Transcript The International System

The International System
Monetary Policy
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.
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
• 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.
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.
Exchange Market Intervention and
the Exchange Rate
• How does an unsterilized intervention affect
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
• How does an unsterilized intervention affect
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.
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.
Intervention in the Foreign
Exchange Market
• If a central bank does not want the currency to
fall, it can follow a contractionary monetary
policy, which reduces base and the money
supply.
– The decrease in the money supply given demand
supports the currency’s value.
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
Intervention in the Foreign
Exchange Market
• If a central bank does not want the currency to
rise, it can follow an expansionary monetary
policy, which increases base and the money
supply.
– The increase in the money supply given demand
tends to decrease the currency’s value.
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, 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.
International Transactions: Balance
of Payments
• Balance of Payments Account
– A tabulation of all transactions between the
residents of a nation and the residents of all
other nations in the world.
International Transactions: Balance
of Payments
• Balance of Payments Accounts
– Current Account
• BOP account that tabulates international trade and
transfers of goods and services and flows of income.
– Capital Account
• BOP account that records all non-governmental
international asset transactions.
Current Account
• Merchandise Trade Balance
– Merchandise exports minus merchandise imports
• In 2000, exports = +773 and imports = – 1,223, so the
merchandise trade balance was – 450.
• Net Service Transactions and Income Flows
– Services we provide to the rest of the world minus
services they provide to us plus other income flows.
• In 2000, net service transactions = 81 – 14 – 53.
• Balance on Goods and Services
– The sum of the merchandise trade balance and net
service transactions.
• In 2000, the balance was – 436.
Current Account
• Net Investment Income Flow
– Individuals and firms that reside in the USA earn
income on assets that they hold in other nations.
– Similarly, residents that reside in other nations earn
income on assets that they hold in the USA.
– Net income flow is the difference between these sums.
– In 2000, net investment income was 14.
• Unilateral Transfers
– Gifts that U.S. residents give to residents or
governments of other nations or that foreign resident or
governments give to the U.S.
– In 2000, unilateral transfers were -53.
The Capital Account
• Changes in asset holdings by U.S. residents
and residents of other nations take place in
international financial markets and are
recorded outside the current account.
• The capital account tabulates asset
transactions involving private individuals or
firms.
Capital Account
• Capital Outflows
– American purchases of foreign assets.
• In 2000, capital outflows = – 553.
• Capital Inflows
– Foreign purchases of American assets.
• In 2000, capital inflows = 952.
• Statistical Discrepancy
– Errors due to unrecorded transactions involving
smuggling and other data discrepancies.
• In 2000, statistical discrepancy = 35
Official Reserves Transactions
Balance
• Official reserves transactions balance gives the
net total of all private exchanges between U.S.
individuals and businesses and the rest of the
world.
– It is the sum of the current account balance
and the capital account balance .
• In 2000, the official reserves transactions balance
was – $436 + $434 = – $2.
Official Reserves Transactions
Balance
• The official reserves transactions balance tells
us the net amount of international reserves that
must move between central banks to finance
international transactions.
– A balance-of-payments deficit can be financed
by a decrease in U.S. international reserves, an
increase in foreign central banks’ holdings of
international reserves (dollar assets) or both.
Methods of Financing
• Change in U.S. Official Reserve Assets
– Change in U.S. international reserves
• In 2000, international reserves increased by $33
billion dollars or a payment of – $33.
– International reserves increase when we buy them from
foreigners with an outflow of dollars.
– Change in foreign holdings of dollars
• In 2000, foreign holdings of dollars increased by
$35.
Overall Balance of Payments
• The overall balance of payments always
equals zero.
– In 2000, the United States indebtedness to
foreign central banks increased by $2 billion.
– This $2 billion increase just matches the $2
billion official reserve transactions deficit.
Balance-of-Payments and the USA
• The USA can run a large balance-ofpayments deficit without losing huge
amounts of international reserves because it
is a major reserve currency country.
• Nevertheless, balance-of-payments deficits
are still a problem to the Federal Reserve.
Balance-of-Payments and the USA
• Current account deficits suggest that the
dollar is too high and may be diminishing the
competitiveness of American businesses.
• Large U.S balance-of-payments deficits lead
to balance-of-payments surpluses in other
countries, which in turn can lead to large
increases in their holdings of international
reserves, leading to higher levels of inflation.
Fixed Exchange Rates
• In a system of fixed exchange rates, each
country’s central bank intervenes in the
foreign exchange market to prevent that
country’s exchange rate from going outside
a narrow band on either side of its par
value.
– The bank must be prepared to offset imbalances
in demand and supply by government sales or
purchases of foreign exchange.
Fixed Exchange Rates: Example
• Let the exchange value of the Hong Kong
dollar be set such that it is overvalued
relative to its current market value.
– Hong Kong must drive up the value of the HK$
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$
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.
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
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 currency.
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.
– Sterilization is not possible because it would
just lead to more losses of international
reserves and an eventual devaluation.
Foreign Exchange Crisis: Mexico
Et
Epar
RETD = the expected return on the peso.
RETF = the expected return on the dollar.
RETD1 RETF1
RETF2
1
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.
2
1’
To maintain Epar, the Mexican government
bought pesos and shifted RETD to the right.
0
RET$
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
An uprising in Chiapas, another assassination,
and concerns about the current account
deficit led to more rumors about devaluation.
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
RET$
Foreign Exchange Crisis: Thailand
Et
Epar
RETD1 RETF1
RETF2
1
2
RETF3
Concerns about Thailand’s current account
deficit and weak financial system caused
speculators to suspect that Thailand would
devalue.
3
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.
1’
0
RET$
Thailand
RETD = the expected return on the baht.
RETF = the expected return on the dollar.
Ultimately, Thailand ran out of international
reserves and devalued.
Capital Outflows
• Capital Outflows
– Capital outflows can promote financial
instability in emerging market countries
because they can lead to a devaluation in the
domestic currency.
• Should capital outflows be restricted?
Capital Controls
• Disadvantages:
– Capital controls are seldom effective during a
crisis because people find ways to evade them.
– Capital controls can increase capital flight as
people lose confidence in the government.
– Capital controls lead to corruption of
government officials.
– Capital controls delay reform of the financial
system.
Capital Inflows
• Capital Inflows
– Capital inflows can promote financial
instability in emerging market countries
because speculative capital can exit the country
as suddenly as it entered, causing or
contributing to a currency crisis.
• Should capital inflows be restricted?
Capital Controls
• Advantages:
– Capital controls on capital inflows can regulate
the flow of capital and avoid sudden changes
that disrupt the financial system.
• There is a strong case for improving bank
regulation and supervision to control capital
inflows.
– Restrictions on how fast banks’ borrowing can
grow could limit capital inflows.
Capital Controls
• Disadvantages:
– Capital controls may block funds that would be used
for productive investment from entering a country.
– Capital controls are unlikely to be effective in
today’s environment.
– Capital controls over time produce substantial
distortions and misallocation of resources as people
avoid them.
– Capital controls can lead to corruption of
government officials.