Transcript The International System

The International System
Monetary Policy
Exchange Rates
• An exchange rate is the price of one
currency in terms of another.
• Exchange rates are important because
exports, imports and all international
financial transactions are affected by the
prices at which currencies exchange for one
another.
Exchange Rate Systems
• Flexible Exchange Rates
– A flexible exchange rate system is one in which
exchange rates are determined by conditions of
supply and demand in the foreign exchange
market.
– Flexible exchange rate systems are also known
as floating exchange rate systems
Exchange Rate Systems
• Fixed Exchange Rates
– A fixed exchange rate system is one in which
exchange rates are set at officially determined
levels and are changed only by direct
governmental action.
Foreign Exchange Market and the
Government
• The foreign exchange market is not free of
government intervention.
– Central banks engage in international financial
transactions called foreign exchange
interventions in order to influence exchange
rates.
• The first step in understanding how this works is to
see how exchange market intervention affects the
monetary base.
Intervention in the Foreign
Exchange Market
• If a central bank does not want the currency to
fall, it must follow a contractionary monetary
policy.
– A decrease in the money supply given demand
supports the currency’s value.
Intervention in the Foreign
Exchange Market
• If a central bank does not want the currency to
rise, it must follow an expansionary monetary
policy.
– An increase in the money supply given demand
tends to decrease the currency’s value.
Intervention in the Foreign
Exchange Market
• Conclusion:
– If a central bank intervenes in the foreign
exchange market, it gives up some control over
its money supply.
• The sale of foreign assets results in a decrease in
the currency worldwide.
• The purchase of foreign assets results in an
increase in the currency worldwide.
Exchange Market Intervention
• Unsterilized:
– The Fed sells $1 billion of foreign assets in
exchange for $1 billion dollars (cash
transaction).
Assets
Federal Reserve
Liabilities
Foreign Assets -$1b
Currency -$1b
Exchange Market Intervention
• Results:
– A central bank’s purchase of domestic
currency and corresponding sale of foreign
assets leads to an equal decline in its
international reserves and the monetary base.
Exchange Market Intervention
• Unsterilized:
– The Fed sells $1 billion of foreign assets in
exchange for $1 billion dollars (check
transaction).
Assets
Federal Reserve
Liabilities
Foreign Assets -$1b
Reserves -$1b
Exchange Market Intervention
• Results:
– A central bank’s purchase of domestic
currency and corresponding sale of foreign
assets leads to an equal decline in its
international reserves and the monetary base.
• International reserves decrease.
• Bank reserves fall when Fed deducts $1 billion
from the bank’s accounts with the Fed.
Exchange Market Intervention
• Unsterilized:
– The Fed buys $1 billion of foreign assets in
exchange for $1 billion dollars.
Assets
Federal Reserve
Liabilities
Foreign Assets +$1b
Currency +$1b
Foreign Assets +$1b
Reserves +$1b
Exchange Market Intervention
• Results:
– A central bank’s sale of domestic currency and
corresponding purchase of foreign assets
leads to an equal increase in its international
reserves and the monetary base.
• International reserves increase.
• Bank reserves rise when Fed increases currency in
circulation or adds $1 billion to the bank’s accounts
with the Fed.
Exchange Market Intervention and
the Exchange Rate
• 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.
Exchange Market Intervention and
the Exchange Rate
• An unsterilized intervention in which
domestic currency is bought by selling
foreign assets leads to a drop in international
reserves, a decrease in the money supply,
and an appreciation of the domestic
currency.
Sterilized Intervention
• If the central bank does not want the
domestic money supply to change, it can
sterilize the transaction by buying or selling
government bonds.
– The Fed would buy bonds to increase base to
its former level.
– The Fed would sell bonds to decrease base to
its former level.
Exchange Market Intervention
• Sterilized:
– The Fed buys $1 billion of foreign assets in
exchange for $1 billion dollars and sells bonds.
Assets
Foreign Assets
Federal Reserve
Liabilities
+$1b Currency or Reserves +$1b
Government Bonds -$1b Currency or Reserves -$1b
Exchange Market Intervention
• Sterilized:
– The Fed sells $1 billion of foreign assets in
exchange for $1 billion dollars and buys bonds.
Assets
Foreign Assets
Federal Reserve
Liabilities
-$1b Currency or Reserves -$1b
Government Bonds +$1b Currency or Reserves +$1b
Sterilized Exchange Market
Intervention
• Conclusions:
– A central bank’s sale or purchase of foreign assets
and corresponding purchase or sale of domestic
currency leads to an equal decrease or increase in
its international reserves and the monetary base.
– But, if the central bank buys or sells and equal
amount of government bonds at the same time,
the monetary base does not change.
Money Supply and the Exchange
Rate
Et
RETD2 RETD1
RETF1
RETF2
A sale of dollars and purchase of foreign
assets cause RETD to shift left from RETD1
to RETD2
The increase in the money supply also causes
RETF to shift right from RETF1 to RETF2.
1
E1
E3
E2
3
2
0
Unsterilized
Therefore, in the short run the exchange rate
falls from E1 to E2.
In the long run, as the domestic rate of
interest rises, RETD shifts right and the
RET$ exchange rate rises to E3
The Money Supply and the
Exchange Rate
• The story:
– A sale of dollars and consequent open market
purchase of foreign assets increase base,
causing the money supply to rise.
– The increase in the money supply results in a
higher domestic price level in the long run,
which leads to a lower expected future
exchange rate.
The Money Supply and the
Exchange Rate
• The story:
– The resulting decline in the expected
appreciation of the dollar raises the expected
return on foreign deposits.
– In the short run, domestic interest rates fall
because of the increase in the money supply.
– The combination of higher expected returns
on foreign deposits and lower domestic
interest rates, causes the exchange rate to fall.
The Money Supply and the
Exchange Rate
• The story:
– In the long run, however, as the domestic
economy expands, domestic interest rates rise,
and the exchange rate rises.
Money Supply and the Exchange
Rate
Et
RETD1 RETD2
RETF2
RETF1
E2
E3
E1
2
A purchase of dollars and sale of foreign
assets cause RETD to shift right from RETD1
to RETD2 in the short run.
The decrease in the money supply also causes
RETF to shift left from RETF1 to RETF2.
3
1
Therefore, in the short run, the exchange
rate rises from E1 to E2.
In the long run, as the domestic rate of interest
falls, RETD shifts left and the exchange rate
RET$ falls to E3
0
Unsterilized
Sterilized Intervention
• In this model, where the domestic and
foreign deposits are perfect substitutes, and
the foreign asset transaction is sterilized, the
exchange rate does not change.
• Why?
Sterilized Intervention
– If the money supply does not change,
domestic interest rates do not change.
– If the money supply does not change,
expectations about inflation and future
exchange rates do not change.
– If the future expected value of the dollar
does not change, the expected return on
foreign deposits also does not change.
Sterilized Intervention
• Theoretically, if the deposits are not perfect
substitutes, the exchange rate can change
even if the foreign asset transaction is
sterilized.
• But empirical studies do not find evidence
of this happening to any great extent.
Fixed Exchange Rates
• In a system of fixed exchange rates, each
country’s central bank intervenes in the
foreign exchange market to prevent that
country’s exchange rate from going outside
a narrow band on either side of its par
value.
– The bank must be prepared to offset imbalances
in demand and supply by government sales or
purchases of foreign exchange.
Fixed Exchange Rates: Example
• Let the exchange value of the Hong Kong
dollar be set such that it is overvalued
relative to its current market value.
– Hong Kong must drive up the value of the HK$
by buying HK$s in the world market.
• Hong Kong loses international reserves.
Fixed Exchange Rates: Example
• Let the exchange value of the Hong Kong
dollar be set such that it is undervalued
relative to its current market value.
– Hong Kong must drive down the value of the
HK$ by selling HK$s in the world market.
• Hong Kong gains international reserves.
Fixed Exchange Rate: Example
$/HK$
$/HK$
S
Market
S
Loss of Reserves
Peg
Peg
Gain of Reserves
Market
D
D
0
Q
Overvalued
0
Q
Undervalued
Fixed Exchange Rates: Overvalued
Currency
Et
RETD1 RETD2
RETF1
At the exchange rate Epar, the currency is
overvalued.
Epar
E2
0
2
1
To keep the currency at Epar, the central bank
must purchase domestic currency, shifting
RETD1 to RETD2.
RET$
Fixed Exchange Rates: Undervalued
Currency
Et
RETD2 RETD1
RETF1
At the exchange rate Epar, the currency is
undervalued.
E2
Epar
0
1
2
To keep the currency at Epar, the central bank
must sell domestic currency to shift RETD1
to RETD2.
RET$
Consequences of Exchange Rate
Intervention
• When a country attempts to maintain an
overvalued exchange rate, it loses
international reserves.
– If the country runs out of international
reserves, it can no longer support its currency
and must devalue.
Consequences of Exchange Rate
Intervention
• When a country attempts to maintain an
undervalued exchange rate, it gains
international reserves.
– If the country does not want to accumulate
international reserves, it may decide to revalue
its currency.
Consequences of Exchange Rate
Intervention
• If domestic and foreign currencies are
perfect substitutes, a sterilized exchange
rate intervention would not be able to
maintain the exchange rate at Epar.
– RETD will not shift.
• No change in domestic interest rates.
– RETF will not shift
• No change in expectations about the future value of
the current.
Consequences of Exchange Rate
Intervention
• When smaller countries tie their exchange
rate to that of a larger country, they lose
control of their monetary policy.
– If the larger country pursues a more
contractionary monetary policy, inflation
expectations in the larger country will fall,
causing the larger country’s currency to
appreciate and the smaller country’s currency
to become overvalued.
Consequences of Exchange Rate
Intervention
– The smaller country will now have to buy its
own currency and sell the currency of the
larger country.
– As a result, the smaller country’s international
reserves, base, and money supply will contract.
Foreign Exchange Crisis: Mexico
Et
Epar
RETD1 RETF1
RETF2
1
2
RETD = the expected return on the peso.
RETF = the expected return on the dollar.
After the assassination of the ruling party’s
presidential candidate, investors became
concerned that the government would devalue
the peso, the expected return on the dollar rose
to RETF2 ,and the value of the peso fell.
1’
To maintain Epar, the Mexican government
bought pesos and shifted RETD to the right.
0
RET Peso
Mexico
Foreign Exchange Crisis: Mexico
Et
Epar
RETD = the expected return on the peso.
RETF3 RETF = the expected return on the dollar.
RETD1 RETF1
RETF2
1
2
3
RETF shifted to RETF3. The Mexicans
intervened, buying pesos. As the speculators
realized that Mexico was running out of
foreign reserves and would have to devalue,
RETF shifted further right.
1’
0
An uprising in Chiapas, another assassination,
and concerns about the current account
deficit led to more rumors about devaluation.
RET Peso
Foreign Exchange Crisis: Thailand
Et
Epar
RETD1 RETF1
RETF2
1
2
1’
0
RETF3
3
RETD = the expected return on the baht.
RETF = the expected return on the dollar.
Concerns about Thailand’s current account
deficit and weak financial system caused
speculators to suspect that Thailand would
devalue.
RETF shifted to the right, putting pressure on
the baht. Thailand intervened and bought
baht. The collapse of Finance One caused
another shift of RETF to the right.
RET Baht Ultimately, Thailand ran out of international
Thailand
reserves and devalued.