economics_of_money_banking__financial_markets

PREVIEW

Thanks to the growing interdependence between the U.S. economy and the economies of the rest of the world, a countryÕs monetary policy can no longer be conducted without taking international considerations into account. In this chapter, we examine how international financial transactions and the structure of the international financial system affect monetary policy. We also examine the evolution of the international financial system during the past half century and consider where it may be heading in the future.

Foreign Exchange

Intervention and

the Money Supply

In Chapter 19, we analyzed the foreign exchange market as if it were a completely free market that responds to all market pressures. Like many other markets, however, the foreign exchange market is not free of government intervention; central banks regularly engage in international financial transactions called foreign exchange interventions in order to influence exchange rates. In our current international financial arrangement, called a managed float regime (or a dirty float), exchange rates fluctuate from day to day, but central banks attempt to influence their countriesÕ exchange rates by buying and selling currencies. The exchange rate analysis we developed in Chapter 19 is used here to explain the impact that central bank intervention has on the foreign exchange market.

The first step in understanding how central bank intervention in the foreign exchange market affects exchange rates is to see the impact on the monetary base from a central bank sale in the foreign exchange market of some of its holdings of assets denominated in a foreign currency (called international reserves). Suppose that the Fed decides to sell $1 billion of its foreign assets in exchange for $1 billion of U.S. currency. (This transaction is conducted at the foreign exchange desk at the Federal Reserve Bank of New YorkÑsee Box 1.) The FedÕs purchase of dollars has two effects. First, it reduces the FedÕs holding of international reserves by $1 billion. Second, because its purchase of currency removes it from the hands of the public, currency in

Unsterilized

Intervention

A foreign exchange intervention with an offsetting open market operation that leaves the monetary base unchanged is called a sterilized foreign exchange intervention.

Now that we understand that there are two types of foreign exchange interventionsÑ unsterilized and sterilizedÑletÕs look at how each affects the exchange rate.

Your intuition might lead you to suspect that if a central bank wants to lower the value of the domestic currency, it should sell its currency in the foreign exchange market and purchase foreign assets. Indeed, this intuition is correct for the case of an unsterilized intervention.

Recall that in an unsterilized intervention, if the Federal Reserve decides to sell dollars in order to buy foreign assets in the foreign exchange market, this works just like an open market purchase of bonds to increase the monetary base. Hence the sale of dollars leads to an increase in the money supply, and we find ourselves analyzing exactly the situation already described in Figure 7 of Chapter 19, which is reproduced here as Figure 1. The higher money supply leads to a higher U.S. price level in the long run and so to a lower expected future exchange rate. The resulting decline in the expected appreciation of the dollar increases the expected return on foreign deposits and shifts the RF schedule to the right. In addition, the increase in the money supply will lead to a higher real money supply in the short run, which causes the interest rate on dollar deposits to fall. The resulting lower expected return on dollar deposits translates as a leftward shift in the RD schedule. The fall in the expected return on dollar deposits and the increase in the expected return on foreign deposits means that foreign assets have a higher expected return than dollar deposits at the old equilibrium exchange rate. Hence people will try to sell their dollar deposits, and the exchange rate will fall. Indeed, as we saw in the previous chapter, the increase in the money supply will lead to exchange rate overshooting, whereby the exchange rate falls by more in the short run than it does in the long run.

Our analysis leads us to the following conclusion about unsterilized interventions in the foreign exchange market: 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.

The reverse result is found for an unsterilized intervention in which domestic currency is purchased by selling foreign assets. The purchase of domestic currency by selling foreign assets (reducing international reserves) works like an open market sale to reduce the monetary base and the money supply. The decrease in the money supply raises the interest rate on dollar deposits and shifts RD rightward, while causing

F I G U R E 1 Effect of a Sale of

Dollars and a Purchase of Foreign

Assets

A sale of dollars and the consequent open market purchase of foreign assets increase the monetary base. The resulting rise in the money supply leads to a higher domestic price level in the long run, which leads to a lower expected future exchange rate. The resulting decline in the expected appreciation of the dollar raises the expected return on foreign deposits, shifting the RF schedule rightward from R1F to RF2. In the short run, the domestic interest rate i D falls, shifting RD from RD1 to RD2. The short-run outcome is that the exchange rate falls from E1 to E2. In the long run, however, the interest rate returns to i D1, and RD returns to RD1. The exchange rate therefore rises from E2 to E3 in the long run.

Sterilized

Intervention

RF to shift leftward, because it leads to a lower U.S. price level in the long run and thus to a higher expected appreciation of the dollar, and hence a lower expected return on foreign deposits. The increase in the expected return on dollar deposits relative to foreign deposits will mean that people will want to buy more dollar deposits, and the exchange rate will rise. 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.

The key point to remember about a sterilized intervention is that the central bank engages in offsetting open market operations, so that there is no impact on the monetary base and the money supply. In the context of the model of exchange rate determination we have developed here, it is straightforward to show that a sterilized intervention has no effect on the exchange rate. Remember that in our model, foreign and domestic deposits are perfect substitutes, so equilibrium in the foreign exchange market occurs when the expected returns on foreign and domestic deposits are equal. A sterilized intervention leaves the money supply unchanged and so has no way of directly affecting interest rates or the expected future exchange rate.1 Because the

1Note that a sterilized intervention could indicate what central banks want to happen to the future exchange rate and so might provide a signal about the course of future monetary policy. In this way, a sterilized intervention could lead to shifts in the RF schedule, but in reality it is the future change in monetary policy, not the sterilized intervention, that is the ultimate source of exchange rate effects. For a discussion of the signaling effect, see Maurice Obstfeld, ÒThe Effectiveness of Foreign Exchange Intervention: Recent Experience, 1985Ð1988,Ó in

International Policy Coordination and Exchange Rate Fluctuations, ed. William H. Branson, Jacob A. Frenkel, and Morris Goldstein (Chicago: University of Chicago Press, 1990), pp. 197Ð237.

http://research.stlouisfed.org /fred/data/exchange.html

This web site contains exchange rates, balance of payments, and trade data.

Because international financial transactions such as foreign exchange interventions have considerable effects on monetary policy, it is worth knowing how these transactions are measured. The balance of payments is a bookkeeping system for recording all receipts and payments that have a direct bearing on the movement of funds between a nation (private sector and government) and foreign countries.

Here we examine the key items in the balance of payments that you often hear about in the media.

The current account shows international transactions that involve currently produced goods and services. The difference between merchandise exports and imports, the net receipts from trade, is called the trade balance. When merchandise imports are greater than exports (by $427 billion), we have a trade deficit; if exports are greater than imports, we have a trade surplus.

Three additional items included in the current account are the net receipts that arise from investment income, the purchase and sale of services, and unilateral transfers (gifts, pensions, and foreign aid). In 2001, for example, net investment income was negative $19 billion for the United States because Americans received less investment income from abroad than they paid out. Americans bought less in services from foreigners than foreigners bought from Americans, so net services generated $79 billion in receipts. Since Americans made more unilateral transfers to foreign countries (especially foreign aid) than foreigners made to the United States, net unilateral transfers were negative $50 billion. The sum of the previous three items plus the trade balance is the current account balance, which in 2001 showed a deficit of $417 billion ( $427 $19 $79 $50 $417 billion).

Another important item in the balance of payments is the capital account, the net receipts from capital transactions. In 2001 the capital account was $416 billion,

Gold Standard

Bretton Woods

System

C H A P T E R 2 0 The International Financial System 469

Before World War I, the world economy operated under the gold standard, meaning that the currency of most countries was convertible directly into gold. American dollar bills, for example, could be turned in to the U.S. Treasury and exchanged for approximately 201 ounce of gold. Likewise, the British Treasury would exchange 14 ounce of gold for £1 sterling. Because an American could convert $20 into 1 ounce of gold, which could be used to buy £4, the exchange rate between the pound and the dollar was effectively fixed at $5 to the pound. Tying currencies to gold resulted in an international financial system with fixed exchange rates between currencies. The fixed exchange rates under the gold standard had the important advantage of encouraging world trade by eliminating the uncertainty that occurs when exchange rates fluctuate.

To see how the gold standard operated in practice, let us see what occurs if, under the gold standard, the British pound begins to appreciate above the $5 par value. If an American importer of £100 of English tweed tries to pay for the tweed with dollars, it costs more than the $500 it cost before. Nevertheless, the importer has another option involving the purchase of gold that can reduce the cost of the tweed. Instead of using dollars to pay for the tweed, the American importer can exchange the $500 for gold, ship the gold to Britain, and convert it into £100. The shipment of gold to Britain is cheaper as long as the British pound is above the $5 par value (plus a small amount to pay for the cost of shipping the gold).

Under the gold standard, the appreciation of the pound leads to a British gain of international reserves (gold) and an equal U.S. loss. Because a change in a countryÕs holdings of international reserves (gold) leads to an equal change in its monetary base, the movement of gold from the United States to Britain causes the British monetary base to rise and the American monetary base to fall. The resulting rise in the British money supply raises the British price level, while the fall in the U.S. money supply lowers the U.S. price level. The resulting increase in the British price level relative to the United States then causes the pound to depreciate. This process will continue until the value of the pound falls back down to its $5 par value.

A depreciation of the pound below the $5 par value, on the contrary, stimulates gold shipments from Britain to the United States. These shipments raise the American money supply and lower the British money supply, causing the pound to appreciate back toward the $5 par value. We thus see that under the gold standard, a rise or fall in the exchange rate sets in motion forces that return it to the par value.

As long as countries abided by the rules under the gold standard and kept their currencies backed by and convertible into gold, exchange rates remained fixed. However, adherence to the gold standard meant that a country had no control over its monetary policy, because its money supply was determined by gold flows between countries. Furthermore, monetary policy throughout the world was greatly influenced by the production of gold and gold discoveries. When gold production was low in the 1870s and 1880s, the money supply throughout the world grew slowly and did not keep pace with the growth of the world economy. The result was deflation (falling price levels). Gold discoveries in Alaska and South Africa in the 1890s then greatly expanded gold production, causing money supplies to increase rapidly and price levels to rise (inflation) until World War I.

World War I caused massive trade disruptions. Countries could no longer convert their currencies into gold, and the gold standard collapsed. Despite attempts to revive it in the interwar period, the worldwide depression, beginning in 1929, led to its permanent

Exchange rate, Et (foreign currency/ domestic currency)

Epar

E1

Expected Return ( in domestic currency terms )

Expected Return ( in domestic currency terms )

(a)Intervention in the case of an overvalued exchange rate

( b ) Intervention in the case of an undervalued exchange rate