5. The international Financial System

For a commercial bank, what are the liabilities on the bank balance sheet?

• checkable deposits

• Nontransaction deposits

• Borrowings

• Bank Capital

For a commercial bank what are the assets of a balance bank sheet?

• reserves

• cash items in process of collection

• Deposits at other banks

• Securities

• Loans

• Other assets

What does a commercial banks balance sheet table look like?

For Feds what are the liabilities of a balance sheet?

• Currency in circulation: in the hands of the public

• Reserves: bank deposits at the Fed and vault cash

For Fed’s what are the assets of a balance sheet?

• Government securities: holdings by the Fed that affect the money supply and earn interest

• Discount loans: provide reserves to

What does a Fed reserve system balance sheet table look like?

When do Foreign exchange interventions occur?

when central banks engage in international transactions to influence exchange rates?

How can Central banks intervene with the Exchange rate?

• pay using currency and pay using deposits - make sure the balance sheets always end up the same

purchase of domestic currency and corresponding sale fo foreign assets in the foreign exchange market → equal decline in its international reserves and the monetary base

sale of domestic currency to purchase foreign asstes in the foreign exchange market results in an equal rise in its international reserves and the monetary base

What is Unsterilised foreign exchange intervention?

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 depreciation of the domestic currency

• increase money supply → more domestic currency → IR dfall → depreciate domestic currency

• Relationship btw money supply + IR

What is the effect of an unsterilised purchase of dollars and sale of foreign assets - graphically?

What is sterilized foreign exchange intervention?

To counter the effect of the foreign exchange intervention conduct an offsetting open market operation → buy or sell gov bonds or securities

There is no effect on the monetary base and no effect on the ER

What are the 2 basic types of exchange rate regimes in the international financial system?

• fixed exchange rate regime

• Floating exchange rate regime

What is a fixed exchange rate regime?

• values of currencies are kept pegged relative to one currency → the ER is fixed

• The currency against which the others are pegged is known as the anchor currency

What is a floating exchange rate regime?

• the values of currencies are allowed to fluctuate against one another

Who is Bretton Woods?

1. created the IMF → sets rules and provides loans to deficit countries

2. Set up the International bankf or reconstruction and development => provides loans to developing banks

3. US emerged from WII as largest economic power. → Us dollar became reserve currency → abandoned in 1971

4. Even post 1971 - the dollar was reserve currency in which international financial transactions were conducted

What is a reserve currency

It is used by other countries to denominate the assets they held in internal reserves

When will the central bank act in the foreign exchange market?

When domestic currency is either overvalued or undervalues

What happens in a fixed exchange rate when the domestic currency is overvalued?

Central bank must purchase domestic currency to keep the exchange rate fixed

• Result: CB loses international reserves

What happens in a fixed exchange rate system when the domestic currency is undervalued?

the CB must sell domestic currency to keep the exchange rate fixed

Result

• CB gains international reserves

What does intervention in case of overvalued exchange rate look like?

What does intervention in case of undervalued exchange rate look like?

When does devaluation occur?

when the domestic currency is overvalued

Eventually the CB may run out of international reserves eliminating its ability to prevent the domestic currency depreciating

What happens if there is a perfect capital mobility?

the sterilized exchange rate intervention keep the exchange rate at E_par

If a country ties it ER to an anchor currency of a larger country it loses control of its monetary policy

What is the policy Trilemma

A country cant pursue the 3 policies at the same time

1. free capital mobility

2. A fixed ER

3. Independent monetary policy

What is floating exchange in terms of policy trilemma

Free capital mobility and independent monetary policy

e.g. Us or EU

What is a dependent monetary policy in policy trilemma?

Fixed ER and Free capital movement

• hong kong and belize

What is a weighted basket exchange in policy trilemma?

Fixed ER and independent monetary policy

e.g. China

• doesnt have free capital mobility via capital controls that restrict capital movement across their borders

What is a monetary union

Union of countries who adopt a common currency, such as EU monetary union and the euro

Aids in cross border trades

all have a dependent monetary policy

What is a currency board?

the most extreme example of monetary union

• the domestic currency is 100% backed by foreign currency

• e.g. Argentina, Hong Kong, Estonia

most extreme example is dollarization

What was Argentina’s currency board?

Adopted in 1991 to end a long history of monetary instability

• Peso/dollar exchange rate fixed and rate guaranteed by the central bank

• Early success was stifled by a mass exchange of pesos for dollars - Real GDP shrunk and unemployment rose to 15% in 1995

• Central bank could do nothing to control - ER was fixed But world organisiations helped out (World bank, IMF)

• ANother recession in 1999 eventually lead to the collapse of the currency board in 2002. The peso depreciated by 70% and a financial crisis ensued.

What are the positives and negatives of dollarisation?

Pos

• avoid CV creating inflationa dn eliminates speculative attacks on currency

Neg

• country cannot pursue its own monetary policy → loses revenue a gov receives by issuing currency

What is seigniorage?

profit a government makes by issuing currency

• difference btw/ face value of currency and cost to produce it

What are the controls on capital outflow?

• promote financial instability by forcing a devaluation

• Seldom effective and may increase capital flight

• Lead to corruption

• Lose opportunity to improve the economy

What are controls on capital inflows?

• lead to a lending boom and excessive risk-taking by financial intermediaries

• controls may block funds for production uses

• Produce substantial distortion and misallocation

• Leads to corruption

What is the effect of capital controls?

It is a strong case for improving bank regulation and supervision

What is the role of the IMF

• Act as international lender of last resort (ILLR)

• ILLR creates moral hazard ( countries have an incentive to behave recklessly bc/ they know IMF will step in

• IMF needs to limit moral hazard - lend only to countries w/ good bank supervision

• Need to do ILLR role fast and infrequently

What is the monetary approach to the balance of payments?

Views the balance of payments as a monetary phenomenon

Money plays crucial role in the LR as both a disturbance and an adjustment

What is the monetary approach under fixed exchange rates?

• Excess stock of money demand that is not satisfied by domestic monetary authorities → BoP surplus

• Excess stock of money supply that is not eliminated by monetary authorities → BoP deficits

• Surplus/deficit is temp + selfcorrecting in LR

Except for currency-reserve nation

What happens in currency-reserve nation when there is a monetary approach?

the nation has no control over its money supply in the LR under fixed exchange system

What are the assumptions for money demand?

• demand for nominal money balances is positively related to the level of nominal income

• stable in LR

What is the equation for demand for money?

M_d = kPY

• M_d = quantity demanded of nominal money balances - stable positive function of the domestic price level and national income

• k = desired ratio of nominal money balances to nominal income

• P = domestic price level

• Y = real output

• PY = nominal national income or output

• K = 1/v where v= belocity of circulation of money

What is the equations for the supply of money

M_s = m(D + F)

• M_s = nations total money supply

• m = money multiplier

• D = domestic component of nation’s monetary base - domestic assets backing the nation

• F = international or foreign component of nation’s monetary base - international reserves of the nation, which can be increased or decreased through BoP surpluses and deficits

From the equation for supply of money what does D + F represent?

D + F = monetary base or high-powerd money

• under a fractional reserve banking system, each nw dollar of D or F deposited results in an increase of m(D+F)

What happens in the equilibrium of Money supply and demand market?

M_d = M_s

Increase in M_d can be satisfied by either an increase in D or F

What happens if there is excess demand for money?

BoP surplus → may increase M_s by the same amount

What happens if there is excess stock of money supplied?

Outflow of reserves (BoP deficit) sufficient to eliminat the excess supply of the money in the country

What do countries have control over?

A country has no control over its money supply under a fixed Er system in the LR

Only a reserve-currency country can retain control over its money supply in the LR under fixed exchange as foreigners willingly hold the currency

Under a flexible exchange rate system what happens in disequilibria?

Immediately corrected by automatic changes in ER w/o international flows of money or reserves

Nation retains dominant control over is money supply and monetary policy

Adjustment occurs as result of the change in domestic prices accompanying the change in ER

Under Flexible exchange rates which does a BoP deficit lead to?

deficit in BoP → automatic depreciation of the nation’s currency → prices and demand for money increase → absorb supply of money → eliminate automatically BoP

Under Flexible exchange rates which does a BoP surplus lead to?

surplus in BoP → automatic appreciation of the nation’s currency → prices fall → eliminating excess demand and BoP surplus

What causes BoP disequilibrium under fixed exhange rates?

Under fixed exchange rates BoP disequilibrium results from an international flow of money and reserves

According to Monetary approach, what does a currency depreciation result from?

excessive money growth in the nation over time

• greater inflationary pressure compared to others → currency is depreciating

According to Monetary approach, what does a currency appreciation result from?

inadequate money growth in the nation