Chapter 19 The International Financial System

1、Chapter 19 The International Financial SystemThe Market for Foreign Exchange When U.S. residents buy foreign goods or services or assets they must purchase foreign currency.Total foreign expenditures by U.S. residents = demand for foreign exchange = Supply of U.S. dollars in exchange markets.When fo

2、reign residents buy U.S. goods or services or assets they must purchase dollars.Total expenditures by foreign residents for U.S. things = demand for dollars = Supply of foreign currency in exchange markets.The exchange rate Suppose that the cost of a pair of shoes in the U.S. is $100, the price in t

3、he foreign country is F50 and the exchange rate is . In that case for $100 you can buy the pair of shoes in the U.S. or use the $100 to get F50 and buy the shoes in the foreign country (we ignore things like shipping costs or excise taxes or assume them to be incorporated in the cost of the good). S

4、uppose that the exchange rate falls to . Now you could take $50 of your $100 and purchase F50, get the shoes and still have $50 left over. In other words the foreign shoes just became cheaper. As usual, when things get cheaper the demand for these goods increases and hence the demand for F will incr

5、ease (while it is possible that the exchange rate could decrease enough that we could buy all we desire at such a low price that the demand for foreign currency might actually decrease we will ignore such a possibility).Result: Figure 1. The demand for foreign exchange.The demand for foreign exchang

6、e is shown in Fig. 1 where is the demand for foreign exchange and is the quantity of foreign exchange. Is the exchange rate increases U.S. goods will become cheaper to foreign resident. They will want to purchase dollars to purchase U.S. goods and must supply foreign currency units to do so. SoFigur

7、e 2. The supply of foreign exchangeThe supply of foreign exchange is shown in Fig. 2 and is indicated by . Equilibrium in the foreign exchange market determines the exchange rate as shown in Fig. 3.Figure 3. Exchange rate determination in the foreign exchange marketIf then it will take more $ to buy

8、 a foreign currency unit and we would say that the dollar has depreciated and that the foreign currency unit has appreciated.then it takes fewer $ to buy a foreign currency unit and we would say that the dollar has appreciated and the foreign currency unit has depreciated.Floating (Flexible) exchang

9、e ratesSuppose now that U.S. residents decide that they want to buy more foreign goods for some reason other than exchange rate consideration. Perhaps they think that foreign good suddenly become cool. Then the demand for foreign currency will increase and the demand curve will shift to the right as

10、 shown in Fig 4.Figure 4. An autonomous increase in the demand for foreign goods.In this case the exchange rate will increase and the dollar will depreciate. At the initial demand for foreign currency is . After the autonomous change the demand for foreign currency is while the supply remains at . T

11、his will force the exchange rate up until supply and demand are in equilibrium again at .Figure 5. An autonomous increase in foreign demand for U.S. goods.Fixed exchange ratesThe exchange rate was determined by the market for foreign exchange in the previous section. Interest rates have often been d

12、etermined by agreements between various governments. Suppose that the U.S. and some other country (call it F) agree that the exchange rate should be maintained at .Figure 6. An increase in the demand for foreign exchangeSuppose that U.S. residents increase the demand for foreign goods. This is repre

13、sented in Fig. 6 by the shift from to . Under floating exchange rates the exchange rate will increase as shown in Fig. 6. Under fixed exchange rates some action will have to be taken to keep the exchange rate at . What is needed is an increase in the supply of foreign exchange. Suppose that the supp

14、ly of foreign exchange shift from to so that the exchange rate does not increase. This is shown in Fig. 7.Figure 7. Pegging the exchange rate at .So an increase in the supply of foreign currency will keep the exchange rate at . The action of keeping the exchange rate fixed at a certain value is also

15、 called pegging. The only catch is where is it supposed to come from? Clearly the central bank of the foreign country can always create new money and supply the foreign currency market that way (the central bank creates the money and uses it to buy dollars). But why should they agree to do that. The

16、 U.S. is the country that created the problem. One way of looking at this is that the U.S. consumer is controlling the foreign countries money supply. Further we would be forcing the other country to maintain the purchasing power of the dollar. Again the other country might not be so accommodating.T

17、he central bank of the U.S. could use its reserve holdings of the other counties money to purchase dollars. That increases the supply of foreign exchange. In this case we would say the FED has intervened to peg the exchange rate.Intervention in the foreign exchange marketSuppose the Fed decided that

18、 it needed to increase the supply of foreign currency. The Fed will have some assets denominated in a foreign currency (international reserves) that it can use to buy dollars. This will increase the supply of foreign currency in the currency markets.Federal Reserve SystemAssetsLiabilitiesForeign Ass

19、ets -$1billionCurrency in circulation -$1billionIf the Fed uses $1 billion of foreign assets to purchase $1 billion U.S. dollars then the Feds holdings of international reserves (foreign assets) will decrease by $1 billion and the volume of U.S. dollars in circulation will decrease by the same amoun

20、t. But this also has an effect on the U.S. money supply.and because C has declined the monetary base will decline as well and so will the U.S. money supply.If the Fed increases the supply of foreign currency the U.S. money supply will decline.Figure 8. U.S. residents decide to buy more foreign goods

21、.Suppose that U.S. residents want to purchase more foreign goods. They will buy more foreign currency driving the exchange rate from to . If exchange rates are fixed, then someone must increase the supply of foreign exchange to drive the exchange rate back to . This will be the responsibility of som

22、e central bank. The other countries central bank could print some money and purchase U.S. dollars. That would increase the supply of foreign currency. The other central bank would increase its holdings of foreign (i.e. U.S.) assets. This would also increase the supply of currency and hence the monet

23、ary base of the other country. The other countrys central bank may not want to do this. This would mean that U.S. residents would be determining monetary policy of the other country. The other countrys central bank may take the position that the problem has been caused by U.S. residents, so it shoul

24、d be solved by the U.S. central bank.If the foreign countrys central bank uses its currency to purchase dollars then the money supply of the foreign country will increase.The operations where central banks purchase each other countries currencies thereby changing the monetary base are called unsteri

25、lized foreign exchange interventions.Sterilized InterventionThe Fed can keep the monetary base fixed after the purchase or sale of international assets by using open market operations. In the following example the Fed uses foreign assets to buy dollars and then follows this with an open market purch

26、ase. The initial action reduces currency and the subsequent one increases reserves. Federal Reserve SystemAssetsLiabilitiesForeign Assets -$1billionCurrency in circulation -$1billionThe initial actionFederal Reserve SystemAssetsLiabilitiesForeign Assets -$1billionCurrency in circulation -$1billionGo

27、vernment bonds +1 billionReserves +$1billionThe subsequent actionThe decrease in currency is now just offset by the increase in reserves, so the monetary base and money supply remain unchanged.Suppose that the Fed used dollars to buy foreign assets. In this case the demand for foreign assets increas

28、es and the exchange rate increases. That is the curve shifts to the right as shown in Figure 8. The difference here is that the Fed wants the exchange rate to increase. The unsterilized result isFederal Reserve SystemAssetsLiabilitiesForeign Assets +$1billionCurrency in circulation +$1billionand the

29、 sterilized result isFederal Reserve SystemAssetsLiabilitiesForeign Assets +$1billionCurrency in circulation +$1billionGovernment bonds -1 billionReserves -$1billionAn unsterialized intervention where the Fed uses U.S. dollars to purchase of foreign currency results in a gain of international reserv

30、es, an increase in the monetary base and in the money supply and a depreciation of the domestic currency (if increases then it takes more dollars to purchase a foreign currency unit).An unsterialized intervention where the Fed uses foreign assets to purchase U.S. dollars results in a loss of interna

31、tional reserves, a decrease in the monetary base and in the money supply and an appreciation of the domestic currency (shifts to the right decreasing . If decreases, then fewer dollars are needed to purchase a foreign currency unit).The purpose of sterilizationAn unsterilized intervention changes a

32、nations money supply. Because the money supply changes interest rates will change as well. Sterilization leaves the money supply and interest rates unchanged. The problem is that the sterilization will set forces in motion that will offset the intervention. The bad news is that only an unsterilized

33、intervention can change exchange rates.Consider again an unsterilized intervention where the Fed uses foreign currency assets to buy dollars (lowering the exchange rate) This reduces currency in circulation and the U.S. money supply thus raising interest rates (this raise in interest rates is why so

34、meone would consider a sterilizing the intervention). This action will increase the value of the dollar. Note that U.S. financial assets will cost foreigners more, but they will get a higher interest rate than they did before the intervention. Now comes the sterilization to reduce U.S. interest rate

35、s. Now U.S. assets cost more but U.S. interest rates have gone back to their previous level. Foreign financial assets have become cheaper and U.S. financial assets are more expensive. We would expect people to buy assets where they are cheapest. That is the demand for foreign currency will increase

36、which will offset the intervention (the exchange rate goes back up).The balance of paymentsThe balance of payments records all movement of funds between countries.The current accountMeasures trade flows between countries. If the U.S. exports more than it import, then the U.S. will have a trade surpl

37、us. If the U.S. imports more than it exports, the U.S. has a trade deficit.The capital account.For years the U.S. has had a balance of trade deficit with Japan and a number of other countries. The Japanese do not just set on the dollars they have accumulated. They will use these dollars to purchase

38、U.S. financial assets. U.S. residents purchase of foreign assets and foreigners purchase of U.S. assets are recorded in the capital account.If the current account shows a trade deficit then the capital account will likely show a surplus (foreigners using these funds to buy U.S. financial assets). Th

39、e offset will not be perfect and any difference must be made up by a change in government reserve assets.current account + capital account= change in government reserves.The U.S. Balance of payments, 1998 (billions of dollars)Current accountReceipts(+)Payments(-)Balance(1) Merchandise exports671(2)

40、Merchandise imports-919 Trade balance-248(3)Net investment Income-23(4)Net Services+79(5)Net Unilateral transfers-41 Balance (1)+(2)+(3)+(4)+(5)-233Capital account(6) Capital outflows-305(7) Capital inflows+564(8) Statistical discrepancy-3 Banalce (6)+(7)+(8)+256Balance of payments+23Method of finan

41、cing(9) Increase in U.S. official reserve assets ($)-1(10) Increase in foreign official assets-22The official reserve transactions balance is equal to the loss of reserves that the central bank must provide to make up for balance of payments deficits or the increase in reserves it will receive if th

42、ere is a surplus.Methods of financing the balance of payments deficitThe U.S. dollar is a widely accepted form of international exchange, so in many cases the Fed will receive dollars in the case of a surplus with a particular country. A foreign country may be quite willing to accept dollars in the

43、case of a deficit. The currencies of other countries are not so readily accepted. These countries may have to use international reserves as a means of settling balance of payments deficits.Evolution of the international financial systemUsing gold as money. This is a hypothetical exercise, but a good

44、 way to think of the workings of a fixed exchange rate system. Suppose that all nations used exactly the same money and that this money is gold coins. Further assume that these gold coins can be transported from one place to another at no cost. If goods were cheaper in Great Britain than in the U.S.

45、 people would tend to buy the goods in Great Britain. Gold would flow from the U.S. to Great Britain. Note that the monetary base of the U.S. is falling and the monetary base of Britain is increasing. So what is determining a nations money supply? International trade. But what will the increase in t

46、he money supply do to prices in Britain? Prices in Britain will increase and prices in the U.S. will drop. Eventually the gold flow will reverse and money will flow from Britain to the U.S. So we have this nice, self regulating system.Gold standardMost nations operated on the gold standard before WW

47、I. A nation on a gold standard will be willing to trade a fixed number of units of its currency for an ounce of gold. Say that Britain set its conversion ratio at ounce of gold for 1 sterling and that the U.S. would exchange ounce of gold for for $1. So the U.S. resident could take $20 and get 1 oun

48、ce of gold. The one once of gold could then be used to purchase 4 sterling. So we have essentially a fixed exchange rate system. In this case =$20/4=5.Suppose that the British pound appreciated so that it now cost American residents more to purchase British goods. An importer could convert U.S. doll

49、ars to gold, however, and still buy British pounds at the five to one exchange rate. So gold (international reserves) will flow from the U.S. to Britain, increasing the British money supply and British prices. The U.S. money supply will decline and so will U.S. prices.The Bretton Woods TreatyThe gol

50、d standard collapsed during the first World War. Most countries went far into debt to pay for fighting the war and did not have enough gold to begin to pay their war debts much less to be able to convert to foreign exchange. Nations tried to reestablish the gold standard after the war but the Great

51、Depression finished it off.The Bretton Woods treaty was signed after World War II. This treaty tried to establish a fixed exchange rate system that did not use gold. Instead countries agreed to maintain the exchange ratio between their currencies at a fixed ratio.The Bretton Woods treaty also establ

52、ished the International Monetary Fund (IMF) and the World Bank. The IMF was supposed to promote world trade by setting the rules for exchange rate maintenance and by making loans to countries with balance of payments problems. The World Bank is an organization that is supposed to encourage economic

53、development in lesser developed countries. The bank provides long term loans to countries for projects like dam building, road building and agricultural projects.The U.S. played a pivotal role in the founding of the Bretton Woods system, particularly in the early days. The economies of almost all of

54、 Europe and much of the far East had been devastated by World War II. The U.S. was the dominant economic power in the world by far. The U.S. dollar became an international reserve currency. Almost any country would be willing to accept dollars as payment for international debt. This became a feature

55、 of the Bretton Woods system and dollars have remained an international currency ever since. The breakdown of the Bretton Woods system.In the 1960s the U.S. was fighting a war in Vietnam and also the war on poverty. The U.S. paid for both of these wars by borrowing money. This drove interest rates u

56、p and the Fed conducted large open market purchases of government securities to try to force them down again. This lead to prices increases for U.S. goods (the Fed is essentially printing money). Foreign goods became relatively cheaper and U.S. citizens started purchasing an increasing volume of foreign, particularly German, goods. This meant a increase in the demand for foreign currency (particularly German marks) driving the exchange rate up (that is the Mark appreciated and the dollar dep