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

Copyright © 2000 Addison Wesley Longman Slide #13-1

Chapter Thirteen

THE INTERNATIONAL FINANCIAL SYSTEM


Exchange Market InterventionUnsterilized:

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, Et


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

Results1. International reserves, +$10 billion2. Monetary base unchanged

3. Et unchanged: no shift in RETD and RETF

Exchange Market Intervention


Exchange Rate Intervention, Sell $

1. Sell $, buy F: MB , Ms

2. Ms , P , Eet+1 ,

expected appreciation of F , RETF shifts right in Fig. 1

3. Ms , i D , RETD shifts left, Ggo to point 2 and Et

4. In long run, iD returns to old level, RETD shifts back, go to point 3

Exchange rate overshooting


The Balance

of Payments


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 $525

2. Buy $500 gold (500/20 = 25 ounces), ship to U.K., convert into £100 (= 25x £4) and buy tweed


If shipping cheap, do alternative 21. 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 Ms

2. World inflation determined by gold production

The Gold Standard


Fixed Exchange Rate Systems

Bretton Woods1. 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


European Monetary System1. Value of currency not allowed outside "snake"

2. New currency unit: ECU

3. Exchange Rate Mechanism (ERM)

Key weakness of fixed rate systemAsymmetry: pressure on deficit countries losing

international reserves to Ms, but no pressure on surplus countries to Ms

Fixed Exchange Rate Systems


Intervention in a Fixed Exchange Rate System


Analysis of Figure 2: Intervention in a Fixed Exchange Rate System

Since Eet+1 = Epar with fixed exchange rate, RETF

doesn't shift

Overvalued exchange rate (panel a)1. Central bank sells international reserves to buy

domestic currency

2. MB , Ms , iD , RETD shifts to right to get to point 2

3. If don't do this have to devalue


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 , Ms , iD , RETD shifts to left to get to point 2

3. if don't do this have to revalue


Exchange Rate Crisis of September 19921. At Epar, RETF right

of RETD because Bundesbank tight money keeps German interest rates high

2. Bank of England buys £, iD , RETD shifts right

3. When speculators expect devaluation, Ee

t+1 , RETF shifts right

4. Requires much bigger intervention

5. When UK pulls out of ERM, £ 10%, big losses to central bank


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


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 Ms 3. Exchange Rate Considerations

When want lower E, need Ms

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

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