1 The International Financial System Chapter 18

Intervention in the FX Market 2 What can a CB do to raise the value of the domestic currency? Demand domestic currency in the FX market. What can a CB do to lower the value of the domestic currency? Demand international reserves in the FX market. International Reserves Monetary Base FED To raise the value of the currency the Fed has to buy USD with international reserves it has: both entries will be negative. To lower the value of the domestic currency, the Fed has to buy international reserves with USD: both entries will be positive.

Sterilized Intervention 3 No change in MB. International Reserves - $1 million Securities + $1 million Monetary Base 0 ΔMB = 0; ΔM = 0; Δi = 0; Δ(€/$) = 0

Unsterilized Intervention 4 International Reserves + Monetary Base + Int’l Res + => MB + => Ms + => i - ; π exp + => €/$ - but Y + and P + will raise Md + => i + => €/$ + €/$ USD An effort to keep the domestic currency value low (to support exports) is inflationary.

Unsterilized Intervention 5 International Reserves - Monetary Base - Int’l Res - => MB - => Ms - => i + ; P - => €/$ + €/$ USD

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Fixed Exchange Regime 8 If the market exchange rate diverges from the fixed exchange rate because of inflation or interest rate or expectations, central bank will enter the picture. If the fixed exchange rate €/$ is higher than the current rate, the Fed will have to buy USD by using €. Fed loses international reserves. If the fixed exchange rate €/$ is lower than the current rate, the Fed will have to buy € using USD. Fed gains international reserves. Blue broken line is the E-par.

Pegging Yuan to USD 9 Productivity and lower inflation rate requires appreciation of yuan. Keeping yuan low (pegging to USD at 12 cents to the yuan meant the Chinese had to buy a lot of USD assets. The Foreign exchange reserves of the People's Republic of China are mainly composed of US dollar in the forms of US government bonds and institutional bonds, and excludes reserves held by Hong Kong and Macau. As of the end of March 2011, the reserve holds $ trillion. Low yuan means it is almost impossible to compete with Chinese products; countries threaten to erect trade barriers. Chinese monetary base increased substantially, threatening high inflation in the future.

European Monetary System 10 8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar8 members of EEC fixed exchange rates with one another and floated against the U.S. dollar ECU value was tied to a basket of specified amounts of European currenciesECU value was tied to a basket of specified amounts of European currencies Fluctuated within limits: 2.25% up or downFluctuated within limits: 2.25% up or down Led to foreign exchange crises involving speculative attackLed to foreign exchange crises involving speculative attack

Collapse of British Pound 11

Emergent Market Crises 12 Riskiness increases. Demand for local assets declines. Exchange rate drops. Current Account deficit increases. Devaluation is expected; under floating regime depreciation is expected. Capital outlow: demand for local assets declines. Government budget deficit shows no indication of reducing. Printing of money is expected. Inflation is expected. Currency depreciation is expected. Demand for local assets declines.