Method 1: Foreign Exchange Intervention

Assume that the exchange rate is pegged to the USD. Speculators are speculating on the Baht. As the governor of the Central Bank, you decided to protect the Baht by intervening directly in the foreign exchange market.

See Figure 1a and Figure 1b below for scenarios of speculative attack against the Thai Baht

  • Figure 1a shows the speculators are selling the Baht against the USD, due to weak confidence in the Thai economy.
  • Figure 1b shows the speculators are buying the Baht against the USD, due to strong confidence in the Thai economy.

Instructions

Explain the impact of BOT's foreign exchange intervention on the value of the Baht vs the USD in the foreign exchange market, and on the quantity supply of money (Baht) in the domestic money market.

Illustrate the impact of the BOT's foreign exchange intervention on the demand or supply line for Baht in the foreign exchange market but moving the specified lines according to the instructions.

Figure 1a

Scenario

Assume that the exchange rate is pegged to the USD. Speculators are selling the Baht against the USD, due to weak confidence in the Thai economy. As the governor of the Central Bank, you decided to protect the Baht by intervening directly in the foreign exchange market.

Explain the impact of foreign exchange intervention on:

  1. exchange rate (see figure on left)
  2. and on money supply (see figure on right)

Simulation: You may click and drag on dd below to see the effects of changes in the demand of the Baht.

Click here for the explanation on what happened

Explanation

  • Speculators are selling the Baht they hold in the foreign exchange market, and increasing their holding of USD, their preferred currency. The Baht depreciate from the fixed rate.
  • BOT, in its mandate to defend the Baht from depreciating, buys the Baht and sells the USD in the foreign exchange market (see figure on left: shift the DD for Baht line to the right, and the Baht moves back up to the fixed rate level).
  • The BOT intervention in the foreign exchange market reduces the net foreign assets(NFA), and this has impact on the quantity supply money in the domestic money market. The money supply line in the domestic money market shifts left (see figure on right; interest rates rises).

Figure 1B

Scenario

Assume that the exchange rate is pegged to the USD. speculators are buying the Baht against the USD, due to strong confidence in the Thai economy. As the governor of the Central Bank, you decided to protect the Baht by intervening directly in the foreign exchange market.

Explain the impact of BOT's foreign exchange intervention on the:

  1. value of the Baht vs the USD in the foreign exchange market (see figure on left)
  2. quantity supply of money (Baht) in the domestic money market (see figure on right)

Simulation: You may click and drag on ss below to see the effects of changes in the supply of the Baht.

Click here for the explanation on what happened

Explanation

  • Speculators are buying the Baht in the foreign exchange market, reducing their holding of USD in preference for Baht. The Baht appreciates from the fixed rate.
  • BOT in its mandate to defend the Baht from appreciating, sells the Baht and buys the USD in foreign exchange market (see figure on left; shift the SS for Baht line to the right, and the Baht moves back down to the fixed rate level).
  • The BOT intervention in the foreign exchange market increases the NFA, and this has impact on the quantity supply of money in the domestic money market. The money supply line in the domestic money market shifts right (see figure on right; interest rates falls).
  • When the banking system accumulates NFA, money supply rises by the same extent (note: unless its impact is sterilised through policy action, which we may study in the course).

Next: Method 2 - Open Market Operations

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