Money and Banking Chapter 16 Notes
Money and Banking Chapter 16 Notes FINA 30203
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Date Created: 03/19/16
Money amp Banking Chapter 16 The International Financial System and Monetary Policy I FOREIGN EXCHANGE INTERVENTION AND THE MONETARY BASE a International financial transactions affect the money supply when central banks or governments try to in uence the foreign exchange values of their currencies i Foreign exchange market intervention deliberate action by a central bank to in uence the exchange rate 1 International reserves assets that are denominated in a foreign currency and used in international transactions a Altered by foreign exchange market interventions 2 Fed wants the foreign exchange value of the dollar to rise increase demand for dollars by selling foreign assets and buying dollars in international currency markets a Decreases Fed s international reserves asset b Decreases bank reserves at the Fed liability c A sale of foreign assets by a central bank has the same e ect on the monetary base as an open market sale of government bonds 1 Monetary base decreases 3 Fed wants the foreign exchange value of the dollar to fall increase supply of dollars by selling dollars and buying foreign assets a Increases Fed s international reserves asset b Increases bank reserves at the Fed liability c A purchase of foreign assets by a central bank has the same e ect on the monetary base as an open market purchase of government bonds i Monetary base increases ii Unsterilized foreign market intervention when a central bank allows the monetary base to respond to the salepurchase of domestic currency in the foreign exchange market iii Sterilized foreign market intervention when a foreign exchange intervention is offset by domestic open market operations that leave the monetary base unchanged II FOREIGN EXCHANGE INTERVENTIONS AND THE EXCHANGE RATE a Central banks occasionally intervene bc seek to minimize uctuations in exchange rates b Unsterilized Intervention i Exchange rate is determined by the demand and supply for dollars in the foreign exchange market ii Example Fed wants to increase exchange value of the dollar vs the Japanese yen l Fed sells shortterm Japanese govt securities decreases the monetary base in the US a Decrease in monetary base increase in US interest rates 2 As US interest rates rise relative to Japanese interest rates foreign investors demand more US dollars in order to buy US financial assets 3 US investors want to buy fewer Japanese financial assets supply of US dollars in exchange for Japanese yen falls c Sterilized Intervention i With sterilized central banks uses open market operations to offset effects of intervention on monetary base ii Since monetary base unaffected domestic interest rates will not change iii Demand and supply curves for dollars in exchange for yen also unaffected and exchange rate does not change d Capital Controls i Countries that experienced currency crises suffered sharp declines in the exchange value of their currencies leading to disruptions of their economies 1 Fueled by sharp capital in ows and capital out ows 2 Created restrictions on capital mobility in emerging market countries called capital controls ii Capital controls governmentimposed restrictions on foreign investors buying domestic assets or on domestic investors buying foreign assets 1 Limit domestic investors ability to diversify portfolios internationally 2 Lead investors to require higher expected return on domestic assets than on foreign iii Problems w capital controls 1 Domestic firms and investors must receive permission from the government to exchange domestic currency for foreign currency 2 Multinational firms may be reluctant to invest in countries that have capital controls bc firms will have difficultly returning any profits they earn to their home countries if they can t exchange domestic for foreign currency 3 Many countries find that their capital controls are evaded by individuals and firms who resort to a black market where currency traders are willing to illegally exchange domestic for foreign currency III THE BALANCE OF PAYMENTS a Balanceofpayments account measure of all ows of private and government funds bw a domestic economy and all foreign countries i Bookkeeping procedure 1 Receipts in ows of funds from foreigners to the US a Recorded as positive numbers b Include in ows of funds for purchases of USproduced goods and services US exports for acquisition of US assets capital in ows and as gifts to US citizens unilateral transfers 2 Payments out ows of funds from the US to foreigners a Recorded as negative numbers b Include purchases of foreign goods and services imports money spent on purchases of foreign assets by US households and businesses capital out ows and gifts to foreigners including foreign aid unilateral transfers ii Current account balance Financial account balance 0 b The Current Account i Summarizes transactions bw a country and its foreign trading partners for purchases and sales of currently produced goods and services GampS ii Current account surplus US citizens selling more GampS to foreigners than they are buying imports from foreigners 1 US citizens have funds to lend to foreigners iii Typically US current account has a negative balance though de cit iv Surplusdeficit must be balanced by international lendingborrowing or by changes in official reserve transactions c The Financial Account i Measures trade in existing financial or real assets among countries ii When someone in a country sells an asset to a foreign investor transaction is recorded in the balanceofpayments accounts as a capital in ow iii Financial account balance Capital in ows Capital out ows Net value of capital account transactions consist mainly of debt forgiveness and transfers of financial assets by migrants when they enter the US d Official Settlements i O icial reserve assets are assets that central banks hold and use in making international payments to settle the balanceofpayments and to conduct international monetary policy ii Official settlements net increase in a country s official reserve assets iii When country has a balanceofpayments surplus it gains international reserves bc its receipts exceed its payments e International trade and financial transactions affect both the current and the financial accounts in the balance of payments IV EXCHANGE RATE REGIMES AND THE INTERNATIONAL FINANCIAL SYSTEM a Exchange rate regime system for adjusting exchange rates and ows of goods and capital among countries b Fixed Exchange Rates and the Gold Standard i Fixed exchange rate systems system in which exchange rates are set at levels determined and maintained by governments ii Gold standard currencies of participating countries are convertible into an agreedupon amount of gold 1 Example Demand for French goods rises relative to demand for US goods a Leads to rising demand for francs falling demand for dollars b US importers make profit from shipping gold to France to buy francs 2 Pricespecie ow mechanism gold standard s automatic mechanism that would cause exchange rates to re ect the underlying gold content of countries currencies iii Problems w gold standard 1 Countries w trade deficits and gold out ows experienced declines in price levels de ation 2 Countries had little control over their domestic monetary policies iv In theory gold standard required that all countries maintain their promise to convert currencies freely into gold at fixed exchange rates c Adapting Fixed Exchange Rates The Bretton Woods System i ii iii iv V vi Bretton Woods system exchange rate system that lasted from 19451971 under which countries pledged to buy and sell their currencies at fixed rates against the dollar and the US pledged to convert dollars into gold if foreign central banks requested it to 1 US held much of the world s gold at that time 2 Exchange rates were supposed to adjust only when a country experienced fundamental disequilibrium International Monetary Fund IMF multinational organization established in 1944 by the Bretton Woods agreement to administer a system of fixed exchange rates and to serve as a lender of last resort to countries undergoing balanceof payments problems Fixed Exchange Rates Under Bretton Woods 1 If a foreign currency appreciated relative to the dollar the central bank of that country would sell its own currency for dollars a Drove the exchange rate back to the fixed rate 2 If a foreign currency depreciated relative to the dollar the central bank would sell dollar assets from its international reserves and buy its own currency a Pushed the exchange rate back toward the fixed rate 3 Reserve out ows caused by balanceofpayments deficits created problems for central banks that were bound by the Bretton Woods system Devaluations and Revaluations Under Bretton Woods 1 Devaluation lowering of the official value of a country s currency relative to other currencies 2 Revaluation raising of the official value of a country s currency relative to other currencies 3 Countries didn t often pursue either of these Speculative Attacks in the Bretton Woods System 1 Speculative attacks occurred when investors came to believe that a government was unwilling or unable to maintain its exchange rate attempted to profit by selling a weak currency or buying a strong one a Could force devaluation or revaluation of the currency b Can product international financial crises 2 Bank of England a Investors sold pounds to the Bank of England expecting the pound to fall in value against the dollar b When pound eventually fell speculators used dollars to buy back the cheaper pounds earning a profit The Speculative Attack on the Deutsche Mark and the Collapse of Bretton Woods 1 By 1971 large balanceofpayments surpluses outside US were causing fear in international financial markets bc many currencies undervalued relative to dollar 2 German mark began to oat against the dollar with its value being determined solely by the forces of demand and supply in the foreign exchange market 3 Dollar assets that foreign central banks owned totaled more than 3x the official US gold holdings at the rate of 35 per ounce of gold 4 System eventually collapsed bc the US was not committed to price stability and bc other countries were reluctant to revalue their currencies against the dollar a Led to strong market pressures on fixed exchange rates d Central Bank Interventions After Bretton Woods i Flexible exchange rate system system in which the foreign exchange value of a currency is determined in the foreign exchange market 1 Managed oat regime dirty oat regime central banks occasionally intervene to affect foreign exchange values ii Policv TradeOffs 1 To increase the exchange rate central bank must sell international reserves and buy the domestic currency a Reduces the domestic monetary base and money supply iii The Case of the US Dollar 1 What would happen if the dollar toppled 2 US households and firms might lose advantage of being able to trade and borrow around the world in US currency 3 Foreigners willingness to hold US dollar bills confers a windfall on US citizens bc foreigners are essentially providing an interestfree loan 4 New York s leading international role as a financial capital might be jeopardized if the dollar ceased to be the reserve currency e Fixed Exchange Rates in Europe i Exchange Rate Mechanism ERM 8 European countries that agreed to participate to limit uctuations in the value of their currencies against each other 1 United Kingdom eventually withdrew ii European Monetary Union plan drafted as part of the 1992 single European market initiative in which exchange rates were fixed and eventually a common currency was adopted 1 Euro the common currency of 17 European countries iii European Central Bank ECB the central bank of the European countries that have adopted the euro f Currency Pegging i Pegging the decision by a country to keep the exchange rate fixed bw its currency and another country s currency 1 Countries peg their currencies to gain the advantage of a fixed exchange rate g China and the Dollar Peg 1 ii iii Pegging against the dollar ensured that Chinese exporters would face stable dollar prices for the goods they sold in the US By early 2000s many economists argued that the yuan was undervalued against the dollar 1 Gave Chinese firms an unfair advantage in competing with US firms 2005 Chinese government announced it would switch from pegging the yuan against the dollar to linking the value of the yuan to the average value of a basket of currencies
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