money, banking, and financial markets : econ. 212

Economics of International Finance Economics of International Finance Prof. M. El-Sakka Prof. M. El-Sakka CBA. Kuwait University CBA. Kuwait University

Money, Banking, and Financial Money, Banking, and Financial Markets : Econ. 212Markets : Econ. 212

Stephen G. Cecchetti: Stephen G. Cecchetti: Chapter 19Chapter 19Exchange-Rate Policy and the Central BankExchange-Rate Policy and the Central Bank


Linking Exchange-Rate Policy with Domestic Monetary PolicyLinking Exchange-Rate Policy with Domestic Monetary Policy Inflation and the Long-Run Implications of Purchasing Power ParityInflation and the Long-Run Implications of Purchasing Power Parity The law of one price says that identical goods should sell for The law of one price says that identical goods should sell for

the same price regardless of where they are sold. The the same price regardless of where they are sold. The concept of purchasing power parity extends the logic of the concept of purchasing power parity extends the logic of the law of one price to a basket of goods and services.law of one price to a basket of goods and services.

The implication of this is that when prices change in one The implication of this is that when prices change in one country, but not in another, the country, but not in another, the exchange rate will adjust to exchange rate will adjust to reflect the changereflect the change. In the long run, changes in the exchange . In the long run, changes in the exchange rate are tied to rate are tied to differences in inflationdifferences in inflation..

If a country wants to fix its exchange rate with another If a country wants to fix its exchange rate with another country, it must therefore conduct its monetary policy so country, it must therefore conduct its monetary policy so that the two countries’ that the two countries’ inflation rates matchinflation rates match..


The central bank must choose between a The central bank must choose between a fixedfixed exchange rate exchange rate and an and an independentindependent inflation policy; it cannot have both. inflation policy; it cannot have both.

Deviations from purchasing power parity occur, and can Deviations from purchasing power parity occur, and can last for years.last for years.

Interest Rates and the Short-Run Implications of Capital Interest Rates and the Short-Run Implications of Capital Market ArbitrageMarket Arbitrage

In the short run, a country’s exchange rate is determined by In the short run, a country’s exchange rate is determined by supply and demand. The exchange value of a currency supply and demand. The exchange value of a currency depends on the preferences of the country’s citizens for depends on the preferences of the country’s citizens for foreign assets and the preferences of foreign investors for foreign assets and the preferences of foreign investors for the country’s assets.the country’s assets.

In the short run, investors can move large quantities of In the short run, investors can move large quantities of currency across international borders, assuming that currency across international borders, assuming that governments allow the free movement of funds.governments allow the free movement of funds.


International capital mobility results in capital market International capital mobility results in capital market arbitrage across nations. Two bonds that are equally risky, arbitrage across nations. Two bonds that are equally risky, with the same maturity and same coupon rate will sell for with the same maturity and same coupon rate will sell for the same price and have the same interest rate; this is true the same price and have the same interest rate; this is true even if the bonds are denominated in different currencies.even if the bonds are denominated in different currencies.

If interest rates differ in two countries and their exchange If interest rates differ in two countries and their exchange rate is fixed, investors will move back and forth, wiping out rate is fixed, investors will move back and forth, wiping out the difference.the difference.


Capital Controls and the Policymakers’ ChoiceCapital Controls and the Policymakers’ Choice If capital cannot flow freely between countries, there is no If capital cannot flow freely between countries, there is no

mechanism to equate interest rates in the two countries.mechanism to equate interest rates in the two countries.

So long as capital can flow freely, monetary policymakers So long as capital can flow freely, monetary policymakers must choose between fixing their exchange rate and fixing must choose between fixing their exchange rate and fixing their interest rate. A country cannot be open to capital their interest rate. A country cannot be open to capital flows, control its domestic interest rate, and fix its exchange flows, control its domestic interest rate, and fix its exchange rate. Policymakers must choose two of these three.rate. Policymakers must choose two of these three.

Different countries make different choices; if a country is Different countries make different choices; if a country is willing to forgo participation in international capital willing to forgo participation in international capital markets it can impose capital controls, fix its exchange rate, markets it can impose capital controls, fix its exchange rate, and still use monetary policy to pursue domestic objectives.and still use monetary policy to pursue domestic objectives.


Capital controls go against the grain of modern economic Capital controls go against the grain of modern economic thinking. Internationally integrated capital markets ensure thinking. Internationally integrated capital markets ensure that capital goes to its most efficient uses.that capital goes to its most efficient uses.

The free flow of capital across borders enhances The free flow of capital across borders enhances competition, improves opportunities for diversification, and competition, improves opportunities for diversification, and equalizes rates of return (adjusted for risk).equalizes rates of return (adjusted for risk).

For a developing country, openness comes with the risk of For a developing country, openness comes with the risk of large movements of funds out of the country, driving the large movements of funds out of the country, driving the interest rate up and the value of the currency down.interest rate up and the value of the currency down.

It is tempting for governments to try to avoid such crises by It is tempting for governments to try to avoid such crises by restricting the ability to move capital in and out of a country restricting the ability to move capital in and out of a country (inflow controls and outflow controls).(inflow controls and outflow controls).


Mechanics of Exchange Rate ManagementMechanics of Exchange Rate Management The Central Bank’s Balance SheetThe Central Bank’s Balance Sheet If all policymakers want to do is fix the exchange rate they If all policymakers want to do is fix the exchange rate they

can offer to buy and sell their country’s currency at a fixed can offer to buy and sell their country’s currency at a fixed rate.rate.

However, these interventions have an impact on interest However, these interventions have an impact on interest rates and on the quantity of money in the economy: buying rates and on the quantity of money in the economy: buying foreign currency or selling dollars increases reserves, foreign currency or selling dollars increases reserves, putting downward pressure on interest rates and expanding putting downward pressure on interest rates and expanding the quantity of money.the quantity of money.

In effect, the decision to control the exchange rate means In effect, the decision to control the exchange rate means giving up control of the giving up control of the size of reservessize of reserves, so that the market , so that the market determines the interest rate.determines the interest rate.

A foreign exchange intervention has the same impact on A foreign exchange intervention has the same impact on reserves as a reserves as a domestic open market operationdomestic open market operation..


A foreign exchange intervention affects the value of a A foreign exchange intervention affects the value of a country’s currency by changing domestic interest rates. In country’s currency by changing domestic interest rates. In general any central bank policy that influences the domestic general any central bank policy that influences the domestic interest rate will affect the exchange rate.interest rate will affect the exchange rate.


Sterilized InterventionSterilized Intervention In a sterilized intervention, a change in foreign exchange In a sterilized intervention, a change in foreign exchange

reserves alters the asset side of the central bank’s balance reserves alters the asset side of the central bank’s balance sheet, but the domestic monetary base remains unaffected.sheet, but the domestic monetary base remains unaffected.

A sterilized intervention is actually a combination of two A sterilized intervention is actually a combination of two transactions, the purchase (or sale) or foreign currency transactions, the purchase (or sale) or foreign currency reserves and an open market operation of exactly the same reserves and an open market operation of exactly the same size, designed to offset the impact of the first transaction on size, designed to offset the impact of the first transaction on the monetary base.the monetary base.

The intervention changes the composition of the asset side of The intervention changes the composition of the asset side of the central bank’s balance sheet but not its size.the central bank’s balance sheet but not its size.


The Costs, Benefits, and Risks of Fixed Exchange RatesThe Costs, Benefits, and Risks of Fixed Exchange Rates Assessing the Costs and BenefitsAssessing the Costs and Benefits Fixed exchange rates simplify operations for businesses Fixed exchange rates simplify operations for businesses

that trade internationally and reduce the risk that that trade internationally and reduce the risk that investors face when they hold foreign stocks and bonds investors face when they hold foreign stocks and bonds as well.as well.

A fixed exchange rate ties policymakers’ hands, and in A fixed exchange rate ties policymakers’ hands, and in countries that are prone to bouts of high inflation, a countries that are prone to bouts of high inflation, a fixed exchange rate may be the only way to establish a fixed exchange rate may be the only way to establish a credible low-inflation policy. Moreover, An exchange credible low-inflation policy. Moreover, An exchange rate target enforces low-inflation discipline on both rate target enforces low-inflation discipline on both central banks and politicians and enhances central banks and politicians and enhances transparency and accountability.transparency and accountability.

There is one serious drawback to a fixed exchange rate; There is one serious drawback to a fixed exchange rate; it means importing monetary policy.it means importing monetary policy.


Fixing our currency to that of another country means Fixing our currency to that of another country means adopting the interest rate policy of the other country, adopting the interest rate policy of the other country, which can be a real problem if the two countries have which can be a real problem if the two countries have different macroeconomic fluctuations.different macroeconomic fluctuations.

In order to fix the rate, the central bank must have In order to fix the rate, the central bank must have ample reserves because it will need to buy (and sell) its ample reserves because it will need to buy (and sell) its currency at the fixed rate; such reserves may be currency at the fixed rate; such reserves may be difficult to obtain and expensive to keep.difficult to obtain and expensive to keep.

Fixing the exchange rate also means reducing the Fixing the exchange rate also means reducing the domestic economy’s natural ability to respond to domestic economy’s natural ability to respond to macroeconomic shocks. The stabilization mechanism of macroeconomic shocks. The stabilization mechanism of interest rates is shut downinterest rates is shut down..


The Danger of Speculative AttacksThe Danger of Speculative Attacks Fixed exchange rates are fragile and are prone to a type of Fixed exchange rates are fragile and are prone to a type of

crisis called a speculative attack.crisis called a speculative attack.

If traders believe that the reserves at the central bank are If traders believe that the reserves at the central bank are insufficient they can launch an attack and, in effect, insufficient they can launch an attack and, in effect, drain drain those reservesthose reserves..

Speculative attacks are caused by traders not believing that Speculative attacks are caused by traders not believing that officials can maintain the exchange rate at its fixed level officials can maintain the exchange rate at its fixed level (perhaps due to expectations of inflation) but can also arise (perhaps due to expectations of inflation) but can also arise spontaneously (and can be contagious).spontaneously (and can be contagious).

Summarizing the Case for a Fixed Exchange RateSummarizing the Case for a Fixed Exchange Rate A country will be better off fixing its exchange rate if it has a A country will be better off fixing its exchange rate if it has a

poor reputation for controlling inflation on its own, an poor reputation for controlling inflation on its own, an economy that is well integrated with the one to whose economy that is well integrated with the one to whose currency the rate is fixed, and a high level of foreign currency the rate is fixed, and a high level of foreign exchange reserves.exchange reserves.


Regardless of how closely a country meets these criteria, fixed Regardless of how closely a country meets these criteria, fixed exchange rates are still risky to adopt and difficult to maintain.exchange rates are still risky to adopt and difficult to maintain.

Fixed Exchange-Rate RegimesFixed Exchange-Rate Regimes Exchange-Rate Pegs and the Bretton Woods SystemExchange-Rate Pegs and the Bretton Woods System The Bretton Woods System, which lasted from 1945 to 1971, was The Bretton Woods System, which lasted from 1945 to 1971, was

a system of fixed exchange rates that offered more flexibility over a system of fixed exchange rates that offered more flexibility over the short term than had been possible under the gold standard.the short term than had been possible under the gold standard.

Each country maintained an agreed-upon exchange rate with the Each country maintained an agreed-upon exchange rate with the U.S. dollar (currencies were pegged to the dollar). Every country U.S. dollar (currencies were pegged to the dollar). Every country held dollar reserves and stood ready to exchange its own currency held dollar reserves and stood ready to exchange its own currency for the dollar at the fixed rate.for the dollar at the fixed rate.

Countries had to intervene regularly to maintain the fixed rates at Countries had to intervene regularly to maintain the fixed rates at the pegthe peg..


The International Monetary Fund (IMF) was created to The International Monetary Fund (IMF) was created to manage the system by making loans to countries in need of manage the system by making loans to countries in need of short-term financing to pay for an excess of imports over short-term financing to pay for an excess of imports over exports.exports.

As capital markets opened up the system came under As capital markets opened up the system came under increasing strain, because with a fixed exchange rate and the increasing strain, because with a fixed exchange rate and the free movements of capital, countries could no longer have free movements of capital, countries could no longer have independent monetary policies. independent monetary policies.

When U.S. inflation began to rise in the late 1960s many When U.S. inflation began to rise in the late 1960s many countries balked; they didn’t want to match the rise in countries balked; they didn’t want to match the rise in inflation.inflation.

By 1971 the system had completely fallen apart, and By 1971 the system had completely fallen apart, and American officials have allowed the dollar to float freely American officials have allowed the dollar to float freely ever since. Europeans took the different approach of ever since. Europeans took the different approach of maintaining various fixed exchange rate mechanisms, up to maintaining various fixed exchange rate mechanisms, up to the introduction of the euro.the introduction of the euro.


Hard Pegs: Currency Boards and DollarizationHard Pegs: Currency Boards and Dollarization Under a hard-peg system the central bank implements an Under a hard-peg system the central bank implements an

institutional mechanism that ensures its ability to convert a institutional mechanism that ensures its ability to convert a domestic currency into the foreign currency to which it is pegged.domestic currency into the foreign currency to which it is pegged.

Only two exchange-rate regimes can be considered hard pegs: a Only two exchange-rate regimes can be considered hard pegs: a currency board (whereby the central bank commits to holding currency board (whereby the central bank commits to holding enough foreign currency assets to back domestic currency liabilities enough foreign currency assets to back domestic currency liabilities at a fixed rate) and dollarization (whereby the country formally at a fixed rate) and dollarization (whereby the country formally adopts the currency of another country for use in all its financial adopts the currency of another country for use in all its financial transactions).transactions).

Currency Boards and the Argentinean ExperienceCurrency Boards and the Argentinean Experience Somewhere between 10 and 20 currency boards operate in the Somewhere between 10 and 20 currency boards operate in the

world today, the best known of which is the Hong Kong Monetary world today, the best known of which is the Hong Kong Monetary Authority.Authority.

With a currency board, the central bank’s only job is to maintain With a currency board, the central bank’s only job is to maintain the exchange rate.the exchange rate.


While that means that policymakers cannot adjust monetary While that means that policymakers cannot adjust monetary policy in response to domestic economic shocks, the system policy in response to domestic economic shocks, the system does have its advantages.does have its advantages.

Prime among the advantages is the control of inflation. But Prime among the advantages is the control of inflation. But currency boards do have their problems, including the fact currency boards do have their problems, including the fact that the central bank loses its role as the lender of last resort that the central bank loses its role as the lender of last resort to the domestic banking system.to the domestic banking system.

Dollarization in EcuadorDollarization in Ecuador In January of 2000, Ecuador officially gave up its currency, In January of 2000, Ecuador officially gave up its currency,

and almost immediately interest rates dropped, the banking and almost immediately interest rates dropped, the banking system reestablished itself, inflation fell dramatically and system reestablished itself, inflation fell dramatically and growth resumed.growth resumed.

A year later El Salvador followed suit. Panama has been A year later El Salvador followed suit. Panama has been dollarized since 1904.dollarized since 1904.


A country might choose dollarization because with no A country might choose dollarization because with no exchange rate there is no risk of an exchange-rate crisis, it exchange rate there is no risk of an exchange-rate crisis, it helps the country become integrated into world markets, and helps the country become integrated into world markets, and it can reduce their risk premium (associated with inflation it can reduce their risk premium (associated with inflation risk).risk).

The benefits of dollarization are balanced against the loss of The benefits of dollarization are balanced against the loss of revenue from issuing currency (called seigniorage), the loss of revenue from issuing currency (called seigniorage), the loss of the central bank’s role as lender of last resort, the loss of the central bank’s role as lender of last resort, the loss of autonomous monetary or exchange rate policy, and the autonomous monetary or exchange rate policy, and the importing of U.S. monetary policy (like it or not).importing of U.S. monetary policy (like it or not).

Dollarization is not the same as monetary union, because Dollarization is not the same as monetary union, because dollarized countries have no “vote” in the monetary policy dollarized countries have no “vote” in the monetary policy chosen by the FOMC. A monetary union is shared chosen by the FOMC. A monetary union is shared governance; dollarization is not.governance; dollarization is not.


Appendix: What You Really Need to Know about the Balance Appendix: What You Really Need to Know about the Balance of Paymentsof Payments

To understand the international financial system you need to To understand the international financial system you need to know three important terms connected with the international know three important terms connected with the international balance of payments: (1) current account balance; (2) capital balance of payments: (1) current account balance; (2) capital account balance; and (3) the official settlements balance.account balance; and (3) the official settlements balance.

The current account tracks the flow of payments across The current account tracks the flow of payments across national boundaries; the balance on the account is the national boundaries; the balance on the account is the difference between a country’s exports and imports of goods difference between a country’s exports and imports of goods and services (also included are transfers and investment and services (also included are transfers and investment income).income).

The capital account tracks the purchase and sale of assets, and The capital account tracks the purchase and sale of assets, and the balance is the difference between a country’s capital inflows the balance is the difference between a country’s capital inflows and outflows.and outflows.


The official settlements balance is the change in a country’s The official settlements balance is the change in a country’s official reserve holdings; it shows the change in the central official reserve holdings; it shows the change in the central bank’s foreign exchange reserves (or gold reserves).bank’s foreign exchange reserves (or gold reserves).

The three must sum to zero. A country running a current The three must sum to zero. A country running a current account deficit can pay for it by running a capital account account deficit can pay for it by running a capital account surplus or it can draw down its foreign exchange reserves.surplus or it can draw down its foreign exchange reserves.

Countries with current account deficits would lose reserves and Countries with current account deficits would lose reserves and those with surpluses would gain them.those with surpluses would gain them.


Lessons of Chapter 19Lessons of Chapter 19

When capital flows freely across a country's borders, fixing the exchange rate When capital flows freely across a country's borders, fixing the exchange rate means giving up domestic monetary policy.means giving up domestic monetary policy.

Purchasing power parity implies that, in the long run, exchange rates are tied Purchasing power parity implies that, in the long run, exchange rates are tied to inflation differentials across countries.to inflation differentials across countries.

Capital market arbitrage means that, in the short run, the exchange rate is Capital market arbitrage means that, in the short run, the exchange rate is tied to differences in interest rates.tied to differences in interest rates.

Monetary policymakers must choose two of the following three options: open Monetary policymakers must choose two of the following three options: open capital markets, control of domestic interest rates, and a fixed exchange rate.capital markets, control of domestic interest rates, and a fixed exchange rate.

Countries that impose controls on capital flowing in and/or out can fix the Countries that impose controls on capital flowing in and/or out can fix the exchange rate without giving up their domestic monetary policy.exchange rate without giving up their domestic monetary policy.

Central banks can intervene in foreign exchange markets.Central banks can intervene in foreign exchange markets. When they do, it affects their balance sheet in the same way as an open When they do, it affects their balance sheet in the same way as an open

market operation.market operation. Foreign exchange intervention affects the exchange rate by changing domestic Foreign exchange intervention affects the exchange rate by changing domestic

interest rates. This is called unsterilized intervention.interest rates. This is called unsterilized intervention. A sterilized intervention is a purchase or sale of foreign exchange reserves A sterilized intervention is a purchase or sale of foreign exchange reserves

that leaves the central bank’s liabilities unchanged. It has no impact on the that leaves the central bank’s liabilities unchanged. It has no impact on the exchange rate.exchange rate.

The decision to fix the exchange rate has costs, benefits, and risks.The decision to fix the exchange rate has costs, benefits, and risks. Both corporations and investors benefit from predictable exchange rates.Both corporations and investors benefit from predictable exchange rates. Fixed exchange rates can reduce domestic inflation by importing the Fixed exchange rates can reduce domestic inflation by importing the

monetary policy of a country with low inflation.monetary policy of a country with low inflation.


Fixed exchange rate regimes are fragile and leave countries open to Fixed exchange rate regimes are fragile and leave countries open to speculative attacks.speculative attacks.

The right conditions for choosing to fix the exchange rate include:The right conditions for choosing to fix the exchange rate include:• a poor reputation for inflation control.a poor reputation for inflation control.• an economy that is well integrated with the one to whose currency the rate an economy that is well integrated with the one to whose currency the rate

is fixed.is fixed.• a high level of foreign exchange reserves.a high level of foreign exchange reserves.

There are a number of examples of exchange-rate systems.There are a number of examples of exchange-rate systems. The Bretton Woods System, set up after World War II, pegged exchange rates The Bretton Woods System, set up after World War II, pegged exchange rates

to the U.S. dollar, but collapsed in 1971 after U.S. inflation began to rise.to the U.S. dollar, but collapsed in 1971 after U.S. inflation began to rise. Most fixed exchange rate regimes are no longer thought to be viable.Most fixed exchange rate regimes are no longer thought to be viable. Two that may work are currency boards and dollarization.Two that may work are currency boards and dollarization. With a currency board, the central bank holds enough foreign currency With a currency board, the central bank holds enough foreign currency

reserves to exchange the entire monetary base at the promised exchange rate.reserves to exchange the entire monetary base at the promised exchange rate. Argentina's currency board collapsed when the regional governments began Argentina's currency board collapsed when the regional governments began

printing their own money.printing their own money. Dollarization is the total conversion of an economy from its own currency to Dollarization is the total conversion of an economy from its own currency to

the currency of another country.the currency of another country. Several Latin American countries have adopted the dollar recently, with good Several Latin American countries have adopted the dollar recently, with good

results over the short run.results over the short run.


Key Terms

•Bretton Woods SystemBretton Woods System capital controlscapital controls

•capital inflow controlscapital inflow controls capital outflow controlscapital outflow controls

•currency boardcurrency board dollarizationdollarization

•foreign exchange interventionforeign exchange intervention gold standardgold standard

•hard peghard peg reserve currencyreserve currency

•speculative attackspeculative attack sterilized interventionsterilized intervention

•unsterilized interventionunsterilized intervention

money, banking, and financial markets : econ. 212

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