The International Financial System Chapter Thirteen The International Financial System

Exchange Market Intervention Unsterilized: Results: International reserves, +1 billion Monetary base, +1 billion Then analysis in Figure 1, Et  Copyright © 2004 Pearson Education Canada Inc.

Exchange Market Intervention Sterilized: Results: International reserves, +1 billion Monetary base unchanged Et unchanged: no shift in RD and RF Copyright © 2004 Pearson Education Canada Inc.

Exchange Rate Intervention, Sell $ Sell $, buy F: MB , Ms  Ms , P , Eet+1 , expected appreciation of F , RF shifts right in Fig. 1 Ms , iD , RD shifts left, go to point 2 and Et  In long run, iD returns to old level, RD shifts back, go to point 3 Exchange rate overshooting Figure 1: Effect of a Sale of Canadian Dollars and a Purchase of Foreign Assets Copyright © 2004 Pearson Education Canada Inc.

Exchange rates, balance of payment, and trade data http://www. statcan Copyright © 2004 Pearson Education Canada Inc.

The Gold Standard Currency convertible into gold at fixed value Example of how it worked: Canada: $20 convert into 1 ounce of gold U.K.: £4 convert into 1 ounce of gold Par value of 1£ = $5.00 If £ to $5.25, importer of £100 of tweed has two alternatives: Pay $525 Buy $500 gold (500/20 = 25 ounces), ship to U.K., convert into £100 (= 25 £4) and buy tweed Copyright © 2004 Pearson Education Canada Inc.

The Gold Standard If shipping is cheap, do alternative 2 Two problems Gold flows to U.K. MB  in U.K, MB  in Canada Price level  U.K.,  Canada £ depreciates back to par Two problems Country on gold standard loses control of Ms World inflation determined by gold production Copyright © 2004 Pearson Education Canada Inc.

Fixed Exchange Rate Systems Bretton Woods Fixed exchange rates Other central banks keep exchange rates fixed to U.S. $: U.S. $ is reserve currency U.S. $ 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 Copyright © 2004 Pearson Education Canada Inc.

Fixed Exchange Rate Systems European Monetary System Value of currency not allowed outside "snake" New currency unit: ECU Exchange Rate Mechanism (ERM) Key weakness of fixed rate system Asymmetry: pressure on deficit countries losing international reserves to  Ms, but no pressure on surplus countries to  Ms Copyright © 2004 Pearson Education Canada Inc.

Intervention in a Fixed Exchange Rate System Figure 2: Intervention in the Foreign Exchange Market under a Fixed Exchange Rate Regime Copyright © 2004 Pearson Education Canada Inc.

Analysis of Figure 2: Intervention in a Fixed Exchange Rate System Since Eet+1 = Epar with fixed exchange rate, RF doesn't shift Overvalued exchange rate (panel a) Central bank sells international reserves to buy domestic currency MB , Ms , iD , RD shifts to right to get to point 2 If don't do this have to devalue Copyright © 2004 Pearson Education Canada Inc.

Analysis of Figure 2: Intervention in a Fixed Exchange Rate System Undervalued exchange rate (panel b) Central bank sells domestic currency and buys international reserves MB , Ms , iD , RD shifts to left to get to point 2 If don't do this have to revalue Copyright © 2004 Pearson Education Canada Inc.

Exchange Rate Crisis of September 1992 At Epar, RF right of RD because Bundesbank tight money keeps German interest rates high Bank of England buys £, iD , RD shifts right When speculators expect devaluation, Eet+1 , RF shifts right Requires much bigger intervention When UK pulls out of ERM, £  10%, big losses to central bank Figure 3: Foreign Exchange Market for British Pounds in 1992 Copyright © 2004 Pearson Education Canada Inc.

Profiting from a FX Crisis September 1992, £ overvalued Once traders know central banks can't intervene enough, £ only head one direction,  One-sided bet, "heads I win, tails I win" Traders sell £, buy DM £  10% after September 16 Citibank makes $200 million Soros makes $1 billion Copyright © 2004 Pearson Education Canada Inc.

Copyright © 2004 Pearson Education Canada Inc.

International Financial Architecture Capital Controls Controls on outflows unlikely to work Controls on inflows may prevent lending boom and financial crisis, but cause distortions Role of 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 Copyright © 2004 Pearson Education Canada Inc.

Monetary Policy: 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  Copyright © 2004 Pearson Education Canada Inc.