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Understanding International Financial Systems

Learn about exchange market interventions, gold standard, fixed exchange rate systems, and the role of IMF in the international financial architecture. Discover the impact of monetary policy on FX markets.

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Understanding International Financial Systems

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  1. Chapter Thirteen The International Financial System

  2. Exchange Market Intervention • Unsterilized: • Results: • International reserves, +1 billion • Monetary base, +1 billion • Then analysis in figure 13-1, Et 

  3. Exchange Market Intervention • Sterilized: • Results: • International reserves, +1 billion • Monetary base unchanged • Et unchanged: no shift in RD and RF

  4. 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 13-1:Effect of a Sale of Dollars and a Purchase of Foreign Assets

  5. The Balance of Payments Exchange rates, balance of payment, and trade data http://www.stls.frb.org/fred/data/exchange.html

  6. 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: • Pay $525 • Buy $500 gold (500/20 = 25 ounces), ship to U.K., convert into £100 (= 25 £4) and buy tweed

  7. The Gold Standard • If shipping is cheap, do alternative 2 • Gold flows to U.K. • MB  in U.K, MB  in U.S. • Price level  U.K.,  U.S. • £ depreciates back to par • Two problems • Country on gold standard loses control of Ms • World inflation determined by gold production

  8. Fixed Exchange Rate Systems • Bretton Woods • Fixed exchange rates • Other central banks keep exchange rates fixed to $: $ is reserve currency • $ 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

  9. 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

  10. Intervention in a Fixed Exchange Rate System Figure 13-2:Intervention in the Foreign Exchange Market under a Fixed Exchange Rate Regime

  11. Analysis of Figure 13-2: Intervention in a Fixed Exchange Rate System • Since Eet+1 = Epar with fixed exchange rate, RFdoesn'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

  12. Analysis of Figure 13-2: 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

  13. 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 13-3:Foreign Exchange Market for British Pounds in 1992

  14. 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

  15. 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

  16. 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

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