumer spending. The
product wage may then be written as W/P = (W/1I) (J/P) = iYOY,where
a _ E/P is the relative price of foreign in terms of domestic goods, or the terms
of trade. By substituting iSy for W/P in equation (i), we obtain y = f (7JOY),
which is the equilibrium relationship between output and the terms of trade.2
It may be simply written as
= < o,
y y(O), y'(.) (2)
since wfand y are treated as constants throughout the paper.
Real aggregate demand for domestic goods, a, is an increasing function of
output, the relative price of foreign in terms of domestic goods, and govern-
ment spending, g, but it is inversely related-to the nominal rate of interest, i:3
a= cy(O),0,i,g], O<aC1< I, a2>o, 0a3<o and 0< C4 (I. (3)
At any instant the level of output may not be equal to aggregate demand.
The difference is assumed to be absorbed by the stock of inventories held by the
retailers who function as intermediaries between the producers and the con-
sumers. The retailers are assumed to set P and agree to purchase from the pro-
ducers (sell to the consumers) any quantity of domestic goods which they wish
to sell (buy) at that price.4 Following Dornbusch (I976), it is further assumed
1 While this assumption is realistic for many European economies, it is not acceptable for countries
like the United States or Canada where labour markets are characterised by long-term wage contracts
and partial indexation. For empirical evidence on this issue, see Sachs (I979) and the references cited
therein. We should note that the main conclusions of this paper would not be affected if we assumed
instead that indexation is only partial in the short run and complete in the long run.
2 This relationship plays a central role in the works of Casas (I 975), Purvis (I 979), Sachs (I 979, I 980)
and Salop (I 974).
3 Assuming that aggregate demand is a function of the real rate of interest rather than the nominal
would not alter any of the qualitative conclusions below. The specification used in the paper simplifies
the exposition to some extent.
4 There are no difficulties involved in allowing for a spread between the buying and the selling price.
We assume that the two prices are equal for notational simplicity only.

I984] CURRENCY MANAGEMENT AND ECONOMIC STABILITY 327
that P is predetermined and adjusts only gradually in response to disequilibrium
in the market for domestic goods. In the absence of persistent monetary growth,
P is assumed to be rising if retailers are decumulating inventories and falling if
inventory accumulation is taking place:'
P = n{4 [y(0), 0, i, g] -y(O)}, 7'{.} > o, and i4o} = o, (4)
where P_ (i /P) (dP/dt) is the proportional rate of change of the price of
domestic goods.
On the asset side of the model, residents are assumed to hold either domestic
currency or traded short-term securities. Securities are issued both at home and
abroad, they are denominated in terms of domestic and foreign currency re-
spectively and are regarded by asset holders as perfect substitutes. If both are to
be held simultaneously, the interest-parity relationship must hold:
i = i* +.R) (5)
where i* is the exogenously given foreign rate of interest and A is the expected
and (under rational expectations) also the actual rate of depreciation of
domestic currency.
Domestic currency is held only by domestic residents. Demand for real
balances, Md/P, is assumed to be an increasing function of real income, but
negatively related to the nominal rate of interest:2
Md
p = m[y(O),i], mI > o, m2 < o? (6)
The nominal money supply, Ml, is controlled by the central bank. With in-
stantaneous adjustment in the money market, money supply is always equal to
money demand, and the equilibrium nominal rate of interest may be written as
a function of the real money stock and real income:
i = A[M/P, y(A)], A1 < o, A2 > o. (7)
Equation (7) may now be used in (4) and (5) to express P and Aas functions
of only P, E, and the exogenous variables:
P = 7T(a{y(E/P),E/P, A[M/P, y(E/P)], g}-y(E/P) ), (8)
A= A[M/P, y(E/P)]-i*. (9)
Equations (8) and (9) are the two basic differential equations that govern the
1 This simple price-adjustment mechanism is somewhat unsatisfactory since the proportional rate of
change of P is only a function of the rate of change of inventories and is independent of the existing
stock of inventories. It is shown in the Appendix, however, that the main conclusions of the paper would
not be affected if P were a function of the level of inventories rather than their rate of change.
2 It would be more
appropriate to specify the demand for real balances as Md/ll = m[Py(O)/II, i],
rather than as in equation (6). It can be easily seen, however, that the two specifications are identical
when iq, the elasticity of demand for real balances with respect to real income, is equal to unity,
but, even if q < i, none of the qualitative results of the paper are affected. I should also point out that
under this alternative specification the S = o schedule in Figs. i and 2 would be negatively sloped for
2j < y/(y- e), where e [dy(0)/d]/1[0/y(0)] < o. Nevertheless, the saddlepath would remain nega-
tively sloped and the adjustment path would have the same properties as the one corresponding to the
substantially simpler money demand function which is used in the text.

dynamics of adjustment. In the neighbourhood of the steady state, the partial

derivatives of (8) and (9) with respect to P and E are given by
p= 7T (1-X3 A2)y 2 E 3 Al M]/F < 0, (IO)
OP 7T'
aI
[(1 -X1-3A2) y' -2l /p > O, II
dE= _(AlM+A2y'E)/P2 > 0, (12)
0E= A2Y'/P < 0, (I3)
/ I S
E E
Fig. I. Stability and the steady state.
where F and E are the steady-state values of P and F. The determinant of the
adjustment matrix is Av= [C- ( I- x1) y'] A1Mir'/P3 < o; thus the two charac-
teristic roots of the system (8)-(9) are real and have opposite signs. This
implies that the long-run equilibrium of the system is a saddlepoint. A graphic
solution is depicted in Fig. I. As can be readily seen from (IO)-(I3), both the
fi= o schedule and the E o schedule are positively sloped. Furthermore,
E dP EA2y'
PdE E=o A1M+EA2y'
EdP _
E(I-_______________<_ I
<PdEt p=o- E(I -c1-x3A2) Y-Ex2-x3A1M<M

thus the slope of the P = o schedule is greater than that of the E = o schedule
and both are inelastic with respect to the ordinate. The directions of arrows

pointing north and south in Fig. I are determined by the signs of partial deriva-
tives in (io) and (i I), and of those pointing east and west by the partial deriva-
tives in (I 2) and (I3). The unique stable branch of the system is negatively
sloped and labelled SS. In the absence of anticipated changes in the exogenous
variables, I assumethat, for any given value of P, rational individuals will select
the correspondingvalue of E which lies on the stable branch. The ray from the
origin labelled O representsthe long-run equilibrium terms of trade.
After setting P and A equal to zero in (8) and (9), we obtain
o = 4{y(E/P), F/F, A[M/P,y(E/P)], g}-y (E/P), (I 4)
o= A[MH/F, y (E/P - i* ( I 5)
which can be solved for the stationary values of P and E as functions of the
exogenous variables.
II. THE FOREIGN RATE OF INTEREST AND

DOMESTIC POLICY RESPONSE
From inspection of equations (8) and (9) it can be seen that an increase in the
foreign rate of interest does not affect the position of the P = o schedule, but
does shift the E = o schedule up and to the left. E will remain equal to zero
following an increase in i* only if i rises by the same amount. For any given a
and M, this requires a higher value of P in order to reduce the real money
supply. In Fig. 2, the (A = o)' schedule correspondingto a higher value of i*,
must thereforeintersect the 00 ray above the old equilibriumpoint A. At the new
long-run equilibrium, representedby point G, both P and E are higher, but the
terms of trade deteriorate so that employment and output are lower.
Consider next the short-run effects of an increase in i*. Slow adjustment in
the price of domestic goods results in overshooting of the exchange rate as E
00
P 01~~~~~~-
(P= 0)"
G (E=0)'
(E 0)'
Al
Po v h
I IHI
I I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
0 Eo E2 El E
Fig. 2. Dynamics of adjustment under alternative intervention policies.

jumps from Eo to E1in Fig. 2. Currency depreciation raises the relative price of
imports, which in turn reduces the supply of and increases the demand for
domestic goods. This creates inflationary pressuresin the goods market. In the
market for assets, the fall of real income reduces the demand for liquidity and
lowers the home country's nominal rate of interest. With a higher foreign rate,
interest parity requires that the domestic currency be expected to appreciate.
This expectation is fulfilled along the saddlepath FG. The initial jump in the
exchange rate also gives rise to a short-run decline in employment which is
larger than the long-run decline. This is a consequence of wage indexation
combined with slow price adjustmentin the market for domestic goods. On the
one hand, instantaneous currency depreciation raises the domestic price of
imports and leads to an immediate increase in the nominal wage; on the other
hand, the price of domestic goods cannot jump discretely. The product wage
therefore rises on impact and the level of employment falls. Along the adjust-
ment path, however, W/P gradually declines and employment increases as the
terms of trade improve.'
In 'summary,an increase in the foreign real rate of interest is clearly a matter
of concern. Rigidity of the real consumption wage permits this disturbance to
have an adverse effect on the steady-state level of employment and output,
while stickiness of domestic prices leads to an even more pronounced drop in
output in the short run. Since exchange-rateflexibility does not serve to insulate
the economy from changes in the foreign real rate of interest, it may be appro-
priate to manage the money supply, and thus the exchange rate, in an attempt
to mitigate fluctuations in employment and prices.2
(a) TheRoleof Intervention in theForeignExchangeMarket

A change in the supply of domestic currency has no long-run effects on any of
the real variables of the model. Equations (I4) and (I5) are homogeneous of
degree zero in all nominal variables; hence a change in M accompanied by a
proportional change in both P and E leaves all markets in equilibrium. In
Fig. 2, a reduction in the nominal money supply can then be depicted as a
proportional shift of both the P = o and . = o schedules down along the 01
1 If the increase in i* is instead perceived to be transitory, instantaneous currency depreciation and
the associated decline in output would be smaller. The exchange rate would initially jump from Eo to
some level between Eo and E1 in Fig. 2, with the magnitude of the jump being directly related to the
length of the period over which i* is expected to remain at its new higher level. Initial depreciation
would set the economy on a path of currency. appreciation and rising prices as it follows an unstable
trajectory with reference to the equilibrium at point G. This trajectory must cross the P = o schedule
(at which time P begins to decline while domestic currency continues to appreciate) and reach the
stable branch of the system corresponding to the old value of i* at time T when the tight monetary
policy is expected to be reversed. If this expectation is fulfilled at time T, the economy will then switch
to the stable branch of the new system which leads it back to point A. Along this stable branch domestic
currency depreciates over time while P continues to fall.
For a more detailed analysis of the dynamics of adjustment in response to disturbances which are
perceived to be transitory, see Buiter and Miller (I98I, I982).
2 Given the assumption that domestic and foreign securities are perfect substitutes, the effects of
changes in the nominal money supply are the same regardless of whether they occur as a result of
intervention in the foreign exchange market or the securities market. The difference between the two
alternatives is reflected only in the central bank's composition of assets. To simplify the analysis later in
the paper, I assume that the central bank intervenes exclusively in the foreign exchange market.

1984] CURRENCY MANAGEMENT AND ECONOMIC STABILITY 331
ray which represents the equilibrium terms ot trade. Following an increase in
the foreign rate of interest, an appropriate reduction in the domestic money
supply can therefore shift the saddlepoint of the dynamic system from G to H.
At point H, monetary contraction sets the domestic rate of interest equal to the
world rate and eliminates the possibility of exchange-rate overshooting as well
as the adverse effects of overshooting on employment, inflation, and output.
The economy instantaneously jumps to its new stationary state at point H
where the real variables of the model take on the same values as at point G, the
stationarystate which correspondsto the passivemonetary response.The crucial
difference between the passive and the contractionary monetary response is
therefore in the adjustment process.
It is important to note that, regardlessof monetary policy, an increase in i*
must be accompanied by an equal increase in i in the new stationary state. For
all markets to reach a state of equilibrium, it is necessary that the real money
supply be reduced. This in turn can be accomplished through a reduction in
M, an increase in P, or some combination of both. In the two extreme cases
analysed in the text, adjustmentin the real money supply takes place exclusively
through a change in M in the case of contractionary monetary response, and P
in the case of passive monetary policy. With a monetary response between the
two extremes, some adjustmenttakes place in both M and P, and the stationary
state can be found on the line between points H and G in Fig. 2. One can easily
see that, the greater the portion of the required adjustment in M/P which is
accomplished through changes in M, the smaller the extent to which the ex-
change rate, terms of trade, employment, and output tend to overshoot their
steady-state values. Should all of the adjustment be accomplished through a
change in M, the new stationary state would be instantaneously attained, as at
H, without any short-run overshooting of the real variables of the model.
The foregoing provides an argument in favour of currency management. In
the case of the passive monetary response we have seen how stickinessof prices
shifts the burden of adjustmentto other variables which are more flexible. But,
if one nominal variable (E) is more flexible than another (P), their ratio, which
is a real variable, will have to fluctuate along the adjustment path, provided
the new stationary state calls for a change in the sticky variable. Greater flexi-
bility of the policy-controlled nominal variable M can, however, reduce the
required long-run change in all other nominal variablesincluding those which
are sticky. Unnecessary real fluctuations can thus be avoided by shifting the
burden of adjustment to M. If deviations of real variables from their steady-
state values impose costs on the economy, one policy implication which emerges
from the analysis is that the supply of domestic currency should be managed so
as to prevent short-run overshooting of the exchange rate.'
The present argument for currency management is very similar to that
advanced by Friedman (I953) in favour of flexible exchange rates. Both argu-
ments recognise the fact that open-economy disturbances require real as well
as nominal adjustments. With domestic prices less than perfectly flexible,
1 Under different cost-of-adjustment assumptions the intervention rule would, of course, be different
See, e.g., Turnovsky (I979).

adjustment costs can be reduced if flexibility of other nominal variables is

increased. While Friedman focused on the exchange rate, the present argu-
ment goes one step further and calls for greater money-supply flexibility, which
in turn implies less exchange-rate variability.'
Underthe 'CrawlingPeg'
(b) Adjustment
So far it has been assumed that the monetary authority's goal is to bring the
economy instantaneously to the new stationary state. Suppose instead that
policymakers wish to avoid jumps in employment and output, even if such jumps
happen to bring the economy immediately to the long-run equilibrium. In
other words, assume that the central bank's perceptions regarding adjustment
costs are such that it prefers a gradual adjustment of the economy's real
variables following an increase in i *. The necessary response in that case is an even
greater reduction in the nominal money supply. To prevent any impact effect
on 0, the central real variable of the model, the nominal money supply must be
sufficiently reduced so that the stable arm of the new system passes through the
initial equilibrium point A in Fig. 2. This entails a rise in the domestic rate of
interest above the foreign rate so that asset holders would be compensated for
the gradual currency depreciation which follows as the momentary equilibrium
slides along the saddlepath AJ. While this policy prevents an instantaneous
decline in output, the increase in the domestic rate of interest has the effect of
lowering the demand for goods, thereby generating deflationary pressures.
With P falling and E rising along the adjustment path, the terms of trade
deteriorate and output gradually declines as the economy approaches its new
steady state at point J.
If from the policymaker's viewpoint the adjustment path AJ looks more
attractive than a jump to point H, currency management should prevent not
only overshooting, but any jumps in the exchange rate. This type of exchange-
rate management, often referred to as the .'crawling peg', requires, however,
that the authorities respond to a foreign monetary contraction by exercising an
even more restrictive monetary policy.2
UnderFixedExchangeRates
(c) Adjustment
Consider next the dynamics of adjustment under the fixed exchange rate
regime. If E is fixed, asset-market equilibrium requires that the domestic rate
of interest be continuously equal to i*. An increase in i* generates a 'stock-
shift' capital outflow which, given the policy of pegging the exchange rate,
reduces the domestic money supply sufficiently to bring i once again in line
with i*. The higher domestic rate of interest reduces the demand for home
goods; thus their price begins to decline. Because E is fixed, the terms of trade
1 These conclusions are similar to those reached by Mundell (I968, chapter i i), where he argued in
favour of fixed exchange rates when capital is perfectly mobile and domestic prices are less than
perfectly flexible. Although his dynamic model differs from the present one, he shows that the adjust-
ment path would be moredirectif the monetary authority were to stabilise the exchange rate. See also
Dornbusch (1979) and Obstfeld (1979), where the issue of exchange rate management is raised in a
model with a sticky nominal wage. For other points of view on this topic, see Boyer (1978), Buiter
(I979), Flood (I979) and Weber (I98I).
2 This seems to have been the policy in Canada over the last four years.

deteriorate and output also declines. The fall in output in turn exerts downward
pressure on the domestic rate of interest. To prevent i from falling below i*, the
central bank must further reduce the money supply through intervention in the
foreign exchange market. Deflation, falling output, and intervention in support
of domestic currency continues until output has declined sufficiently so as to
restore goods-market equilibrium, given the fixed exchange rate and i = i*. In
Fig. 2, this occurs at point K which lies on the 01 ray vertically below point A.'
(d) ReserveUse UnderAlternative

ExchangeRateRegimes
It is now simple to compare the extent to which foreign-exchange reserves are
used in implementing various intervention policies. Returning to Fig. 2, we
recall that points G, H, J and K represent respectively the long-run equilibrium
attained under the perfectly flexible exchange rate regime, the policy of
allowing the exchange rate to jump to its steady-state level, the policy of pre-
venting exchange-rate jumps but allowing the currency to depreciate over time
(the 'crawling peg'), and the policy of keeping the exchange rate absolutely
fixed. In order for the economy to reach point G, which corresponds to the case
of perfect exchange-rate flexibility, the central bank does not use any foreign-
exchange reserves. As we move down from point G along the 01 ray, we observe
that the steady-state values of P which correspond to points H, J and K are
successively lower. Because the long-run values of all real variables (and in
particular the real money stock) are invariant with respect to the degree of
intervention, the nominal money stock must also be lower at each successive
point. It follows that
MO-MK> MO-MJ> MO-MH)
where MO-MK, M0-JiI and MO- MH denote the number of units of domestic
currency that the central bank must purchase on the foreign exchange market
in order to attain the long-run equilibrium at points K, J and H, respectively.
Furthermore, the price that the central bank must pay per unit of domestic
currency is equal to i/Eo units of foreign currency when the steady state is at
points K and J, and I/E2 when it is at point H. The quantity of foreign-
exchange reserves expended in the long run under the fixed exchange rate
regime is therefore greater than that expended under either the 'crawling peg'
or under the policy which brings the economy immediately to steady state at
point H.
In the short run, however, limited intervention may require greater reserve
use than does the fixed exchange rate system. To see this, consider for example
the 'crawling peg' regime. The long-run equilibrium that corresponds to it is
1 Under fixed rates, equation (4), with i* substituted for i, describes the time path of P, given the
values of E, i*, g, and the initial value of P. One can easily see that aP/aP < o, which guarantees
stability. Given the value of P at any instant, the money-market equilibrium condition determines the
now endogenous money supply. Note that the long-run values of the real variables are homogeneous
of degree zero with respect to changes in the nominal money supply. This implies that in the long run,
following an increase in i*, 01 are the equilibrium terms of trade regardless of the extent to which the
central bank intervenes in the foreign exchange market. The long-run equilibrium under fixed exchange
rates is therefore at point K, as described in the text.
I2 ECS 7I

represented by point J in Fig. 2. At the time of an increase in i*, as was demon-

strated above, this policy requires a one-time sale of foreign exchange that is
sufficiently large so as to shift the point of intersection between the P = o and
X = o schedules from G to J. This has the effect of keeping the economy at
point A for an instant and thus preventing a jump in the exchange rate, while
allowing the currency to depreciate over time as the momentary equilibrium
slides down along the saddlepath AJ. On the other hand, under the fixed
exchange rate regime the magnitude of initial intervention is smaller. All that is
required is a reduction in the money supply that restores equality between i
and i* at the initial values of P and E (i.e. point A). In other words, under the
fixed exchange rate regime initial intervention must shift the point of inter-
section between the P = o and k: = o schedules from G to T, such that the X = o
schedule passes through point A. This clearly requires less use of foreign-
exchange reserves than does the 'crawling peg' policy which shifts the saddle-
point further down to J.
The intuition behind this result is relatively simple. When asset holders
expect the central bank to allow the currency to depreciate in the future, as
under the 'crawling peg' regime, equilibrium in the international financial
markets cannot be restored unless i exceeds i* by the expected rate of deprecia-
tion. Under fixed exchange rates such expectations are not justified and asset
markets are in equilibrium only when i = i*. If under the 'crawling peg' i must
be raised above i*, while under fixed rates it must be set equal to i*, and, if in
both cases the momentary equilibrium remains at point A, it follows that the
necessary reduction in the nominal money supply at the time of the disturbance
must be greater under the former regime. Given that intervention by the central
bank is conducted in both cases at the exchange rate equal to Eo, the 'crawling
peg' policy which calls for a greater initial reduction in the money supply also
entails greater use of foreign-exchange reserves at the time of the disturbance.
The policy of maintaining a fixed exchange rate, however, requires further
intervention along the adjustment path. This intervention gradually brings the
point of intersection between the P = o and .9 = o schedules from point T all
the way to K. The long-run use of reserves under fixed rates is therefore more
extensive than in the case of other policies that were considered. Nonetheless,
the analysis does suggest an explanation for the apparently paradoxical finding
that managed floating may in some cases require greater reserve use than the
fixed exchange rate system.'
(e) TheProblemof InsulatingtheEconomy

In the analysis of alternative monetary responses it was found that the steady-
state values of real variables are invariant with respect to changes in the money
supply. Although slow price adjustment enables monetary policy to influence
real variables in the short run, the steady-state decline in output was unavoid-
1 Williamson (1976) and Suss (1976) have found that the use of reserves increased in a number of
countries following the introduction of managed floating and the abandonment of fixed exchange rates.
Other empirical studies on this issue have been conducted by Frenkel (1978), and Heller and Khan
(1978). Djajii (1983) presents a more detailed theoretical analysis of the dynamics of reserve use for
various degrees of intervention in the foreign exchange market.

able regardless of the monetary response. Insulation of output and prices from
the effects of an increase in the foreign rate of interest obviously requires the
use of a real as well as a monetary policy instrument. If the steady state is to
remain at point A in Fig. 2, equations (I4) and (I5) imply that the required
reduction in the nominal money supply and increase in government spending
are
dM/M = -di* and dg- -(ax3/a4) di*, (i6)
where o- P/MA1 > o is the 'semi-elasticity' of demand for money with
respect to the nominal rate of interest, % < o is the partial derivative of
aggregate demand with respect to the rate of interest, and a4 > o is the same
with respect to a change in government spending. Complete insulation there-
fore requires the use of monetary policy to raise the domestic rate of interest
to the level of the foreign rate, while fiscal expansion is needed to counter the
effect of monetary restraint on aggregate demand.
III. CONCLUSIONS
The analysis of this paper suggests that, in a world of flexible exchange rates and
perfect capital mobility, an increase in the foreign real rate of interest is likely
to set a small-open economy with sticky prices and real-consumption-wage
rigidity on a costly adjustment path unless the monetary authority intervenes
to support the price of domestic currency. The extent to which the exchange
rate should be stabilised depends, of course, on the adjustment costs associated
with changes in the relevant macroeconomic variables. For any reasonable
assumptions regarding such costs, however, some intervention will be appropri-
ate. Although our conclusions were reached on the basis of a simple model with
rather restrictive assumptions, their generality extends beyend the present
model. Inflexibility of any important ncminal price justifies intervention if
fluctuations of real variables are perceived to be costly.
The paper also examined the extent to which foreign-exchange reserves are
used by the central bank in response to an increase in the foreign rate of interest
under various intervention policies. Although the fixed exchange rate system
requires the most extensive use of reserves in the long run, short-run use of
reserves was found to be greater under the 'crawling peg' regime. A move from
fixed to managed exchange rates maytherefore lead to an increase in the use of
official reserves, as empirical evidence seems to indicate. Once again, this result
does not depend on the specific functional forms used in the present model,
but only on the assumption that some nominal price is less flexible than others.
Queen'sUniversity,Kingston
Date of receiptof thefinaltypescript:October1983
APPENDIX
According to the simple price-adjustment mechanism described in equation

(4) of the text, P is a function of the rate of change of the stock of inventories of
domestic goods. This hypothesis can be criticised on the grounds that it ignores
I2-2

any influence that the levelof inventories may have on the evolution of prices.
The purpose of this Appendix is to explore the properties of our model under
flexible exchange rates when the level of inventories plays a crucial role in the
dynamics of price adjustment.
Assume that P is an increasing function of S1- N, where SI is the desired
stock of inventories (assumed constant) and N is the actual stock:
P = ?i/(2V-N), V
,r(.) > o, ?/t(o) = o. (Ai)
The rate of accumulation of inventories, X, is equal to the excess supply of
domestic goods.
AT = y(E/P) -c{y(E/P), E/P, A[M/P, y(E/P)], g}. (A 2)
The interest parity condition along with the money market equilibrium condi-
tion yields
. = A[M/P, y(E/P)] -i, (A 3)
which is the same as equation (9) of the text.
By setting (A i)-(A 3) equal to zero, we can solve for the long-run values of
N, P and E. It is evident that N = X and that the solutions for P and E are
identical to those given by equations (i4) and (I5) of the text. The long-run
effects of changes in exogenous variables on P and E are therefore the same
regardless of whether prices adjust according to equation (4) or (A I). With
respect to the dynamics of adjustment, however, the two specifications are not
the same. Nevertheless, in both cases an unanticipated permanent increase in
i* gives rise to initial overshooting of the exchange rate which, as we have seen,
is crucial to our argument in favour of intervention. The dynamic properties of
the system (A i)-(A 3) are examined in the remainder of the Appendix.
After linearising this system in the neighbourhoodof its long-run equilibrium
(P, N, E), we may write it as the following matrix differential equation:
21 oa.2] [NP-
[ j = [oa2l ? a23] N-EI (A4)
a31 0 a33 E-E
where a12 = - 'FP< o,
a21 = - [(I -al-a3 A2) -FY' >2E-a3 AlS] o,
a23 [I-aC1-
( c3 A2) y'-0C2]/ P < O,
a3t = -(Al M+ A2Ey')E/P2 > O,
a33 = A2 Ey' /P < o.
We observe that the trace of the system's matrix is negative. Since this trace is
equal to the sum of the system's characteristicroots, there must be at least one
root with negative real part. Furthermore, the determinant of the system's
matrix A may be written as
JAI = [(I ->0) y. - a2] ?fEA M/F2 > O.
Because JAI is equal to the product of the system's characteristic roots, there are
either two roots with negative real part or no negative roots. Having shown

i984] CURRENCY MANAGEMENT AND ECONOMIC STABILITY 337
that there must be at least one negative root, we conclude that there are
exactly two roots with negative real part.
Since the model involves two predeterminedstate variables, P and N, and a
third state variable, E, which may take (unanticipated) discrete jumps, the
fact that two of the system's roots are negative and one is positive implies the
existence of a unique path converging on long-run equilibrium. Following the
usual practice, I assume that, at the time of the unanticipatedincrease in i*, the
actions of rational market participants will give rise to a jump in the exchange
rate that is required to place the system on the stable manifold.1
To solve for this initial jump in E, we use a technique suggested by Dixit
(I980) and employed in models of exchange-rate determination by Buiter and
Miller (I 982) and Neary and Purvis (I 98 I). Dixit has shown that, if the system
is to travel to its new long-run equilibrium (P, N, E) along the stable manifold,
it must be the case that, at each point of time t,
E(t) -E = U1[P(t) -P] + U2jN(t)-N], (A 5)
where u1and u2are elements of the (appropriately normalised) left character-
istic vector of A corresponding to the positive characteristic root pi. In other
words, u1 and u2satisfy the following equation:
[U1 U2 -I] o o].
[-A+jpI] = [o (A 6)
Equation (A 6) can be solved for u1 and U2as functions of ji:
U1=-,
= U2 = (A 7)
a12
thus u1 < o and U2 > o.
Consider now the effect of an unanticipated permanent increase in i* on
the exchange rate at the time of the disturbance, t = o. According to equation
(A 5),
E(o)-E = u1[P(o) -P] +U2[N(o) -] (A 8)
Assuming that the system was at a point of long-run equilibrium just before
the disturbance, and recalling that dP/di* > o, dR/di* = o, and dE/di* > o,
we have P(o) -P < o and N(o) -N = o. Since u1 < o, we conclude that
E(o) - > o. Thus the exchange rate must overshoot its new long-run equi-
librium value in order to place the system on the unique stable path.
In examining the behaviour of E, P and N along this path, we proceed by
using equation (A 5) to reduce the system (A 4) to just two differential equa-
tions in P and N. We obtain
[1' =[ a12 ]P-P (A9)
[NJ [a21+a23U1 a2J[N-NJA
Since the determinant of the matrix in (A 9) is equal to -a12(a21 + a23U1) > o,
and its trace is equal to a23i2 < o, the system's two characteristic roots must
have negative real part. The system is thereforestable, although cyclical adjust-
1 It is implicitly assumed that a jump in E can indeed place the economy on the convergent path.
The condition that there be as many stable roots as predetermined variables and as many unstable
roots as non-predetermined variables does not guarantee that the unique stable path is in fact attainable.

338 THE ECONOMIC JOURNAL [JUN E
ment cannot be ruled out. A graphic solution is presented in Fig. 3, where P(o)
is the initial and P the new long-run equilibriumvalue of P. On the other hand,
N is both the initial and the new long-run equilibrium value of N. The P = o
schedule is vertical at N = N, while the slope of the X = o schedule is equal to
- a23u2/(a21+ a23u1) > o. The direction of movement of P and N in the neigh-
bouirhoodof the steady state is indicated by the arrows in the figure. Finally,
V- , N=O
E =E
P ---
l,.
P(O) - O
0-
N N
Fig. 3. Price and inventory adjustment in response to an increase in i* under flexible exchange rates.
the E = E schedule representsthe various combinations of P and N for which

the spot exchange rate is equal to E. As can be seen in equation (A 5), the slope
of the E = E schedule is equal to- u2/u1, which is not only positive, but also
greater than the slope of the N = o schedule. At points below (above) the
E = E schedule, E > E (E < E).
The behaviour of P, N and E along the unique stable path can now be seen
in Fig. 3. Initial overshooting of the exchange rate gives rise to an excess
demand for domestic goods and inventory decumulation. This moves the
economy leftward from the initial point Q. Since the stock of inventories is now
below N, prices begin to rise. At the same time domestic currency is appreci-
ating towards E. At point R the exchange rate is equal to E, but it continues to
fall even as the economy moves past S, the point at which demand for domestic
goods is equal to supply. Beyond that point there is excess supply because P
continues to rise while domestic currency is appreciating. The decline in E is
gradually reversed, however, as the economy travels from S to T. At point T
the stock of inventories is again at its desired level, although an excess supply of
goods still prevails on the market, leading to further inventory accumulation.
Prices now begin to fall. In the meantime domestic currency continues to
depreciate, reaching the value E once again at point U, and depreciating further

1984] CURRENCY MANAGEMENT AND ECONOMIC STABILITY 339
beyond that point as the adjustmentprocessproceeds to move the system closer
to its new steady state at point X.
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