Chapter 20 The International Financial System

© 2004 Pearson Addison-Wesley. All rights reserved 20-2 Exchange Market Intervention Unsterilized: Fed sells $1 billion of $, buys $1 billion of foreign assets Federal Reserve Assets Liabilities Foreign assets+ $1 bCurrency or reserves+ $1 b (international reserves)(monetary base) Results: 1. International reserves, +$1 billion 2. Monetary base, + $1 billion 3. Then analysis in Fig 1, E t 

© 2004 Pearson Addison-Wesley. All rights reserved 20-3 Exchange Market Intervention Sterilized: To reduce MB back to old level, Fed sells $1 billion of government bonds Federal Reserve Assets Liabilities Foreign assets+ $1 bCurrency or reserves $0 b (international reserves)(monetary base) Government bonds– $1 b Results 1. International reserves, +$1 billion 2. Monetary base unchanged 3. E t unchanged: no shift in R D and R F

© 2004 Pearson Addison-Wesley. All rights reserved 20-4 The Goals of International Monetary System Confidence, Liquidity, and Adjustment Inconsistent Trinity (Trilemma)

© 2004 Pearson Addison-Wesley. All rights reserved 20-5 Macroeconomic Policy Goals in an Open Economy Internal balance: the full employment of a country’s resources and domestic price stability External balance: a country’s CA is neither so deeply in deficit that the country may be unable to repay its foreign debts in the future nor so strongly in surplus that foreigners are put in that position.

© 2004 Pearson Addison-Wesley. All rights reserved Worldwide gold standard Disruption from two world wars and intervening depression (brief return to gold standard, ) Bretton Woods system of fixed exchange rates present Floating exchange rates among leading nations

© 2004 Pearson Addison-Wesley. All rights reserved 20-7 The 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 $ Buy $500 gold (500/20 = 25 ounces), ship to U.K., convert into £100 (= 25  £4) and buy tweed

© 2004 Pearson Addison-Wesley. All rights reserved 20-8 The Gold Standard If shipping cheap, do alternative 2 1.Gold flows to U.K. 2.MB  in U.K, MB  in U.S. 3.Price level  U.K.,  U.S. 4.£ depreciates back to par Two Problems: 1.Country on gold standard loses control of M s 2.World inflation determined by gold production

© 2004 Pearson Addison-Wesley. All rights reserved 20-9 Fixed Exchange Rate Systems Bretton Woods 1.Fixed exchange rates 2.Other central banks keep exchange rates fixed to $: $ is reserve currency 3.$ convertible into gold for central banks only ($35 per ounce) 4.International Monetary Fund (IMF) sets rules and provides loans to deficit countries 5.World Bank makes loans to developing countries European Monetary System 1.Value of currency not allowed outside “snake” 2.New currency unit: ECU 3.Exchange Rate Mechanism (ERM) Key weakness of fixed rate system Asymmetry: pressure on deficit countries losing international reserves to  M, but no pressure on surplus countries to  M