When capital account outflows occur, investors sell the domestic currency and buy foreign currency, which puts downward pressure on the exchange rate. In order to avoid a depreciation, a government can raise interest rates in an effort to persuade investors to keep their money in the country. But as our discussion of second-generation models suggests, there may be limits to this policy, due to the weakness of the domestic economy or the banking system. Another option is for the government to instruct its central bank to engage in foreign exchange intervention, namely to buy the domestic currency being sold by selling the central bank's foreign currency reserves.
The central bank will sell foreign currency if it wants to stop its domestic currency falling but will buy foreign currency and sell domestic if it wants to stop the exchange rate rising. For instance, in 2004 central banks of Asia owned huge amounts of foreign currency reserves, more than $2.1trillion. Japan had $777bn of FX reserves, China $403bn, Taiwan $215bn, Korea $160bn, and Singapore $101bn. This came about because the United States was running very large current account deficits with this region, so that Asian exporters were receiving lots of dollars from U.S. consumers. If Chinese firms tried to sell these dollars to buy the Chinese currency, remnimbi, this would lead the dollar to fall and the remnimbi to rise. To stop this happening, the Chinese central bank intervened to buy the dollars and give remnimbi to firms. This stops the Chinese currency appreciating, although at the expense of increasing the Chinese money supply (because it has issued remnimbi).2 Note that, as a result of this intervention, what is in effect happening is that Asian central banks are providing the credit (by expanding their own money supply) with which the United States can run a trade deficit with Asia. By continuing to accumulate dollar currency reserves, the Asian banks are continuing to provide the funding needed to finance the U.S. current account deficit. As Jacques Rueff, a French economist, put it in 1965: "If I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him."
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