Mishkin Econ12eGE CH19

The Economics of Money, Banking, and
Financial Markets
Twelfth Edition, Global Edition
Chapter 19
The International Financial
System
Copyright © 2019 Pearson Education, Ltd.

Preview
• This chapter examines how international financial
transactions and the structure of the international financial
system affect monetary policy.

Learning Objectives (1 of 2)
• Use graphs and T-accounts to illustrate the distinctions
between the effects of sterilized and unsterilized
interventions on foreign exchange markets.
• Interpret the relationships among the current account, the
financial (capital) account, and official reserve transactions
balance.
• Identify the mechanisms for maintaining a fixed exchange
rate and assess the challenges faced by fixed exchange
rate regimes.
• Summarize the advantages and disadvantages of capital
controls.
Learning Objectives (2 of 2)
• Assess the role of the IMF as an international lender of last
resort.
• Identify the ways in which international monetary policy
and exchange rate arrangements can affect domestic
monetary policy operations.
• Summarize the advantages and disadvantages of
exchange-rate targeting.

Intervention in the Foreign Exchange
Market (1 of 4)
• Foreign exchange intervention and the money supply
Federal Reserve System Blank Blank Blank

Assets Blank Liabilities Blank
Foreign Assets −$1B Currency in Circulation −$1B
(International Reserves) Blank Blank Blank

Foreign Assets −$1B Deposits with the Fed −$1B
(International Reserves) Blank (reserves) Blank

Market (2 of 4)
• The Fed’s purchase of dollars has two effects. First, it
reduces the Fed’s holdings of international reserves by
$1 billion. Second, because the Fed’s purchase of currency
removes it from the hands of the public, currency in
circulation falls by $1 billion.
• A central bank’s purchase of domestic currency and
corresponding sale of foreign assets in the foreign exchange
market lead to an equal decline in its international reserves
and the monetary base.
• A central bank’s sale of domestic currency to purchase
foreign assets in the foreign exchange market results in an
equal rise in its international reserves and the monetary
base.
Market (3 of 4)
• Unsterilized foreign exchange intervention:
– Recall that in an unsterilized intervention, if the Federal Reserve
decides to buy dollars and therefore sells foreign assets in
exchange for dollar assets, this exchange works just like an open
market sale of bonds to decrease the monetary base. Hence the
purchase of dollars leads to a decrease in the money supply,
which raises the domestic interest rate and increases the relative
expected return on dollar assets.
– *An unsterilized intervention in which domestic
currency is bought and foreign assets are sold leads to
a fall in international reserves, a fall in the money
supply, and an appreciation of the domestic currency.

Market (4 of 4)
- The reverse result is found for an unsterilized intervention in which
domestic currency is sold and foreign assets are purchased. The sale
of domestic currency and purchase of foreign assets (which increases
international reserves) work like an open market purchase to increase
the monetary base and the money supply. The increase in the money
supply lowers the interest rate on dollar assets. The resulting decrease
in the relative expected return on dollar assets means that people will
buy less dollar assets, so the demand curve shifts to the left and the
exchange rate falls.
- An unsterilized intervention in which domestic currency is

sold and foreign assets are purchased leads to a rise in
international reserves, a rise in the money supply, and a
depreciation of the domestic currency.

Figure 1 Effect of an Unsterilized Purchase
of Dollars and Sale of Foreign Assets

CH 18: The Interest Parity Condition
e
D F Et 1  Et
i i 
Et
Let’s re-write the parity condition so that it is easier to see how an
increase in (LHS) leads to an appreciation of the spot exchange rate
() when Where and are fixed (i.e., ceteris paribus):

Market (4 of 4)
• Sterilized foreign exchange intervention
Foreign Assets Monetary Base

(International Reserves) −$1B (reserves) 0
Government Bonds +$1B Blank Blank
• To counter the effect of the foreign exchange intervention,

conduct an offsetting open market operation.
• There is no effect on the monetary base and no effect on
the exchange rate.

Balance of Payments
• Current Account
– Country’s current international transactions that involve
currently produced goods and services (excludes the
purchase or sale of financial assets)
– Trade Balance/Net Exports
– Net investment income
– Transfers are funds sent by domestic residents and the
government to foreigners; they include remittances
(money sent by domestic workers to foreigners, usually
relatives), pensions, and foreign aid

Balance of Payments
• Financial Account (nonofficial) / Capital Account
– shows the international transactions that involve the purchase or
sale of assets.
– When Americans increase their net holdings of foreign assets,
this change is recorded as a net U.S. acquisition of financial
assets in the financial account. When foreigners increase their net
holdings of U.S. assets, this change is recorded as a net U.S.
incurrence of liabilities because foreigners’ claims on U.S. assets
are liabilities for Americans. The difference between the net U.S.
acquisition of financial assets and net U.S. incurrence of liabilities
is the financial account balance i.e., net receipts from capital
transactions
• Sum of these two is the official reserve transactions balance
• Wikipedia entry
Balance of Payments
• The financial account balance tells us the amount of net capital inflows
into the United States. When foreigners increase their holdings of U.S.
assets, capital has flowed into the United States. In contrast, when
Americans increase their holdings of foreign assets, capital has flowed
out of the United States.
• You probably have noticed that this financial account balance is equal
in absolute value to the current account deficit. This equality makes
sense because if Americans are spending more than they are taking in
on the current account, they must be financing this spending by
borrowing an equal amount from foreigners. Another way to see this
equality is to use the accounting principle that the uses of funds must
equal the sources of funds. Hence the current account deficit, which
provides the net uses of funds for current items, must equal the
sources of funds, which is what the financial account balance tells us

Global: Should We Worry About the Large
U.S. Current Account Deficit?
• Persistent trade deficits are a concern for several reasons.
• First, it indicates that, at current exchange rates, foreign
demand for U.S. exports is far less than the U.S. demand
for foreign goods.
• Second, a current account deficit means that foreigners’
claim on U.S. assets is growing.

Exchange Rate Regimes in the International
Financial System (1 of 3)
• Fixed exchange rate regime
– Value of a currency is pegged relative to the value of
one other currency *(anchor currency) so that the
exchange rate is fixed in terms of the anchor currency.
• Floating exchange rate regime
– Value of a currency is allowed to fluctuate against all
other currencies
• Managed float regime (dirty float)
– Attempt to influence exchange rates by buying and
selling currencies

• Gold standard
– Fixed exchange rates
– No control over monetary policy
– Influenced heavily by production of gold and
gold discoveries
• Bretton Woods System ("gold exchange standard“)
– Fixed exchange rates using U.S. dollar as reserve
currency ($35/ounce)
– International Monetary Fund (IMF)
(given the task of promoting the growth of world trade by setting rules for the
maintenance of fixed exchange rates and by making loans to countries that
were experiencing balance-of-payments difficulties)
• Bretton Woods System (cont’d)
– World Bank
(it provides long-term loans to help developing countries build dams, roads,
and other physical capital that will contribute to their economic development)
– General Agreement on Tariffs and Trade (GATT)
 World Trade Organization
• European Monetary System
– Exchange rate mechanism

How the Bretton Woods System Worked
• Exchange rates adjusted only when experiencing a
“fundamental disequilibrium” (large persistent deficits in
balance of payments)
• Loans from IMF to cover loss in international reserves
• IMF encouraged contractionary monetary policies
• Devaluation only if IMF loans were not sufficient
• No tools for surplus countries
• U.S. could not devalue currency

How a Fixed Exchange Rate
Regime Works
• When the domestic currency is overvalued, the central
bank must:
– Purchase domestic currency to keep the exchange rate
fixed (it loses international reserves), or
– Conduct a devaluation
~If the country’s central bank eventually runs out of international reserves, it
cannot keep its currency from depreciating, and a devaluation, in which the
par exchange rate is reset at a lower level, must occur.

Regime Works
• At Epar (domestic currency is fixed relative to an anchor currency) , the exchange
rate is now overvalued: The demand curve D1 intersects the
supply curve at an exchange rate E1 that is lower than the fixed
(par) value of the exchange rate Epar. To keep the exchange rate
at Epar, the central bank must intervene in the foreign exchange
market and purchase domestic currency by selling foreign
assets. This action, like an open market sale, causes both the
monetary base and the money supply to decrease, driving up
the interest rate on domestic assets, iD.4 This increase in the
domestic interest rate raises the relative expected return on
domestic assets, shifting the demand curve to the right. The
central bank will continue to purchase domestic currency until
the demand curve reaches D2 and the equilibrium exchange
rate is at Epar, at point 2 in panel (a).
Regime Works
• When the domestic currency is undervalued, the central
bank must:
– Sell domestic currency to keep the exchange rate fixed
(it gains international reserves), or
– Conduct a revaluation
~the central bank might not want to acquire these international reserves, and
so it might want to reset the par value of its exchange rate at a higher level
(a revaluation)

Regime Works
• Panel (b) in Figure 2 describes the situation in which the
demand curve has shifted to the right to D1 because the
relative expected return on domestic assets has risen and
hence the exchange rate at Epar is undervalued: The initial
demand curve D1 intersects the supply curve at exchange
rate E1, which is above Epar. In this situation, the central
bank must sell domestic currency and purchase foreign
assets. This action works like an open market purchase; it
increases the money supply and lowers the interest rate on
domestic assets iD. The central bank keeps selling
domestic currency and lowering iD until the demand curve
shifts all the way to D2, where the equilibrium exchange
rate is at Epar—point 2 in panel (b).
Figure 2 Intervention in the Foreign Exchange
Market Under a Fixed Exchange Rate Regime

European Monetary System (EMS)
• Eight members of EEC fixed exchange rates with one
another and floated against the U.S. dollar.
• ECU value was tied to a basket of specified amounts of
European currencies.
• Fluctuated within limits.
• Led to foreign exchange crises involving speculative
attacks. To illustrate consider the market for British pounds
in 1992.
• A speculative attack involves massive sales of a weak
currency or purchases of a strong currency that cause a
sharp change in the exchange rate.
Figure 3 Foreign Exchange Market for
British Pounds in 1992

Figure 4 The Policy Trilemma

The Policy Trilemma
• An important implication of the foregoing analysis is that a country that ties its
exchange rate to an anchor currency of a larger country loses control of its
monetary policy. If the larger country pursues a more contractionary monetary
policy and raises interest rates, this action will lead to lower expected inflation
in the larger country, thus causing an appreciation of the larger country’s
currency and a depreciation of the smaller country’s currency. The smaller
country, having locked its exchange rate to the anchor currency, will now find
its currency overvalued and will therefore have to sell the anchor currency and
buy its own to keep its currency from depreciating. The result of this foreign
exchange intervention will be a decline in the smaller country’s international
reserves, a contraction of its monetary base, and a rise in interest rates.
Sterilization of this foreign exchange intervention is not an option because this
course of action would just lead to a continuing loss of international reserves,
until the smaller country was forced to devalue its currency. The smaller
country no longer controls its monetary policy because movements in its
interest rates are completely determined by movements in the larger country’s
interest rates.
The Policy Trilemma
• Our analysis therefore indicates that a country (or a monetary
union like the Eurozone) can’t pursue the following three
policies at the same time: (1) free capital mobility, (2) a fixed
exchange rate, and (3) an independent monetary policy.
Economists call this result the policy trilemma (or, more
colorfully, the impossible trinity).
• If perfect capital mobility exists—that is, if there are no
barriers to domestic residents purchasing foreign assets or to
foreigners purchasing domestic assets—then a sterilized
exchange rate intervention cannot keep the exchange rate at
Epar because, as we saw earlier in the chapter, the relative
expected return on domestic assets is unaffected .

The Policy Trilemma
• If the central bank keeps purchasing its domestic currency
but continues to sterilize, it will just keep losing
international reserves until it finally runs out of them and is
forced to let the value of the currency seek a lower level.
• *Capital controls, or restrictions on the free movement of
capital across the borders, cannot have free capital
mobility.
*Capital control represents any measure taken by a government, central bank, or
other regulatory body to limit the flow of foreign capital in and out of the domestic
economy. These controls include taxes, tariffs, legislation, volume restrictions,
and market-based forces.
• Refer to pg. 514-515 in textbook

Application: How Did China Accumulate $4
Trillion of International Reserves?
• By 2014, China had accumulated $4 trillion in international
reserves.
• The Chinese central bank engaged in massive purchases
of U.S. dollar assets to maintain the fixed relationship
between the Chinese yuan and the U.S. dollar.

Monetary Unions
• A variant of a fixed exchange rate regime is a monetary (or
currency) union, in which a group of countries decides to
adopt a common currency, thereby fixing the countries’
exchange rates in relation to each other.
• The key economic advantage of a monetary union is that it
makes trade across borders easier because goods and
services in all of the member countries are now priced in
the same currency. However, as with any fixed exchange
rate regime and free capital mobility, a currency union
means that individual countries no longer have their own
independent monetary policies with which to address
shortfalls of aggregate demand.
Managed Float
• Hybrid of fixed and flexible
– Small daily changes in response to market
– Interventions to prevent large fluctuations
• Appreciation hurts exporters and employment
• Depreciation hurts imports and stimulates inflation
• Special drawing rights as substitute for gold

Managed Float (extended explanation)
• Furthermore, countries with surpluses in their balances of
payments frequently do not want to see their currencies
appreciate, because it makes their goods more expensive
abroad and foreign goods cheaper in the home country.
Because an appreciation might hurt sales for domestic
businesses and increase unemployment, countries with
balance-of-payments surpluses often have sold their
currencies in the foreign exchange market and acquired
international reserves.
• Countries with balance-of-payments deficits do not want to
see their currencies lose value because it makes foreign
goods more expensive for domestic consumers and can
stimulate inflation.
Global: Will the Euro Survive?
• The global financial crisis of 2007–2009 led to economic
contraction throughout Europe, with the countries in the
southern part of the Eurozone hit especially hard.
• This “straightjacket” effect of the euro has weakened
support for the euro in the southern countries, leading to
increased talk of abandoning the euro.

Capital Controls (1 of 2)
• Controls on capital outflows:
– Promote financial instability by forcing a devaluation
– Seldom effective and may increase capital flight
– Lead to corruption
– Lose opportunity to improve the economy
• Controls on capital inflows:
– Lead to a lending/credit boom and excessive risk-
taking by financial intermediaries

Capital Controls (2 of 2)
• Controls on inflows (cont’d):
– Controls may block funds for production uses
– Produce substantial distortion and misallocation
– Leads to corruption
• Strong case for improving bank regulation
and supervision

International Considerations and Monetary
Policy (1 of 2)
• Balance of payment considerations:
– Current account deficits in the United States suggest
that American businesses may be losing ability to
compete because the dollar is too strong.
– U.S. deficits mean surpluses in other countries  large
increases in their international reserve holdings 
world inflation.

International Considerations and Monetary
Policy (2 of 2)
• Exchange rate considerations:
• A contractionary monetary policy will raise the domestic
interest rate and strengthen the currency.
• An expansionary monetary policy will lower interest rates
and weaken currency.

To Peg or Not to Peg: Exchange-Rate
Targeting as an Alternative Monetary Policy
Strategy
• *Another strategy that uses a strong nominal anchor to
promote price stability is called exchange-rate targeting
(sometimes referred to as an exchange-rate peg).
• Advantages of exchange-rate targeting:
– Contributes to keeping inflation under control
– Automatic rule for conduct of monetary policy that helps
mitigate the time-inconsistency problem (refer pg. 520)
– Simplicity and clarity

To Peg or Not to Peg: Exchange-Rate
Targeting as an Alternative Monetary Policy
Strategy
• Disadvantages of exchange-rate targeting:
– Cannot respond to domestic shocks and shocks to anchor
country are transmitted
– Open to speculative attacks on currency
– Weakens the accountability of policy makers as the
exchange rate loses value as signal

When Is Exchange-Rate Targeting Desirable
for Industrialized Countries?
• Exchange-rate targeting for industrialized countries is
desirable if
– Domestic monetary and political institutions are not
conducive to good policy making (either because the
central bank is not independent or because political
pressures on the central bank lead to an inflationary
bias in monetary policy)
– Other important benefits such as integration arise from
this strategy (encourages integration of the domestic
economy with the economies of neighboring countries)

When Is Exchange-Rate Targeting Desirable
for Emerging Market Countries?
• Exchange-rate targeting for emerging market countries is
desirable if
– Political and monetary institutions are weak (strategy
becomes the stabilization policy of last resort).
– exchange-rate targeting may be the only way to break
*inflationary psychology and stabilize the economy.
– However, if the exchange-rate targeting regimes in
emerging market countries are not transparent, they
are more likely to break down, often resulting in
disastrous financial crises.

Currency Boards
• Solution to lack of transparency and commitment to target.
• Domestic currency is backed 100% by a foreign currency.
• Note issuing authority establishes a fixed exchange rate and
stands ready to exchange currency at this rate.
• Money supply can expand only when foreign currency is
exchanged for domestic currency.
• Stronger commitment by central bank.
• Loss of independent monetary policy and increased
exposure to shock from anchor country.
• Loss of ability to create money and act as lender of last
resort.
Currency Boards
• In addition, if a speculative attack on a currency board
occurs, the exchange of domestic currency for foreign
currency leads to a sharp contraction of the money supply,

Global: Argentina’s Currency Board
• The currency board experiment in Argentina was initially a
stunning success, with inflation falling from 800% in 1990
to less than 5% in 1994.
• Due to the long-term weakness in Argentine exports and
bad timing, the currency board ultimately ended in
widespread violence and bloodshed in January 2002.

Dollarization
• Another solution to lack of transparency and commitment
• Adoption of another country’s money
• Even stronger commitment mechanism
• Completely avoids possibility of speculative attack on
domestic currency
• Lost of independent monetary policy and increased
exposure to shocks from anchor country
• Inability to create money and act as lender of last resort
• Loss of *seignorage (refers to the profit made by a
government when it issues currency. It loses the revenue
that a government receives by issuing money)

Mishkin Econ12eGE CH19

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Mishkin Econ12eGE CH19

Uploaded by

Copyright:

Available Formats

The Economics of Money, Banking, and

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Federal Reserve System Blank Blank Blank

Federal Reserve System Blank Blank Blank

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

- An unsterilized intervention in which domestic currency is

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Federal Reserve System Blank Blank Blank

Assets Blank Liabilities Blank

Foreign Assets Monetary Base

• To counter the effect of the foreign exchange intervention,

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

• Refer to pg. 514-515 in textbook

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

Copyright © 2019 Pearson Education, Ltd.

You might also like