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FRBSF

WEEKLY LETTER

March 1, 1985

The Dollar and Policy Options
The phenomenal strength of the dollar in the
foreign exchange markets - rising more than 50
percent on a trade-weighted average basis
against other currencies since mid-1980 - has
raised concern both here and abroad. On the
one hand, U.S. business and government officials are chafing at the decline in U.S. international competitiveness that has resulted in a
record $107 billion trade deficit in 1984. On the
other hand, foreign officials are concerned
about the inflationary pressures arising from the
higher domestic cost of imports caused by the
decline in the value of their currencies against
the dollar.
Against this background, the finance ministers of
the United States, Great Britain, France, Germany
and Japan met in Washington in January and
issued a statement reiterati ng thei r commitment to
coordinated intervention in the currency markets
"whenever it is deemed helpful." Market commentators interpreted the statement as signal Iing a
significant departure from the established U.S.
policy of minimal intervention, that is, intervention only to counteract disorderly conditions in
the foreign exchange market. Many hoped that the
Federal Reserve would now actively intervene to
halt the dollar's rise by large dollar sales in the
foreign exchange market. This Letter considers
the efficacy and desirability of using foreign
exchange market intervention and, more generally, monetary policy to bring the dollar
exchange rate down.
Sterilized intervention
An exchange intervention involves a central
bank's open market purchase or sale of a foreign
currency against the domestic currency. Besides
its impact on the exchange rate, the action also
affects bank reserves in the same way as the central bank's domestic open-market operations. For
instance, when the Federal Reserve purchases the
German mark with dollars, it injects reserves into
the banking system justas a Federal Reserve openmarket purchase of domestic securities does.
Thus, an exchange intervention has a monetary
dimension as well as a pure exchange market
dimension.

The pure exchange market effect can be conceived as arising from a sterilized exchange
intervention, that is, one in which the monetary
effect is offset by a domestic open-market operation. In the example above, a sterilized Federal
Reserve purchase of German marks would be one
that is coupled with a simultaneous open-market
sale of U.S. securities to "mop up" the additional
liquidity injected into the banking system by the
exchange intervention. When the Federal Reserve
buys marks in the foreign exchange market, it
invests the proceeds in interest-bearing, mark-.
denominated securities. The public holds fewer
mark-denominated securities and more dollar
deposits as a consequence. These additional dollar
holdingsofthe public, in turn, are replaced by
U.S. securities when the Federal Reserve undertakes an open market securities sale. The net
outcome of a sterilized intervention operation to
support the German mark, therefore, is that the
public asa whole holds fewer mark-denominated
securities and more dollar-denominated securities.
Investors may not be indifferent about the
"currency mix" of securities in their portfolios,
however. If they do have other preferences, they
will try to restore their portfolios by buying markdenom inated secu rities and sell ing dollar-denominated securities. This will tend to place downward
pressure on the dollar and cause it to depreciate.
Hence, whether a sterilized exchange intervention can have a significant and lasting effect on
exchange rates depends on the extent to which
the two types of securities substitute for each
other in private portfolios. If they were perfect
substitutes, there would be little or no effect on
the exchange rate; for investors indifferent to the
currency mix of securities, shifts in their relative
supply caused by intervention operations would
not matter. In contrast, the less the two securities
are substitutable for one another, the greater the
likely effect of sterilized exchange intervention
on the exchange rate.
Empirical studies find, not surprisingly, that securities denominated in different currencies are not
perfect substitutes for one another. Thus the question becomes, how large is the effect of sterilized

FRBSF
exchange intervention? Besides the degree to
which assets can be substituted for one another,
the magnitude of the effect should also depend
on the size of the intervention relative to the total
size of the securities in the public's aggregate
portfolio. Purely on a priori grounds, in view of
the huge aggregate stock of domestic and foreign
securities outstanding in private portfolios, it is
hard to see how any realistic magnitudes of exchange intervention by major central banks,
either in isolation or as a coordinated group, can
have a lasting effect on exchange rates.
This inference has been borne out at least in part
by empirical investigations. Atthe Versailles Economic Summit in 1982, the heads of state of
major industrial nations ordered a joint study by
thei r central banks on the effects of exchange
intervention on the exchange market. In the
report that was issued in April 1983, the Working
Group stated after extensive statistical studies that
there was little evidence of a significant lasting
impact during normal times. More specifically,
the report found that during episodes of great
turmoil in the exchange market-for instance, in
October 1978 -coordinated intervention by
major central banks was able to restore orderly
market conditions. However, for the longer
period since the beginning of floating exchange
rates in 1973, there was little evidence of a systematic relationship between sterilized exchange
interventions and exchange-rate changes, despite
the many episodes of heavy interventions by the
major central banks.
Monetary policy
The monetary dimension of exchange intervention, or "unsterilized" intervention, is likely to
have a larger effect on the exchange rate, however. In the aforementioned case, if the Federal
Reserve purchase of German marks is allowed to
increase U.S. bank reserves, the effect on the
money supply is similar to that of domestic openmarket securities purchases.

A monetary stimulus is likely to depreciate the
value of the dollar quite significantly through two
channels: prices and real interest rates. Because
prices adjust slowly, real liquidity in the economy
initially expands in proportion to the rise in
money growth. This causes real interest rates to
fall and leads to dollar depreciation as dollar
investments become less attractive compared to
investments abroad.
The initial fall of the dollar takes place in both
nominal and real (adjusted for domestic and
foreign relative prices) terms, and therefore
translates into a rise in the international competitiveness of U.S. exports. The second round
of adjustment begins to eliminate the improvement in the U.S. competitive position, how.ever.
As prices begin to rise in response to more rapid
money growth, real liquidity falls. The fall in real
liquidity, in turn, puts upward pressure on real
interest rates and the real value of the dollar.
Higher real rates again make the dollar an attractive investment.
Most empirical work suggests that a rise in the
rate of money growth is fully reflected in a higher
domestic price level after approximately two
years. Moreover, even the temporary dollar depreciation in real terms only improves the U.S.
trade balance with a considerable lag. Empirical
studies find that the trade balance improves
about six months after a dollar depreciation and
keeps on improving for up to two years. As the
real value of the dollar gradually appreciates
back to its initial level, however, the tradeimprovement effect also wears off -largely by
the end of the third year following the initial
monetary stimulus.
This suggests that although a monetary expansion
could bring about a dollar depreciation fairly
quickly, its intended effects would be transitory.
Against this short-term gain, one must weigh the
costs to society of a potential rekindling of infla-

tion caused by the substantial acceleration of
money-growth rates that would be needed to
bring about a significant depreciation ofthe dollar
exchange rate. Considering the hard-won gains in
bringing down the public's "inflation psychology"
in recent years, taking this risk is difficult to justify.
Moreover, past experience both in this country and
abroad shows that repeated attempts at exploiting
this short-term gain would soon see it disappear.

Finally, many analysts bel ieve that at the heart of
the dollar's rise, at least over the past two years, is a
"real side" phenomenon that is associated with the
rise in the federal government budget deficit and
that is not monetary in nature. A long-run solution
to the problem, therefore, lies outside the realm of
Federal Reserve policies, and must be sought in a
resolution of the federal budget deficit problem.

Hang-Sheng Cheng and Michael Hutchison

MONETARY POLICY OBJECTIVES FOR 1985

Federal Reserve Chairman Pau I Volcker presented a report to the Congress on the Federal
Reserve's monetary pol icy objectives for 1985 on February 20. The report includes a summary of
the Federal Reserve's monetary policy plans along with a review of economic and financial
developments in 1984 and the economic outlook in 1985. Single or multiple copies of the report
can be obtained upon request from the Public Information Department, Federal Reserve Bank of
San Francisco, P.O. Box 7702, San Francisco, CA 94120; phone (415) 974-2246.

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millionsl
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ l/Deficiency (- l
Borrowings
Net free reserves (+ l/Net borrowed( - l
1
2

3
4

S
6
7

Amount
Outstanding
02/13/85
187,541
169,340
52,070
62,163
32,494
5,292
11,116
7,085
192,818
44,182
30,246
12,903
135,733

-

-

-

Period ended
02/11/85
31
21
10

148
24
3
79
10
930
782
547
323
176

-

-

195

-

69
757

-

12,177
14,230
5,894
2,567
5,666
282
1,194
857
7,499
130
469
888
6,481

6.9
9.2
12.8
4.3
21.1
5.6
- 9.7
- 10.8
4.0
0.3
1.6
7.4
5.0

3,527

628

- 717
- 208

43,628
39,114
20,371

Change from
02/15/84
Dollar
Percent 7

Change
from
02/06/85

8.7

1,219
249

Period ended
01/28/85
123
57
66

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change

-

3.2
1.2