Chapter 20: The International Financial System

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Chapter 20 The International Financial System
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• 1. Intervention in the Foreign Exchange Market

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Intervention and the Money Supply

• Unsterilized
• Fed sells 1 billion of , buys 1 billion of
  foreign assets
• T-Account
• Results
• International reserves, 1 billion
• Monetary base, 1 billion
• Lowered Exchange Rate -- Left shift in RETD
  (lower i) and right shift in RETF (higher price
  level)
• Diagram

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Intervention and the Money Supply

• Sterilized
• To reduce MB back to old level, Fed sells 1
  billion of government bonds
• T-Account
• Results
• International reserves, 1 billion
• Monetary base, unchanged
• Et unchanged no shift in RETD and RETF

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• 2. Balance of Payments

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Balance of Payments

• Current Account
• International transactions that involve currently
  produced goods and services
• Recently negative
• Capital Account
• Flow of capital between the U.S. and other
  countries
• Recently positive (capital inflowsgtcapital
  outflows)
• Official Reserves Transactions Balance
• Equals Current Account plus Capital Account

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• 3. Evolution of the International Financial System

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Gold Standard

• Currency convertible into gold at fixed value
• Example of how it worked
• U.S. 20 converted into 1 ounce
• U.K. 4 converted into 1 ounce
• Par value of 1 5.00
• If ? to 5.25, importer of 100 of tweed has
  two alternatives
• 1. Pay 525
• 2. Buy 500 gold (500/20 25 ounces), ship to
  U.K., convert into 100 ( 25 ??4) and buy tweed

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Gold Standard

• If shipping cheap, do alternative 2
• Gold flows to U.K.
• MB rises in U.K, MB falls in U.S.
• Price level rises in U.K., falls in U.S.
• depreciates back to par
• Two Problems
• Country on gold standard loses control of Ms
• World inflation determined by gold production

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Fixed Exchange Rate Systems

• Bretton Woods
• Fixed exchange rates
• Other central banks keep exchange rates fixed to
  is reserve currency
• convertible into gold for central banks only
  (35 per ounce)
• International Monetary Fund (IMF) sets rules and
  provides loans to deficit countries
• World Bank makes loans to developing countries

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Fixed Exchange Rate Systems

• European Monetary System
• Value of currency not allowed outside snake
• New currency unit ECU
• Exchange Rate Mechanism (ERM) forced symmetric
  intervention

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Fixed Exchange Rate Systems

• Key weakness of fixed rate system
• Asymmetry pressure on deficit countries losing
  international reserves to ? Ms, but no pressure
  on surplus countries to ? Ms

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Fixed Exchange Rate Systems

• Intervention in Fixed Exchange System
• Since Eet1 Epar with fixed exchange rate, RETF
  doesnt shift
• Overvalued exchange rate
• Central bank sells international reserves to buy
  domestic currency
• MB ?, Ms ?, iD ?, RETD to right --diagram
• If dont do this, have to devalue

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Fixed Exchange Rate Systems

• Undervalued exchange rate
• Central bank sells domestic currency and buys
  international reserves
• MB ?, Ms ?, iD ?, RETD to left diagram
• If dont do this, have to revalue

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Exchange Rate Crisis

• At Epar, RET2F right of RETD because Bundesbank
  tight money keeps German interest rates high
• Bank of England could buy , iD ?, RETD shifts
  right
• When speculators expect devaluation, Eet1 ?,
  RETF shifts right
• Requires much bigger intervention by UK
• When UK pulls out of ERM, ? 10, big losses to
  central bank

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• 4. Capital Controls

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Capital Controls

• Controls on outflows unlikely to work
• Controls on inflows may prevent lending boom and
  financial crisis, but cause distortions

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• 5. The Role of the IMF

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The Role of The IMF

• There is a need for international lender of last
  resort (ILLR) and IMF has played this role
• ILLR creates moral hazard problem
• IMF needs to limit moral hazard
• Lend only to countries with good bank supervision
• Need to do ILLR role fast and infrequently

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• 6. International Considerations and Monetary
  Policy

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International Considerations

• Direct effects of FX market
• When intervene, MB changes
• Balance of payments considerations
• When B of P is in deficit need Ms ?
• Exchange rate considerations
• When want lower E, need Ms ?

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EndChapter 20