Finance, Forex and Investments

If foreign currency inflow soars, Central Bank can do nothing to maintain REER?

Even when Central Bank buys all the inflow to keep nominal exchange rate, that leads to an increase in local currency money supply => inflation happens => Real Effective Exchange Rate still rises. So, there are no ways to keep REER? Export depends wholly on REER (not the nominal)? So, export will definitely drop?

Public Comments

1. Your argument is correct. But, foreign exchange inflows can be counteracted by foreignexchange outflows if the country's citizens could import commenurately or invest abroad in different projects including buying foreign companies. In that case the central bank need not have to buy foreign exchange and hold them in foreign currency reserves. Second, the increased buying of foreign exchange by the central bank can be sterilised by issue of fresh Govt. bonds and thereby mopping up the liquidity (neutralising the money suply increase due to foreign exchange buying). This may help curb the inflation effect and protect REER. But there are other implications of the oversupply of bonds like bond prices may fall and interest rates may rise. In open macro-economies, you cannot do everything you like- you have balance trade-offs. In closed economies, the costs will be hidden but they are there. Note: Read this piece below:- The Impossible Trinity (also known as the Inconsistent Trinity, Triangle of Impossibility or Unholy Trinity) is the hypothesis in international economics that it is impossible to have all three of the following at the same time: A fixed exchange rate, Free capital movement, and An independent monetary policy. The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).– Paul Krugman The formal model for this hypothesis is the Mundell-Fleming model developed in the 1960s by Robert Mundell and Marcus Fleming. The idea of the impossible trinity went from theoretical curiosity to becoming the foundation of open economy macroeconomics in the 1980s, by which time capital controls had broken down in many countries, and conflicts were visible between pegged exchange rates and monetary policy autonomy. While one version of the impossible trinity is focused on the extreme case — with a perfectly fixed exchange rate and a perfectly open capital account, a country has absolutely no autonomous monetary policy — the real world has thrown up repeated examples where the capital controls are loosened, resulting in greater exchange rate rigidity and less monetary-policy autonomy. In the modern world, given the growth of trade in goods and services, capital controls are easily evaded. In addition, capital controls introduce numerous distortions. Hence, there is virtually no important country which has an effective system of capital control. Under these conditions, the Impossible Trinity asserts that a country has to choose between reducing currency volatility and running a stabilising monetary policy: it cannot do both.
2. You must be located on the context of economic policy not only on theoretical context; if REER are not affected then the impact on external account won´t occurs. The idea is to impact on external accounts occurs because US economy needs to reduce the external deficits. Now, if we suppose an scenario where there is not big external deficits and exchange rate begin to soar (by a confidence crisis, in example) then the government can buy external papers to impact capital account. It can be made by Central Bank or another office but it is not necessary to create more money (but if you want you can do it) because this paper can be used like public reserve, in example. Here you are making a change in financial structure of economy, for this you need a deep knowledge about that economy because your are not guided by a model. The economics model are oriented to reach the equilibrium and teach us the conduct of variables and, only a little, to design an economic policy. Economics model are not usefull for monitoring economics variables or for make corrections. Remember Descartes, all the time look for the dude, and do not sell your reason to economics models