copyright © 2010 pearson addison-wesley. all rights reserved. chapter 21 the international...

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 21

The International Financial System

Copyright © 2010 Pearson Addison-Wesley. All rights reserved.21-2

International financial system

• Growing interdependent economies in the world

• Interconnected financial system and monetary policies

• International financial system– International financial transactions– Structure of international financial system– Domestic and foreign monetary policy


Intervention in the foreign exchange market

• Foreign exchange intervention and money supply– Sterilized vs. unsterilized


Unsterilized Foreign Exchange Intervention

• A central bank’ s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base

• A central bank’ s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base

Federal Reserve System Federal Reserve System

Assets Liabilities Assets Liabilities

Foreign Assets

-$1B Currency in circulation

-$1B Foreign Assets

-$1B Deposits with the Fed

-$1B

(International Reserves)

(International Reserves)

(reserves)


Unsterilized Intervention

• An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

• What if the central bank does not want the foreign assets transactions affect domestic money supply?


Sterilized Foreign Exchange Intervention

• To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation

• There is no effect on the monetary base and no effect on the exchange rate

Federal Reserve System

Assets Liabilities

Foreign Assets Monetary Base

(International Reserves) -$1B (reserves) 0

Government Bonds +$1B


FIGURE 1 Effect of a Sale of Dollars and a Purchase of Foreign Assets

Sale of $ , purchase of foreign assets $ supply increasing 1.Long Run: higher price lower expected return of $ demand of $ decreasing2.Short Run: lower interest rate lower expected return demand of $ decreasing

•Overshooting


Balance of Payments

• Current Account– International transactions

that involve currently produced goods and services

– Trade Balance

• Capital Account– Net receipts from capital

transactions

• Sum of these two is the official reserve transactions balance

International financial transactions- Balance of payments


Balance of Payments• The "Balance of Payments" is an accounting

statement reflecting all economic transactions between domestic nationals and foreign nationals. It consists of:– Current Account Records Flows of goods, services &

transfers– Capital Account All public and private capital

investment and lending are included.• Double-entry bookkeeping - debits equal credits.


The Current Account

• (Export – Import) of goods, services, and military transactions.– Goods Trade goods– Services

• Interest & Dividend Income• Tourism Revenue / Expenses• Financial charges paid & received • Transportation expenses

– Unilateral Transfers• Remittance - made / received• Foreign Aid received / given• Pensions


The Current Account (continued) Exports to other nations will be recorded as income,

while import costs will be shown as expenses or cash outflows.

The service related cashflows include royalties, licensing fees, foreign travel and transportation.

Investment income refers to interest and dividend earned on U.S. investments abroad versus the dividend and interest paid to foreign investors in the U.S.

Unilateral transfers include foreign aid given to other nations and those received from other nations

The current account records the trade balance of a country. If exports exceed imports, a nation will have a trade surplus; otherwise they would have a trade deficit.


The Current Account (continued)


The Capital Account

• The capital account measures capital flows in or out of a country. – The balance is the difference between the wealth invested

by the public and government in other countries and the wealth invested by foreigners in the home country.

• Surpluses (deficits) in the capital accounts offset deficits (surpluses) in the current account.

• Surpluses (a positive balance) in the U.S. capital accounts means that foreign investors buy more U.S. assets, creating a capital inflows into U.S.

• Pressure on exchange rates from the current account is reversed with capital account flows.


Exchange Rate Regimes

• Fixed exchange rate regime– Value of a currency is pegged relative to the

value of one other currency (anchor currency)

• Floating exchange rate regime– Value of a currency is allowed to fluctuate against

all other currencies

• Managed float regime (dirty float)– Attempt to influence exchange rates by buying

and selling currencies


Past Exchange Rate Regimes

• Gold standard– Fixed exchange rates– No control over monetary policy– Influenced heavily by production of gold and

gold discoveries– Before WWI: 1 oz gold = £4 = $20

• Bretton Woods System (1944)– Fixed exchange rates using U.S. dollar as reserve

currency– International Monetary Fund (IMF,1945)


Past Exchange Rate Regimes (cont’ d)

• Bretton Woods System (cont’ d)– World Bank– General Agreement on Tariffs and Trade (GATT)

• World Trade Organization

– U.S as the largest economy• 1 oz gold = $35• $ as international reserve currency

– Abandoned in 1971

• European Monetary System– Exchange rate mechanism


How a Fixed Exchange Rate Regime Works

• When the domestic currency is overvalued, the central bank must– purchase domestic currency to keep the exchange rate

fixed (it loses international reserves), or

– conduct a devaluation

• When the domestic currency is undervalued, the central bank must– sell domestic currency to keep the exchange rate fixed (it

gains international reserves), or

– conduct a revaluation

• Fixed exchange rate & domestic monetary policy


FIGURE 2 Intervention in the Foreign Exchange Market Under a Fixed Exchange Rate Regime


How Bretton Woods Worked

• Exchange rates adjusted only when experiencing a ‘ fundamental disequilibrium’ (large persistent deficits in balance of payments)

• Loans from IMF to cover loss in international reserves

• IMF encouraged contractionary monetary policies

• Devaluation only if IMF loans were not sufficient

• No tools for surplus countries

• U.S. could not devalue currency


Managed Float

• Hybrid of fixed and flexible– Small daily changes in response to market– Interventions to prevent large fluctuations

• Appreciation hurts exporters and employment

• Depreciation hurts imports and stimulates inflation

• Special drawing rights issued by IMF– substitute for gold as international reserves


European Monetary System

• 8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar (1979)

• ECU value was tied to a basket of specified amounts of European currencies

• Fluctuated within limits

• Require central banks intervention

• Led to foreign exchange crises involving speculative attack


FIGURE 3 Foreign Exchange Market for British Pounds in 1992

German reunification rising inflation pressureto decrease money supply by increasing interest rate

German mark : relative higher return UK pound demand decreasingSpeculation further lowers the exchange rate


Capital Controls

• Outflows – Promote financial instability by forcing a

devaluation as capital outflows– Controls are seldom effective and may increase

capital flight– Lead to corruption– Lose opportunity to improve the economy

• Inflows– Lead to a lending boom and excessive risk taking

by financial intermediaries


Capital Controls (cont’ d)

• Inflows (cont’ d)– Controls may block funds for productions uses– Produce substantial distortion and misallocation– Lead to corruption

• Strong case for improving bank regulation and supervision


The IMF: Lender of Last Resort

• Emerging markets: poor ability of central banks and short-run debt contracts denominated in foreign currencies– Lending as last resort increased money supply

domestic currency depreciation and higher inflation

• Provide liquid and prevent contagion

• The safety net may lead to excessive risk taking (moral hazard problem)


How Should the IMF Operate?

• May not be tough enough– Humanitarian aid

• Austerity programs focus on tight macroeconomic policies rather than financial reform

• Too slow, which worsens crisis and increases costs

• Countries were restricting borrowing from the IMF until the recent subprime financial crisis


International consideration and monetary policy


Direct Effects of the Foreign Exchange Market on the Money Supply

• Intervention in the foreign exchange market affects the monetary base

• To keep domestic currency appreciating– Accumulate international reserves money

supply increasing

• U.S. dollar has been a reserve currency: monetary base and money supply is less affected by foreign exchange market


Balance-of-Payments Considerations• Current account deficits in nonreserve

currency countries – export < import losing international reserves

to balance, implement contractionary monetary policy

• Current account deficits in the U.S.– dollar is too strong American businesses may

be losing ability to compete

• U.S. deficits surpluses in other countries– large increases in international reserve holdings

world inflation


Exchange Rate onsiderations

• A greater role in the current managed float system

• A contractionary monetary policy will raise the domestic interest rate and strengthen the currency

• An expansionary monetary policy will lower interest rates and weaken currency

• Central banks’ intervention and protectionism


To peg or Not to peg

• Exchange rate targeting – As one monetary policy strategy to achieve price

stability– Various forms

• Gold • Anchor country (e.g United States)


Advantages of Exchange-Rate Targeting

• Contributes to keeping inflation under control

• Automatic rule for conduct of monetary policy

• Simplicity and clarity

• Examples:– UK,France – German mark


Disadvantages of Exchange-Rate Targeting

• Loss of independent domestic monetary policy– Unable to respond to domestic shocks

– Shocks on anchor country are transmitted

• Open to speculative attacks on currency– Industrialized vs. emerging market countries

• Weakens the accountability of policymakers as the exchange rate loses value as signal– Undeveloped capital markets and central banks

(emerging market countries)


Exchange-Rate Targeting for Industrialized Countries

• Exchange-rate targeting for industrialized countries is desirable if

– Domestic monetary and political institutions are not conducive to good policy making

– Other important benefits such as integration arise from this strategy


Exchange-Rate Targeting for Emerging Market Countries

• Exchange-rate targeting for emerging market countries is desirable if – Political and monetary institutions are weak– Potential risk of hyperinflation– Exchange rate targeting the stabilization policy

of last resort


Currency Boards

• Solution to lack of transparency and commitment to target

• Domestic currency is backed 100% by a foreign currency

• Note issuing authority establishes a fixed exchange rate and stands ready to exchange currency at this rate

• Money supply can expand only when foreign currency is exchanged for domestic currency (currency match)


Currency Boards (cont’ d)

• Stronger commitment by central bank

• Loss of independent monetary policy and increased exposure to shock from anchor country

• Loss of ability to create money and act as lender of last resort

• Cases– Hong Kong (1983), Argentina (1991)


Dollarization

• Another solution to lack of transparency and commitment

• Adoption of another country’ s money

• Even stronger commitment mechanism

• Completely avoids possibility of speculative attack on domestic currency

• Lost of independent monetary policy and increased exposure to shocks from anchor country


Dollarization (cont’ d)

• Inability to create money and act as lender of last resort

• Loss of revenue by issuing money for the government

copyright © 2010 pearson addison-wesley. all rights reserved. chapter 21 the international...

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