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Chapter Thirteen

Chapter Thirteen. The International Financial System. Exchange Market Intervention. Unsterilized:. Results: International reserves, +1 billion Monetary base, +1 billion Then analysis in figure 13-1, E t  . Exchange Market Intervention. Sterilized:. Results:

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Chapter Thirteen

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  1. Chapter Thirteen The International Financial System

  2. Exchange Market Intervention • Unsterilized: • Results: • International reserves, +1 billion • Monetary base, +1 billion • Then analysis in figure 13-1, Et 

  3. Exchange Market Intervention • Sterilized: • Results: • International reserves, +1 billion • Monetary base unchanged • Et unchanged: no shift in RD and RF

  4. Exchange Rate Intervention, Sell $ • Sell $, buy F: MB, Ms • Ms, P, Eet+1, expected appreciation of F, RF shifts right in Fig. 1 • Ms, iD, RD shifts left, go to point 2 and Et • In long run, iD returns to old level, RD shifts back, go to point 3 • Exchange rate overshooting Figure 13-1:Effect of a Sale of Dollars and a Purchase of Foreign Assets

  5. The Balance of Payments Exchange rates, balance of payment, and trade data http://www.stls.frb.org/fred/data/exchange.html

  6. The Gold Standard • Currency convertible into gold at fixed value • Example of how it worked: • U.S.: $20 convert into 1 ounce of gold • U.K.: £4 convert into 1 ounce of gold • Par value of 1£ = $5.00 • If £ to $5.25, importer of £100 of tweed has two alternatives: • Pay $525 • Buy $500 gold (500/20 = 25 ounces), ship to U.K., convert into £100 (= 25 £4) and buy tweed

  7. The Gold Standard • If shipping is cheap, do alternative 2 • Gold flows to U.K. • MB  in U.K, MB  in U.S. • Price level  U.K.,  U.S. • £ depreciates back to par • Two problems • Country on gold standard loses control of Ms • World inflation determined by gold production

  8. Fixed Exchange Rate Systems • Bretton Woods • Fixed exchange rates • Other central banks keep exchange rates fixed to $: $ is reserve currency • $ convertible into gold for central banks only ($35 per ounce) • International Monetary Fund (IMF) sets rules and provides loans to deficit countries • World Bank makes loans to developing countries

  9. Fixed Exchange Rate Systems • European Monetary System • Value of currency not allowed outside "snake" • New currency unit: ECU • Exchange Rate Mechanism (ERM) • Key weakness of fixed rate system • Asymmetry: pressure on deficit countries losing international reserves to Ms, but no pressure on surplus countries to Ms

  10. Intervention in a Fixed Exchange Rate System Figure 13-2:Intervention in the Foreign Exchange Market under a Fixed Exchange Rate Regime

  11. Analysis of Figure 13-2: Intervention in a Fixed Exchange Rate System • Since Eet+1 = Epar with fixed exchange rate, RFdoesn't shift • Overvalued exchange rate (panel a) • Central bank sells international reserves to buy domestic currency • MB, Ms, iD, RD shifts to right to get to point 2 • If don't do this have to devalue

  12. Analysis of Figure 13-2: Intervention in a Fixed Exchange Rate System • Undervalued exchange rate (panel b) • Central bank sells domestic currency and buys international reserves • MB, Ms, iD, RD shifts to left to get to point 2 • If don't do this have to revalue

  13. Exchange Rate Crisis of September 1992 • At Epar, RF right of RD because Bundesbank tight money keeps German interest rates high • Bank of England buys £, iD, RD shifts right • When speculators expect devaluation, Eet+1, RF shifts right • Requires much bigger intervention • When UK pulls out of ERM, £  10%, big losses to central bank Figure 13-3:Foreign Exchange Market for British Pounds in 1992

  14. Profiting from a FX Crisis • September 1992, £ overvalued • Once traders know central banks can't intervene enough, £ only head one direction,  • One-sided bet, "heads I win, tails I win" • Traders sell £, buy DM • £  10% after September 16 • Citibank makes $200 million • Soros makes $1 billion

  15. International Financial Architecture • Capital Controls • Controls on outflows unlikely to work • Controls on inflows may prevent lending boom and financial crisis, but cause distortions • Role of IMF • There is a need for international lender of last resort (ILLR) and IMF has played this role • ILLR creates moral hazard problem • IMF needs to limit moral hazard • Lend only to countries with good bank supervision • Need to do ILLR role fast and infrequently

  16. Monetary Policy: International Considerations • Direct Effects of FX market • When intervene, MB changes • Balance of Payments Considerations • When B of P is in deficit need Ms • Exchange Rate Considerations • When want lower E, need Ms

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