1. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 21 The International Financial System

2. 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

3. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-3 Intervention in the foreign exchange market Foreign exchange intervention and money supply –Sterilized vs. unsterilized

4. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-4 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 AssetsLiabilitiesAssetsLiabilities Foreign Assets -$1BCurrency in circulation -$1BForeign Assets -$1BDeposits with the Fed -$1B (International Reserves) (reserves)

5. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-5 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?

6. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-6 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 AssetsLiabilities Foreign AssetsMonetary Base (International Reserves)-$1B(reserves)0 Government Bonds+$1B

7. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-7 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 $ decreasing 2.Short Run:  lower interest rate  lower expected return  demand of $ decreasing Overshooting

8. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-8 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

9. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-9 9 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.

10. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-10 10 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

11. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-11 11 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.

12. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-12 12 The Current Account (continued)

13. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-13 13 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.

14. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-14 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

15. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-15 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)

16. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-16 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

17. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-17 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

18. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-18 FIGURE 2 Intervention in the Foreign Exchange Market Under a Fixed Exchange Rate Regime

19. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-19 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

20. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-20 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

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

22. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-22 FIGURE 3 Foreign Exchange Market for British Pounds in 1992 German reunification  rising inflation pressure  to decrease money supply by increasing interest rate  German mark : relative higher return  UK pound demand decreasing  Speculation further lowers the exchange rate

23. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-23 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

24. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-24 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

25. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-25 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)

26. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-26 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

27. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-27 International consideration and monetary policy

28. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-28 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

29. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-29 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

30. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-30 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

31. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-31 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)

32. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-32 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

33. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-33 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)

34. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-34 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

35. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-35 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

36. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-36 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)

37. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-37 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)

38. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-38 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

39. Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 21-39 Dollarization (cont’d) Inability to create money and act as lender of last resort Loss of revenue by issuing money for the government