economics_of_money_banking__financial_markets

Direct Effects of the Foreign

Exchange Market on the Money Supply

Our analysis in this chapter so far has suggested several ways in which monetary policy can be affected by international matters. Awareness of these effects can have significant implications for the way monetary policy is conducted.

When central banks intervene in the foreign exchange market, they acquire or sell off international reserves, and their monetary base is affected. When a central bank intervenes in the foreign exchange market, it gives up some control of its money supply. For example, in the early 1970s, the German central bank faced a dilemma. In attempting to keep the German mark from appreciating too much against the U.S. dollar, the Germans acquired huge quantities of international reserves, leading to a rate of money growth that the German central bank considered inflationary.

The Bundesbank could have tried to halt the growth of the money supply by stopping its intervention in the foreign exchange market and reasserting control over its own money supply. Such a strategy has a major drawback when the central bank is under pressure not to allow its currency to appreciate: The lower price of imports and higher price of exports as a result of an appreciation in its currency will hurt domestic producers and increase unemployment.

Because the U.S. dollar has been a reserve currency, the U.S. monetary base and money supply have been less affected by developments in the foreign exchange market. As long as foreign central banks, rather than the Fed, intervene to keep the value of the dollar from changing, American holdings of international reserves are unaffected. The ability to conduct monetary policy is typically easier when a countryÕs currency is a reserve currency.9

9However, the central bank of a reserve currency country must worry about a shift away from the use of its currency for international reserves.

Balance-of-

Payments

Considerations

Exchange Rate

Considerations

C H A P T E R 2 0 The International Financial System 483

Under the Bretton Woods system, balance-of-payments considerations were more important than they are under the current managed float regime. When a nonreserve currency country is running balance-of-payments deficits, it necessarily gives up international reserves. To keep from running out of these reserves, under the Bretton Woods system it had to implement contractionary monetary policy to strengthen its currencyÑexactly what occurred in the United Kingdom before its devaluation of the pound in 1967. When policy became expansionary, the balance of payments deteriorated, and the British were forced to Òslam on the brakesÓ by implementing a contractionary policy. Once the balance of payments improved, policy became more expansionary until the deteriorating balance of payments again forced the British to pursue a contractionary policy. Such on-again, off-again actions became known as a Òstop-goÓ policy, and the domestic instability it created was criticized severely.

Because the United States is a major reserve currency country, it can run large balance- of-payments deficits without losing huge amounts of international reserves. This does not mean, however, that the Federal Reserve is never influenced by developments in the U.S. balance of payments. Current account deficits in the United States suggest that American businesses may be losing some of their ability to compete because the value of the dollar is too high. In addition, large U.S. balance-of-payments deficits lead to balance-of-payments surpluses in other countries, which can in turn lead to large increases in their holdings of international reserves (this was especially true under the Bretton Woods system). Because such increases put a strain on the international financial system and may stimulate world inflation, the Fed worries about U.S. balance-of-payments and current account deficits. To help shrink these deficits, the Fed might pursue a more contractionary monetary policy.

Unlike balance-of-payments considerations, which have become less important under the current managed float system, exchange rate considerations now play a greater role in the conduct of monetary policy. If a central bank does not want to see its currency fall in value, it may pursue a more contractionary monetary policy of reducing the money supply to raise the domestic interest rate, thereby strengthening its currency. Similarly, if a country experiences an appreciation in its currency, domestic industry may suffer from increased foreign competition and may pressure the central bank to pursue a higher rate of money growth in order to lower the exchange rate.

The pressure to manipulate exchange rates seems to be greater for central banks in countries other than the United States, but even the Federal Reserve is not completely immune. The growing tide of protectionism stemming from the inability of American firms to compete with foreign firms because of the strengthening dollar from 1980 to early 1985 stimulated congressional critics of the Fed to call for a more expansionary monetary policy to lower the value of the dollar. As we saw in Chapter 18, the Fed then did let money growth surge to very high levels. A policy to bring the dollar down was confirmed in the Plaza Agreement of September 1985, in which the finance ministers from the five most important industrial nations in the free world (the United States, Japan, West Germany, the United Kingdom, and France) agreed to intervene in foreign exchange markets to achieve a decline in the dollar. The dollar continued to fall rapidly after the Plaza Agreement, and the Fed played an important role in this decline by continuing to expand the money supply at a rapid rate.

1.An unsterilized central bank intervention in which the 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. Available evidence suggests, however, that sterilized central bank interventions have little longterm effect on the exchange rate.

2.The balance of payments is a bookkeeping system for recording all payments between a country and foreign countries that have a direct bearing on the movement of funds between them. The official reserve transactions balance is the sum of the current account balance plus the items in the capital account. It indicates the amount of international reserves that must be moved between countries to finance international transactions.

3.Before World War I, the gold standard was predominant. Currencies were convertible into gold, thus fixing exchange rates between countries. After World War II, the Bretton Woods system and the IMF were established to promote a fixed exchange rate system in which the U.S. dollar was convertible into gold. The Bretton Woods system collapsed in 1971. We now have an international financial system that has elements of a managed float and a fixed exchange rate system. Some exchange rates fluctuate from day to day, although central banks intervene in the foreign exchange market, while other exchange rates are fixed.

4.Controls on capital outflows receive support because they may prevent domestic residents and foreigners from pulling capital out of a country during a crisis and make devaluation less likely. Controls on capital inflows make sense under the theory that if speculative capital

cannot flow in, then it cannot go out suddenly and create a crisis. However, capital controls suffer from several disadvantages: they are seldom effective, they lead to corruption, and they may allow governments to avoid taking the steps needed to reform their financial systems to deal with the crisis.

5.The IMF has recently taken on the role of an international lender of last resort. Because central banks in emerging market countries are unlikely to be able to perform a lender-of-last-resort operation successfully, an international lender of last resort like the IMF is needed to prevent financial instability. However, the IMFÕs role as an international lender of last resort creates a serious moral hazard problem that can encourage excessive risk taking and make a financial crisis more likely, but avoiding the problem may be politically hard to do. In addition, it needs to be able to provide liquidity quickly during a crisis in order to keep manageable the amount of funds lent.

6.Three international considerations affect the conduct of monetary policy: direct effects of the foreign exchange market on the money supply, balance-of-payments considerations, and exchange rate considerations. Inasmuch as the United States has been a reserve currency country in the postÐWorld War II period, U.S. monetary policy has been less affected by developments in the foreign exchange market and its balance of payments than is true for other countries. However, in recent years, exchange rate considerations have been playing a more prominent role in influencing U.S. monetary policy.

Key Terms

managed float regime (dirty float), p. 462

official reserve transactions balance, p. 468

reserve currency, p. 470

revaluation, p. 472

Web Exercises

1.The Federal Reserve publishes information online that explains the workings of the foreign exchange market. One such publication can be found at www.ny.frb

.org/pihome/addpub/usfxm/. Review the table of contents and open Chapter 10, the evolution of the international monetary system. Read this chapter and write a one-page summary that discusses why each monetary standard was dropped in favor of the succeeding one.

2.The International Monetary Fund stands ready to help nations facing monetary crises. Go to www.imf.org. Click on the tab labeled ÒAbout IMF.Ó What is the stated purpose of the IMF? How many nations participate and when was it established?

PREVIEW

www.federalreserve.gov /centralbanks.htm

Features links to home pages for central banks around the world.

Getting monetary policy right is crucial to the health of the economy. Overly expansionary monetary policy leads to high inflation, which decreases the efficiency of the economy and hampers economic growth. The United States has not been exempt from inflationary episodes, but more extreme cases of inflation, in which the inflation rate climbs to over 100% per year, have been prevalent in some regions of the world such as Latin America, and have been very harmful to the economy. Monetary policy that is too tight can produce serious recessions in which output falls and unemployment rises. It can also lead to deflation, a fall in the price level, as occurred in the United States during the Great Depression and in Japan more recently. As we have seen in Chapter 8, deflation can be especially damaging to the economy, because it promotes financial instability and can even help trigger financial crises.

In Chapter 18 our discussion of the conduct of monetary policy focused primarily on the United States. However, the United States is not the source of all wisdom about how to do monetary policy well. In thinking about what strategies for the conduct of monetary policy might be best, we need to examine monetary policy experiences in other countries.

A central feature of monetary policy strategies in all countries is the use of a nominal anchor (a nominal variable that monetary policymakers use to tie down the price level such as the inflation rate, an exchange rate, or the money supply) as an intermediate target to achieve an ultimate goal such as price stability. We begin the chapter by examining the role a nominal anchor plays in promoting price stability. Then we examine three basic types of monetary policy strategyÑexchange-rate targeting, monetary targeting, and inflation targetingÑand compare them to the Federal ReserveÕs current monetary policy strategy, which features an implicit (not an explicit) nominal anchor. We will see that despite the recent excellent performance of monetary policy in the United States, there is much to learn from the foreign experience.

The Time-

Consistency

Problem

money. Thus, a nominal anchor of some sort is a necessary element in successful monetary policy strategies.

One reason a nominal anchor is necessary for monetary policy is that it can help promote price stability, which most countries now view as the most important goal for monetary policy. A nominal anchor promotes price stability by tying inflation expectations to low levels directly through its constraint on the value of domestic money. A more subtle reason for a nominal anchorÕs importance is that it can limit the time-consistency problem, in which monetary policy conducted on a discretionary, day-by-day basis leads to poor long-run outcomes.1

The time-consistency problem of discretionary policy arises because economic behavior is influenced by what firms and people expect the monetary authorities to do in the future. With firmsÕ and peopleÕs expectations assumed to remain unchanged, policymakers think they can boost economic output (or lower unemployment) by pursuing discretionary monetary policy that is more expansionary than expected, and so they have incentives to pursue this policy. This situation is described by saying that discretionary monetary policy is time-consistent; that is, the policy is what policymakers are likely to want to pursue at any given point in time. The problem with timeconsistent, discretionary policy is that it leads to bad outcomes. Because decisions about wages and prices reflect expectations about policy, workers and firms will raise their expectations not only of inflation but also of wages and prices. On average, output will not be higher under such an expansionary strategy, but inflation will be. (We examine this more formally in Chapter 28.)

Clearly, a central bank will do better if it does not try to boost output by surprising people with an unexpectedly expansionary policy, but instead keeps inflation under control. However, even if a central bank recognizes that discretionary policy will lead to a poor outcomeÑhigh inflation with no gains on the output frontÑit may still fall into the time-consistency trap, because politicians are likely to apply pressure on the central bank to try to boost output with overly expansionary monetary policy.

Although the analysis sounds somewhat complicated, the time-consistency problem is actually something we encounter in everyday life. For example, at any given point in time, it seems to make sense for a parent to give in to a child to keep the child from acting up. The more the parent gives in, however, the more the demanding the child is likely to become. Thus, the discretionary time-consistent actions by the parent lead to a bad outcomeÑa very spoiled childÑbecause the childÕs expectations are affected by what the parent does. How-to books on parenting suggest a solution to the time-consistency problem (although they donÕt call it that) by telling parents that they should set rules for their children and stick to them.

A nominal anchor is like a behavior rule. Just as rules help to prevent the timeconsistency problem in parenting, a nominal anchor can help to prevent the time-

1The time-consistency problem is also called the time-inconsistency problem because monetary policy that leads to a good outcome by controlling inflation is not sustainable (and is thus time-inconsistent). When the central bank pursues such a policy, it has incentives to deviate from it to try to boost output by engaging in discretionary, time-consistent policy. The time-consistency problem was first outlined in Finn Kydland and Edward Prescott, ÒRules Rather Than Discretion: The Inconsistency of Optimal Plans,Ó Journal of Political Economy 85 (1977): 473Ð491; Guillermo Calvo, ÒOn the Time Consistency of Optimal Policy in the Monetary Economy,Ó Econometrica 46 (November 1978): 1411Ð1428; and Robert J. Barro and David Gordon, ÒA Positive Theory of Monetary Policy in a Natural Rate Model,Ó Journal of Political Economy 91 (August 1983).

Advantages of

Exchange-Rate

Targeting

Targeting the exchange rate is a monetary policy strategy with a long history. It can take the form of fixing the value of the domestic currency to a commodity such as gold, the key feature of the gold standard described in Chapter 20. More recently, fixed exchange-rate regimes have involved fixing the value of the domestic currency to that of a large, low-inflation country like the United States or Germany (called the anchor country). Another alternative is to adopt a crawling target or peg, in which a currency is allowed to depreciate at a steady rate so that the inflation rate in the pegging country can be higher than that of the anchor country.

Exchange-rate targeting has several advantages. First, the nominal anchor of an exchange-rate target directly contributes to keeping inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country. It does this because the foreign price of internationally traded goods is set by the world market, while the domestic price of these goods is fixed by the exchange-rate target. For example, until 2002 in Argentina the exchange rate for the Argentine peso was exactly one to the dollar, so that a bushel of wheat traded internationally at five dollars had its price set at five pesos. If the exchange-rate target is credible (i.e., expected to be adhered to), the exchange-rate target has the added benefit of anchoring inflation expectations to the inflation rate in the anchor country.

Second, an exchange-rate target provides an automatic rule for the conduct of monetary policy that helps mitigate the time-consistency problem. As we saw in Chapter 20, an exchange-rate target forces a tightening of monetary policy when there is a tendency for the domestic currency to depreciate or a loosening of policy when there is a tendency for the domestic currency to appreciate, so that discretionary, time-consistent monetary policy is less of an option.

Third, an exchange-rate target has the advantage of simplicity and clarity, which makes it easily understood by the public. A Òsound currencyÓ is an easy-to- understand rallying cry for monetary policy. In the past, this aspect was important in France, where an appeal to the Òfranc fortÓ (strong franc) was often used to justify tight monetary policy.

Given its advantages, it is not surprising that exchange-rate targeting has been used successfully to control inflation in industrialized countries. Both France and the United Kingdom, for example, successfully used exchange-rate targeting to lower inflation by tying the value of their currencies to the German mark. In 1987, when France first pegged its exchange rate to the mark, its inflation rate was 3%, two percentage points above the German inflation rate. By 1992, its inflation rate had fallen to 2%, a level that can be argued is consistent with price stability, and was even below that in Germany. By 1996, the French and German inflation rates had converged, to a number slightly below 2%. Similarly, after pegging to the German mark in 1990, the United Kingdom was able to lower its inflation rate from 10% to 3% by 1992, when it was forced to abandon the exchange rate mechanism (ERM, discussed in Chapter 20).

Disadvantages of

Exchange-Rate

Targeting

Exchange-rate targeting has also been an effective means of reducing inflation quickly in emerging market countries. For example, before the devaluation in Mexico in 1994, its exchange-rate target enabled it to bring inflation down from levels above 100% in 1988 to below 10% in 1994.

Despite the inherent advantages of exchange-rate targeting, there are several serious criticisms of this strategy. The problem (as we saw in Chapter 20) is that with capital mobility the targeting country no longer can pursue its own independent monetary policy and so loses its ability to use monetary policy to respond to domestic shocks that are independent of those hitting the anchor country. Furthermore, an exchangerate target means that shocks to the anchor country are directly transmitted to the targeting country, because changes in interest rates in the anchor country lead to a corresponding change in interest rates in the targeting country.

A striking example of these problems occurred when Germany reunified in 1990. In response to concerns about inflationary pressures arising from reunification and the massive fiscal expansion required to rebuild East Germany, long-term German interest rates rose until February 1991 and short-term rates rose until December 1991. This shock to the anchor country in the exchange rate mechanism (ERM) was transmitted directly to the other countries in the ERM whose currencies were pegged to the mark, and their interest rates rose in tandem with those in Germany. Continuing adherence to the exchange-rate target slowed economic growth and increased unemployment in countries such as France that remained in the ERM and adhered to the exchange-rate peg.

A second problem with exchange-rate targets is that they leave countries open to speculative attacks on their currencies. Indeed, one aftermath of German reunification was the foreign exchange crisis of September 1992. As we saw in Chapter 20, the tight monetary policy in Germany following reunification meant that the countries in the ERM were subjected to a negative demand shock that led to a decline in economic growth and a rise in unemployment. It was certainly feasible for the governments of these countries to keep their exchange rates fixed relative to the mark in these circumstances, but speculators began to question whether these countriesÕ commitment to the exchange-rate peg would weaken. Speculators reasoned that these countries would not tolerate the rise in unemployment resulting from keeping interest rates high enough to fend off attacks on their currencies.

At this stage, speculators were, in effect, presented with a one-way bet, because the currencies of countries like France, Spain, Sweden, Italy, and the United Kingdom could go only in one direction and depreciate against the mark. Selling these currencies before the likely depreciation occurred gave speculators an attractive profit opportunity with potentially high expected returns. The result was the speculative attack in September 1992 discussed in Chapter 20. Only in France was the commitment to the fixed exchange rate strong enough so that France did not devalue. The governments in the other countries were unwilling to defend their currencies at all costs and eventually allowed their currencies to fall in value.

The different response of France and the United Kingdom after the September 1992 exchange-rate crisis illustrates the potential cost of an exchange-rate target. France, which continued to peg to the mark and was thus unable to use monetary policy to respond to domestic conditions, found that economic growth remained slow after 1992 and unemployment increased. The United Kingdom, on the other hand,