Transcript Lecture 12 - uni

Lecture 11
THE INTERNATIONAL
FINANCIAL SYSTEM (1)
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Balance sheet of a central bank
Assets
Gold
International reserves
Liabilities
Base money
Securities
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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”.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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“Sterilized” forex intervention
Central Bank
Assets
Foreign assets
(International reserves)
-€1 billion
Liabilities
Monetary base
(reserves)
unchanged
Government bonds
+€1 billion
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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 RETFschedule to the right.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Effect of a purchase of $ against €
Exchange rate
($/€)
RETD1
RETF1
RETF2
E1
E2
1
2
iD 1
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
Expected return
in €
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Effect of a purchase of $ against €
Exchange rate
RETD2 RETD1
($/€)
RETF1
RETF2
1
E1
E2
E3
2
In the long run
the RETD-curve
moves back to the
original position.
iD 1
Expected return
in €
3
iD
2
In the short run
the RETD-curve
moves to the left
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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Sterilized intervention
• Sterilized intervention has no impact
on 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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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:
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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“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.
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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).
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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The Bretton-Woods System (2)
• The international financial system (BrettonWoods 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 balanceof-payments disequilibria”.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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.
Paul Bernd Spahn, Goethe-Universität Frankfurt/Main
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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 “lowinflation” 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.
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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.
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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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