Copyright © 2000 Addison Wesley Longman Slide #13-1 Chapter Thirteen THE INTERNATIONAL FINANCIAL SYSTEM

Copyright © 2000 Addison Wesley Longman Slide #13-2 Exchange Market Intervention Unsterilized: Fed sells $10 billion of $, buys $10 billion of foreign assets Federal Reserve Assets Liabilities Foreign Assets + $10 b Currency or Reserves + $10 b (international reserves) (Monetary Base) Results: 1. International reserves, +$10 billion 2. Monetary base, + $10 billion 3. Then analysis in Fig. 1, E t 

Copyright © 2000 Addison Wesley Longman Slide #13-3 Sterilized: To lower MB back to old level, Fed sells $10 billion of government bonds Federal Reserve Assets Liabilities (Foreign Assets) (Monetary Base) International reserves + $10 b Currency or Reserves $0 b Government Bonds - $10 b Results 1. International reserves, +$10 billion 2. Monetary base unchanged 3. E t unchanged: no shift in RET D and RET F Exchange Market Intervention

Copyright © 2000 Addison Wesley Longman Slide #13-4 Exchange Rate Intervention, Sell $ 1. Sell $, buy F: MB , M s  2. M s , P , E e t+1 , expected appreciation of F , RET F shifts right in Fig M s , i D , RET D shifts left, Ggo to point 2 and E t  4. In long run, i D returns to old level, RET D shifts back, go to point 3 Exchange rate overshooting

Copyright © 2000 Addison Wesley Longman Slide #13-5 The Balance of Payments

Copyright © 2000 Addison Wesley Longman Slide #13-6 The Gold Standard Currency convertible into gold at fixed value Example of how it worked: U.S.: $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 : 1. Pay $ Buy $500 gold (500/20 = 25 ounces), ship to U.K., convert into £100 (= 25x £4) and buy tweed

Copyright © 2000 Addison Wesley Longman Slide #13-7 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 The Gold Standard

Copyright © 2000 Addison Wesley Longman Slide #13-8 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

Copyright © 2000 Addison Wesley Longman Slide #13-9 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 s, but no pressure on surplus countries to  M s Fixed Exchange Rate Systems

Copyright © 2000 Addison Wesley Longman Slide #13-10 Intervention in a Fixed Exchange Rate System

Copyright © 2000 Addison Wesley Longman Slide #13-11 Analysis of Figure 2: Intervention in a Fixed Exchange Rate System Since E e t+1 = E par with fixed exchange rate, RET F doesn't shift Overvalued exchange rate (panel a) 1. Central bank sells international reserves to buy domestic currency 2. MB , M s , i D , RET D shifts to right to get to point 2 3. If don't do this have to devalue

Copyright © 2000 Addison Wesley Longman Slide #13-12 Analysis of Figure 2: Intervention in a Fixed Exchange Rate System Undervalued exchange rate (panel b) 1. Central bank sells domestic currency and buys international reserves 2. MB , M s , i D , RET D shifts to left to get to point 2 3. if don't do this have to revalue

Copyright © 2000 Addison Wesley Longman Slide #13-13 Exchange Rate Crisis of September At E par, RET F right of RET D because Bundesbank tight money keeps German interest rates high 2. Bank of England buys £, i D , RET D shifts right 3. When speculators expect devaluation, E e t+1 , RET F shifts right 4. Requires much bigger intervention 5. When UK pulls out of ERM, £  10%, big losses to central bank

Copyright © 2000 Addison Wesley Longman Slide #13-14 Profiting from a FX Crisis Sept. 1992, £ overvalued; Once traders know central banks can't intervene enough, £ only head one direction,  1. One-sided bet, "heads I win, tails I win" 2. Traders sell £, buy DM 3. £  10% after Sept. 16 A. Citibank makes $200 million B. Soros makes $1 billion

Copyright © 2000 Addison Wesley Longman Slide #13-15 Monetary Policy: International Considerations 1.Direct Effects of FX market When intervene, MB changes 2.Balance of Payments Considerations When B of P is in deficit need M s  3.Exchange Rate Considerations When want lower E, need M s 