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Lecture 10

Lecture 10. THE INTERNATIONAL FINANCIAL SYSTEM (1). Interventions in forex markets. Our analysis of foreign exchange markets assumed completely free markets so far. In practice, there are also monetary policy interventions in these markets.

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Lecture 10

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  1. Lecture 10 THE INTERNATIONAL FINANCIAL SYSTEM (1)

  2. Interventions in forex markets • Our analysis of foreign exchange markets assumed completely free markets so far. • In practice, there are also monetary policy interventions in these markets. • Under the present system („managed floating” or „dirty floating“), exchange rates might fluctuate daily, but central banks attempt to „smooth“ price behavior in the very short run, and even over some extended period of time.

  3. Forex interventions • By statute, Treasuries (governments) possess typically the lead role in setting forex policy, but in practice it is usually based on a consensus between the government and the central bank. • However stabilizing forex interventions for longer periods have become extremely rare in the US (‘benign neglect’) and in the EU. • In carrying out stabilizing interventions, the central bank sells/buys international reserves.

  4. Gold International reserves Balance sheet of a central bank Assets Liabilities Base money Securities

  5. Sterilized intervention in forex markets • If a central bank buys/sells international reserves, this has the same effect on the monetary base as OMOs. • If the central bank allows this effect to happen, this is called an “unsterilized foreign exchange intervention”. • If the expansionary (or contractionary) effect on base money is offset by a counteracting OMO, this is called “sterilization”.

  6. “Sterilized” forex intervention Central Bank Liabilities Assets Foreign assets(International reserves) Monetary base(reserves) -€1 billion unchanged Government bonds +€1 billion

  7. Unsterilized forex intervention • As this type of policy is equivalent to an OMO, it also produces the same results. • An increase in the money supply leads to a higher price level in the long run, and hence to a devaluation of the currency. • This increases the expected return on foreign deposits, and shifts the RETF-schedule to the right.

  8. RETF2 E2 2 Effect of a purchase of $ against € Exchange rate($/€) RETF1 RETD1 1 E1 Expected returnin € iD1

  9. The long-run adjustment process • In the short run, not only the return on foreign asset increases, but also the return on domestic assets declines. • The short-run outcome is a fall in the exchange rate from E1 to E3. • In the long run, however, the domestic interest rate returns to the former level. • The exchange rate moves back to its new longer term position at point E2.

  10. RETD2 In the short run the RETD-curvemoves to the left In the long run the RETD-curvemoves back to theoriginal position. E3 3 Effect of a purchase of $ against € Exchange rate($/€) RETF1 RETD1 RETF2 1 E1 E2 2 Expected returnin € iD1 iD2

  11. Consequences • 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. • An unsterilized intervention in which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and an appreciation of the domestic currency.

  12. Sterilized intervention • Sterilized intervention has no impacton the money supply. • Therefore it does not affect domestic interest rates, and hence expected future exchange rates are also unaffected. • It seems puzzling that an intervention in forex markets has no effect on the exchange rate, but this cannot occur unless domestic interest rates are changed.

  13. Evolution of the international financial system • Before World War I, the world economy operated under the gold standard. • It means that most world currencies were backed by, and convertible into gold. • For currencies whose unit is permanently tied to a certain quantity of gold, the gold standard represents a fixed-exchange rate regime. • To see how it works we take an example:

  14. Operation of the gold standard (1) • The exchange rate between the $ and the £ is effectively fixed at $5:£1 via the common denominator gold. • As the £ appreciates beyond $5 in financial markets, an American importer importing goods for £100 from the UK would have to pay more than $500. • This importer could arbitrage against the “financial” £ by exchanging $500 for gold, shipping it to the UK, and converting it into £100 at the fixed gold parity.

  15. Operation of the gold standard (2) • An appreciation of the £ leads to British gains in international reserves, and an equal loss in international reserves in the United States. • It entails a commensurate expansion of base money in Great Britain, and a contraction of base money in the United States. • This must raise the British price level, and provoke a deflation in the US. • It causes a depreciation of the £ against the $ until the former parity is reinstalled.

  16. “Price-species-flow” mechanism • Price adjustments under fixed exchange rates work through symmetries in the supply of base money between two countries. • One country loses international reserves, the other gains international reserves. • This mechanism will ultimately entail a countervailing adjustment of price levels for goods and services in each country. • This “price-species-flow” mechanism was first described by David Hume.

  17. Example: The United States during the 1870s • During the Civil War in the US, the gold standard had been abandoned and the government had issued significant amounts of paper money to finance the war. • In the end, this had lead to an almost doubling of the price level. • After the war, the US returned to the gold standard at the parity that had reigned before. • This (“shock”) contraction of the money supply caused the depression of 1873-79.

  18. Return to the gold standard after WW I • After World War I most countries tried to return to the gold standard. • International trade was mainly carried out in British pounds, French francs, US dollars, all (partially) covered by gold. • Payments were made in gold certificates (promissory notes denominated in gold), the volume of which increased by credit expansion. • The Great Depression caused insolvencies in gold, which brought the gold standard to an end.

  19. The Bretton-Woods System (1) • In 1944, the post-war international economic order was conceived in the little town of Bretton Woods (New Hampshire). • The three international institutions created are • the International Monetary Fund (IMF); • the Bank for Reconstruction and Development (Worldbank); • the General Agreement on Tariffs and Trade (GATT), now World Trade Organization (WTO).

  20. The Bretton-Woods System (2) • The international financial system (Bretton-Woods System) was based on gold and the US dollar. • The parity between the dollar and gold was fixed at $35 for an ounce of gold. • The exchange rates of other countries adhering to the system were pegged to the dollar. • Discretionary exchange-rate adjustments were possible in the case of “fundamental balance-of-payments disequilibria”.

  21. Forex interventions by central banks • If the domestic currency was undervalued, the central bank must sell domestic currency to keep the exchange rate fixed (within limits of ± 1 percent), but as a result it had to take international reserves (US dollars) on board. • If the domestic currency was overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result it lost international reserves.

  22. The role of the IMF • Surplus countries faced a strengthening of their currencies (revaluation). • Deficit countries experienced a weakening (devaluation). • The IMF took (and takes) the role of an international lender under certain conditions. • Loans are given to member countries with balance-of-payment difficulties. • The IMF has now close to 190 members.

  23. IMF as “lender of last resort” • A “lender-of-last-resort” operation by the IMF is a two-edged sword: • central bank lending during a financial crisis could stabilize the currency and strengthen domestic balance sheets; and it could • fend off speculation and prevent contagion. • But it could also • arouse fears of inflation spiraling out of control, and hence cause a further depreciation; and it could • increase moral hazard and adverse selection problems and make the crisis worse.

  24. The operation of the system • As for any fixed-exchange-rate regime, the “price-species-flow” mechanism was also working under the BW-system. • However, revaluations and devaluations were devices to “let out steam” and to ease economic pressures, and hence to avoid the full price adjustment. • This was in particular helpful for deficit countries, because internal prices are typically rigid downwards (in particular wages), and a painful deflation could thus be avoided.

  25. Problems of the BW system • The US-dollar became an international trading and reserve currency, for which the Fed held a monopoly. • As more and more dollars would be issued (US gold reserves remaining constant), trust in the world currency was expected to weaken (“Triffin Dilemma”). • However, initially there was a shortage of international reserves worldwide, although this changed later.

  26. Special Drawing Rights (SDR) • In order to overcome the apparent shortage of international reserves in the 1960s, the US and other key IMF members had allowed the IMF to issue a paper substitute for gold: “special drawing rights” (SDRs). • SDRs function as international reserves, but -- unlike gold -- they can (within limits) be issued by the IMF through credit creation. • SDRs are only being used for official payments among central banks.

  27. The end of Bretton Woods • The Bretton-Woods agreement lasted until 1971, when it broke down due to institutional and economic asymmetries. • When the US pursued an inflationary policy during the 1960s and early 1970s, the “low-inflation” Deutsche Mark became an increasingly attractive speculative asset. • Prices for gold in the free market provided opportunities for arbitrage gains; there were mounting incentives for currency speculation.

  28. The end of Bretton Woods • One option of surplus countries would have been to follow US inflationary policies (and take on board US dollars without limits!). • This opens up unlimited seignorage gains for the issuer of the reserve currency, the US. • The other option was to revalue. • For countries that use the dollar as a reserve instrument, their relative wealth position is tied to the exchange rate of international reserves. • A revaluation of the DM implies a devaluation of the acquired claims in US dollars.

  29. Forex market and monetary policy • Moreover, an appreciation of the currency entails an increase in export prices for foreigners, and a fall of import prices at home. • This could trigger higher unemployment. • “Because surplus countries were not willing to revise their exchange rates upward, adjustment .. did not take place and the BW System collapsed in 1971.” (F. Mishkin). • “The ability to conduct monetary policy is easier when a country’s currency is a reserve currency” (F. Mishkin).

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