2. The International Financial System
Chapter Thirteen
The International Financial System

3. 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.

4. 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.

5. 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.

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

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. Copyright © 2004 Pearson Education Canada Inc.

17. 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.

18. 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.