The International System

Monetary Policy

Foreign Exchange Market and the Government

• The foreign exchange market is not free of government intervention.– Central banks engage in international financial

transactions called foreign exchange interventions in order to influence exchange rates.

• The first step in understanding how this works is to see how exchange market intervention affects the monetary base.

Exchange Market Intervention• Unsterilized:

– The Fed sells $1 billion of foreign assets in exchange for $1 billion dollars (cash transaction).

Federal Reserve Assets Liabilities

Foreign Assets -$1b Currency -$1b

Exchange Market Intervention• Unsterilized:

– The Fed sells $1 billion of foreign assets in exchange for $1 billion dollars (check transaction).

Federal Reserve Assets Liabilities

Foreign Assets -$1b Reserves -$1b

Exchange Market Intervention

• Results:– A central bank’s purchase of domestic

currency and corresponding sale of foreign assets leads to an equal decline in its international reserves and the monetary base.

Exchange Market Intervention

• Unsterilized:– The Fed buys $1 billion of foreign assets in

exchange for $1 billion dollars.

Federal Reserve Assets Liabilities

Foreign Assets +$1b Currency +$1b

Foreign Assets +$1b Reserves +$1b

Exchange Market Intervention

• Results:– A central bank’s sale of domestic currency

and corresponding purchase of foreign assets leads to an equal increase in its international reserves and the monetary base.

Exchange Market Intervention and the Exchange Rate

• How does an unsterilized intervention affect the exchange rate?– An unsterilized intervention in which domestic

currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency.

Exchange Market Intervention and the Exchange Rate

• How does an unsterilized intervention affect the exchange rate?– An unsterilized intervention in which domestic

currency is bought by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency.

Intervention in the Foreign Exchange Market

• Conclusion:– If a central bank intervenes in the foreign

exchange market, it gives up some control over its money supply.

• The sale of foreign assets results in a decrease in the currency worldwide.

• The purchase of foreign assets results in an increase in the currency worldwide.

Intervention in the Foreign Exchange Market

• If a central bank does not want the currency to fall, it can follow a contractionary monetary policy, which reduces base and the money supply.– The decrease in the money supply given demand

supports the currency’s value.

Exchange Market Intervention

• Sterilized:– The Fed buys $1 billion of foreign assets in

exchange for $1 billion dollars and sells bonds.

Federal Reserve Assets Liabilities

Foreign Assets +$1b Currency or Reserves +$1b

Government Bonds -$1b Currency or Reserves -$1b

Intervention in the Foreign Exchange Market

• If a central bank does not want the currency to rise, it can follow an expansionary monetary policy, which increases base and the money supply.– The increase in the money supply given demand

tends to decrease the currency’s value.

Exchange Market Intervention

• Sterilized:– The Fed sells $1 billion of foreign assets in

exchange for $1 billion dollars and buys bonds.

Federal Reserve Assets Liabilities

Foreign Assets -$1b Currency or Reserves -$1b

Government Bonds +$1b Currency or Reserves +$1b

Sterilized Exchange Market Intervention

• Conclusions:– A central bank’s sale or purchase of foreign

assets and corresponding purchase or sale of domestic currency leads to an equal decrease or increase in its international reserves and the monetary base.

– But, if the central bank buys or sells and equal amount of government bonds at the same time, the monetary base does not change.

Money Supply and the Exchange Rate

Et

RET$

RETD1

RETF1

RETF2

RETD2 A sale of dollars and purchase of foreign

assets cause RETD to shift left from RETD1

to RETD2

The increase in the money supply also causesRETF to shift right from RETF1 to RETF2.

Therefore, in the short run the exchange rate falls from E1 to E2.

In the long run, as the domestic rate ofinterest rises, RETD shifts right and the exchange rate rises to E3

2

3

1

0Unsterilized

E1

E3

E2

The Money Supply and the Exchange Rate

• The story:– A sale of dollars and consequent open market

purchase of foreign assets increase base, causing the money supply to rise.

– The increase in the money supply results in a higher domestic price level in the long run, which leads to a lower expected future exchange rate.

The Money Supply and the Exchange Rate

• The story:– The resulting decline in the expected

appreciation of the dollar raises the expected return on foreign deposits.

– In the short run, domestic interest rates fall because of the increase in the money supply.

– The combination of higher expected returns on foreign deposits and lower domestic interest rates, causes the exchange rate to fall.

The Money Supply and the Exchange Rate

• The story:– In the long run, however, domestic interest

rates rise, and the exchange rate rises.

Money Supply and the Exchange Rate

Et

RET$

RETD1

RETF1

E2

E3

E1

RETF2

RETD2 A purchase of dollars and sale of foreign

assets cause RETD to shift right from RETD1

to RETD2 in the short run.

The decrease in the money supply also causesRETF to shift left from RETF1 to RETF2.

Therefore, in the short run, the exchange rate rises from E1 to E2.

In the long run, as the domestic rate of interestfalls, RETD shifts left and the exchange rate falls to E3

2

3

1

0

Unsterilized

Sterilized Intervention

• In this model, where the domestic and foreign deposits are perfect substitutes, and the foreign asset transaction is sterilized, the exchange rate does not change.

• Why?

Sterilized Intervention

– If the money supply does not change, domestic interest rates do not change.

– If the money supply does not change, expectations about inflation and future exchange rates do not change.

– If the future expected value of the dollar does not change, the expected return on foreign deposits also does not change.

Sterilized Intervention

• Theoretically, if the deposits are not perfect substitutes, the exchange rate can change even if the foreign asset transaction is sterilized.

• But empirical studies do not find evidence of this happening to any great extent.

International Transactions: Balance of Payments

• Balance of Payments Account– A tabulation of all transactions between the

residents of a nation and the residents of all other nations in the world.

International Transactions: Balance of Payments

• Balance of Payments Accounts– Current Account

• BOP account that tabulates international trade and transfers of goods and services and flows of income.

– Capital Account• BOP account that records all non-governmental

international asset transactions.

Current Account

• Merchandise Trade Balance– Merchandise exports minus merchandise imports

• In 2000, exports = +773 and imports = – 1,223, so the merchandise trade balance was – 450.

• Net Service Transactions and Income Flows– Services we provide to the rest of the world minus

services they provide to us plus other income flows.• In 2000, net service transactions = 81 – 14 – 53.

• Balance on Goods and Services – The sum of the merchandise trade balance and net

service transactions.• In 2000, the balance was – 436.

Current Account• Net Investment Income Flow

– Individuals and firms that reside in the USA earn income on assets that they hold in other nations.

– Similarly, residents that reside in other nations earn income on assets that they hold in the USA.

– Net income flow is the difference between these sums.– In 2000, net investment income was 14.

• Unilateral Transfers– Gifts that U.S. residents give to residents or

governments of other nations or that foreign resident or governments give to the U.S.

– In 2000, unilateral transfers were -53.

The Capital Account

• Changes in asset holdings by U.S. residents and residents of other nations take place in international financial markets and are recorded outside the current account.

• The capital account tabulates asset transactions involving private individuals or firms.

Capital Account

• Capital Outflows – American purchases of foreign assets.

• In 2000, capital outflows = – 553.• Capital Inflows

– Foreign purchases of American assets.• In 2000, capital inflows = 952.

• Statistical Discrepancy– Errors due to unrecorded transactions involving

smuggling and other data discrepancies.• In 2000, statistical discrepancy = 35

Official Reserves Transactions Balance

• Official reserves transactions balance gives the net total of all private exchanges between U.S. individuals and businesses and the rest of the world.– It is the sum of the current account balance

and the capital account balance .• In 2000, the official reserves transactions balance

was – $436 + $434 = – $2.

Official Reserves Transactions Balance

• The official reserves transactions balance tells us the net amount of international reserves that must move between central banks to finance international transactions.– A balance-of-payments deficit can be financed

by a decrease in U.S. international reserves, an increase in foreign central banks’ holdings of international reserves (dollar assets) or both.

Methods of Financing

• Change in U.S. Official Reserve Assets– Change in U.S. international reserves

• In 2000, international reserves increased by $33 billion dollars or a payment of – $33.

– International reserves increase when we buy them from foreigners with an outflow of dollars.

– Change in foreign holdings of dollars• In 2000, foreign holdings of dollars increased by

$35.

Overall Balance of Payments

• The overall balance of payments always equals zero.– In 2000, the United States indebtedness to

foreign central banks increased by $2 billion.– This $2 billion increase just matches the $2

billion official reserve transactions deficit.

Balance-of-Payments and the USA

• The USA can run a large balance-of-payments deficit without losing huge amounts of international reserves because it is a major reserve currency country.

• Nevertheless, balance-of-payments deficits are still a problem to the Federal Reserve.

Balance-of-Payments and the USA

• Current account deficits suggest that the dollar is too high and may be diminishing the competitiveness of American businesses.

• Large U.S balance-of-payments deficits lead to balance-of-payments surpluses in other countries, which in turn can lead to large increases in their holdings of international reserves, leading to higher levels of inflation.

Fixed Exchange Rates

• In a system of fixed exchange rates, each country’s central bank intervenes in the foreign exchange market to prevent that country’s exchange rate from going outside a narrow band on either side of its par value.– The bank must be prepared to offset imbalances

in demand and supply by government sales or purchases of foreign exchange.

Fixed Exchange Rates: Example

• Let the exchange value of the Hong Kong dollar be set such that it is overvalued relative to its current market value.– Hong Kong must drive up the value of the HK$

by buying HK$s in the world market.• Hong Kong loses international reserves.

Fixed Exchange Rates: Example

• Let the exchange value of the Hong Kong dollar be set such that it is undervalued relative to its current market value.– Hong Kong must drive down the value of the

HK$ by selling HK$s in the world market.• Hong Kong gains international reserves.

Fixed Exchange Rate: Example

Overvalued Undervalued

D

S

D

S

QQ

$/HK$ $/HK$

Peg Peg

Market

Market

0 0

Loss of Reserves

Gain of Reserves

Fixed Exchange Rates: Overvalued Currency

Et

RET$

RETD1

RETF1

Epar

RETD2

At the exchange rate Epar, the currency isovervalued. To keep the currency at Epar, the central bankmust purchase domestic currency, shiftingRETD

1 to RETD2.

2

1

0

E2

Consequences of Exchange Rate Intervention

• When a country attempts to maintain an overvalued exchange rate, it loses international reserves.– If the country runs out of international

reserves, it can no longer support its currency and must devalue.

Fixed Exchange Rates: Undervalued Currency

Et

RET$

RETD1

RETF1

Epar

RETD2

At the exchange rate Epar, the currency isundervalued. To keep the currency at Epar, the central bankmust sell domestic currency to shift RETD

1

to RETD2.

2

1

0

E2

Consequences of Exchange Rate Intervention

• When a country attempts to maintain an undervalued exchange rate, it gains international reserves.– If the country does not want to accumulate

international reserves, it may decide to revalue its currency.

Consequences of Exchange Rate Intervention

• If domestic and foreign currencies are perfect substitutes, a sterilized exchange rate intervention would not be able to maintain the exchange rate at Epar.– RETD will not shift.

• No change in domestic interest rates.

– RETF will not shift• No change in expectations about the future value of

the currency.

Consequences of Exchange Rate Intervention

• When smaller countries tie their exchange rate to that of a larger country, they lose control of their monetary policy.– If the larger country pursues a more

contractionary monetary policy, inflation expectations in the larger country will fall, causing the larger country’s currency to appreciate and the smaller country’s currency to become overvalued.

Consequences of Exchange Rate Intervention

– The smaller country will now have to buy its own currency and sell the currency of the larger country.

– As a result, the smaller country’s international reserves, base, and money supply will contract.

– Sterilization is not possible because it would just lead to more losses of international reserves and an eventual devaluation.

Foreign Exchange Crisis: Mexico

Et

RET$

RETD1 RETF

1

Epar

RETD = the expected return on the peso.RETF = the expected return on the dollar.

After the assassination of the ruling party’spresidential candidate, investors became concerned that the government would devaluethe peso, the expected return on the dollar roseto RETF

2 ,and the value of the peso fell.

To maintain Epar, the Mexican governmentbought pesos and shifted RETD to the right.

0

RETF2

1’

1 2

Mexico

Foreign Exchange Crisis: Mexico

Et

RET$

RETD1 RETF

1

Epar

RETD = the expected return on the peso.RETF = the expected return on the dollar.

An uprising in Chiapas, another assassination,and concerns about the current account deficit led to more rumors about devaluation.

RETF shifted to RETF3. The Mexicans

intervened, buying pesos. As the speculatorsrealized that Mexico was running out offoreign reserves and would have to devalue,RETF shifted further right.

0

RETF2

RETF3

1’

1 2 3

Foreign Exchange Crisis: Thailand

Et

RET$

RETD1 RETF

1

Epar

RETD = the expected return on the baht.RETF = the expected return on the dollar.

Concerns about Thailand’s current accountdeficit and weak financial system causedspeculators to suspect that Thailand woulddevalue.

RETF shifted to the right, putting pressure on the baht. Thailand intervened and bought baht. The collapse of Finance One caused another shift of RETF to the right.

Ultimately, Thailand ran out of international reserves and devalued.

0

RETF2

RETF3

1’

1 2 3

Thailand

Capital Outflows

• Capital Outflows– Capital outflows can promote financial

instability in emerging market countries because they can lead to a devaluation in the domestic currency.

• Should capital outflows be restricted?

Capital Controls

• Disadvantages:– Capital controls are seldom effective during a

crisis because people find ways to evade them.– Capital controls can increase capital flight as

people lose confidence in the government.– Capital controls lead to corruption of

government officials.– Capital controls delay reform of the financial

system.

Capital Inflows

• Capital Inflows– Capital inflows can promote financial

instability in emerging market countries because speculative capital can exit the country as suddenly as it entered, causing or contributing to a currency crisis.

• Should capital inflows be restricted?

Capital Controls

• Advantages:– Capital controls on capital inflows can regulate

the flow of capital and avoid sudden changes that disrupt the financial system.

• There is a strong case for improving bank regulation and supervision to control capital inflows.– Restrictions on how fast banks’ borrowing can

grow could limit capital inflows.

Capital Controls

• Disadvantages:– Capital controls may block funds that would be used

for productive investment from entering a country.– Capital controls are unlikely to be effective in

today’s environment. – Capital controls over time produce substantial

distortions and misallocation of resources as people avoid them.

– Capital controls can lead to corruption of government officials.