Ch18 (8th edition) THE INTERNATIONAL FINANCIAL SYSTEM

--(Note: In the 6th edition (Study guide) this chapter coverage is found in 2 chapters—Mish6ed_ch19_StGuide_019.pdf and Mish6ed_ch20_StGuide_020.pdf

--(Note: Be sure to study the sample questions from Study guide to chapter 17 in new 9ed edition: the document is named: Mish9ed_c18_SGALLwANS_018.pdf

--(In this 9th edition there is only a small change in the text, an additional half page titled “Global The Subprime Financial Crisis and the IMF” and found in another reading named “Mish9ed_c18_TXTnewIMFsubpriNSGSum.pdf”

-Read text material, pages 463-490

-End of Chapter Questions: pp.488-489

-EndChKeyQs: Key Questions are

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NOTES:

=This chapter shows why international financial transactions have important implications for the conduct of monetary policy. This is also true for the structure of the international financial system.

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pp.459-463

**INTERVENTION IN THE FOREIGN EXCHANGE MARKET—Central Banks:

=The beginning of the chapter explains how foreign exchange market CENTRAL BANK INTERVENTION affects both the exchange rate, a country’s international reserves, and the money supply.

--“International Reserves”: holdings of the Central Bank of assets denominated in foreign currencies.

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*UNSTERILIZEDForeign ExchangeIntervention(p.462)

=> ”Unsterilized”This means that thecentral bank’s foreign exchange interventionleads to a equalchange (down or up) of the monetary base (MB):

--(a) Lower MBase: A central bank’s PURCHASE of domestic currency and CORRESPONDING SALE of foreign assets in the foreign exchange market leads to an EQUAL DECLINE in its international reserves and the monetary base

-------See the T-accounts on pages 460-461 to show this equivalency (does not matter whether the central bank buys currency or bank deposits, the effect on monetary base is the same in both cases)

-------Note that the effect on the monetary base is the same in this case as when the central bank sold domestic assets (bonds); the monetary base declines (less currency or deposits with the central bank are held by banking system)

--(b) Rise in MBase: 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

-------This is just the opposite of the intervention in that above (a)

-------The monetary base rises by this same amount (more currency, or deposits held by banking system)

--(c) So, an UNSTERILIZED INTERVENTION (by Central Bank) 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

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*STERILIZED FOREIGN EXCHANGE INTERVENTION(p.463)

=> “sterilized”This means that when the central bank buys or sells foreign assets to sell or buy domestic currency (or deposits), it offsets the net effect on the monetary base by selling or buying domestic bonds (‘open market operations’ by the FED in the U.S.).

--So, to counter (counteract, or ‘offset’) the effect of the foreign exchange intervention, conduct an offsetting open market operation

--Then, there is no effect on the monetary base and no effect on the exchange rate

--e.g. The Central bank sells foreign assets and then buys domestic currency and then to sterilize this decline in the monetary base it offsets this effect by buying a domestic bondwith domestic currency, thus leaving the Monetary Base unchanged.

--------See the T-account on the bottom of page 461 for the changes to the balance sheet of the US central bank, the Fed that shows the results of the initial purchase of currency and then the sale of the same amount.

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p.462

*UNSTERILIZED Intervention

--An unsterilized intervention in which domestic currency is sold to purchase foreign assetsleads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

--------e.g. See results of this in the dollar-denominated asset market in Fig.1, p. 462 (and notice that the intervention produces essentially identical results seen in Chapter 17, Fig.8 (then, it was the effect of an increase in the money supply, by, for example the purchase of domestic bonds with currency by the central bank; now it is almost the same although foreign assets are the source (their sale) )

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*STERILIZED Foreign Exchange Intervention(p.463)

--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

--(NOTE: This analysis ignores the effect of this sterilization on the ratio of domestic securities to foreign securities (the so-called ‘portfolio balance effect’) that could in theory have an impact on some variables or expectations, but the text leaves aside this complication noting that empirical work indicates that the effect is minimal if anything, and adds that the size of the US asset market is so great that any effect would be a raindrop in the ocean. See footnote, p. 463)

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pp.464

The chapter then discusses the balance of payments, a technical issue, but with a discussion of (the box on page 465, 8th ed.) on why large current account deficits worry economists.

*BALANCE OF PAYMENTS

--Current Account

--------International transactions that involve currently produced goods and services

--------Trade Balance {= merchandise or goods trade balance = (exports – imports)

-------------if exports < imports of goods, then there is a trade deficit

---------Other Items: Net receipts from (i) investment services, (ii) services transactions, (iii) net transfers

---Total Current account balance:

------------- = (goods & services exported)-(goods & services imported)

------------- if this balance is negative (it’s a Current Account Deficit);

------------- if this balance is positive (it’s a Current Account Surplus)

--Capital Account

--------Net receipts from all capital {financial, monetary) transactions (purchases of stocks, bonds, bank loans, etc.)

--BOTH together: the Sum of these two (Current + Capital Accounts) is the official reserve transactions balance( = net change in government international reserves)

p.465

‘Global: Why Current Account Deficit worries economists (and humans too! ;-)

--The deficit is one of trade imbalance and the country with the deficit has to pay for this excess consumption/purchases by borrowing somehow.

--The danger comes from persistent deficits, where one country is continuously borrowing. At some point borrowing may be impossible and then the adjustment (in both financing and perhaps trade also) may be very disruptive of markets and even develop into a major crisis, depending on the balance sheets of the private sector companies and banks involved in the borrowing processes.

--In theory, the exchange rate can change to help bring about a balancing of trade (the current account deficit country’s currency depreciates allowing it to increase its exports and tending to reduce its imports; or on the other side, the surplus country’s currency could appreciate; or both together [actually one implies the other]). However, this does not always work smoothly or quickly so that imbalances can lead to international crises (working their mayhem through debt crises, banking crises, currency crises) involving sudden movements in financial/monetary variables due to markets seizing up or agents’ defaults, etc.).

--{Rock: Keynes recognized this problem and worked hard to convince the US representatives to ‘Bretton Woods’ negotiations from 1943-45 to consider a mechanism to deal with the problem of both persistent trade deficit countries (and the other side of the coin) the trade surplus countries. He wanted incentives as well as punitive measures to be established to deal with this ‘IMBALANCE’ problem of the modern world of trade and money/credit/finance/currencies. He even proposed an international currency that could have helped deal (in part) with the ‘imbalance persistence problem’.}

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pp.465-

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*Basic Types of EXCHANGE RATE REGIMES (methods of dealing with Exchange Rates)

--(I) FIXED exchange rate regime

--------Value of a currency is pegged relative to the value of one other currency (anchor currency) or to a weighted ‘basket’ of currencies (several, often representing one’s main trade partners)

---------Alternative is fixing one’s currency to the currency (a ‘major’ international currency) and promising not to remove this single ‘anchor’

--(II) FLOATING exchange rate regime

--------Value of a currency is allowed to fluctuate against all other currencies

--------Sometimes referred to as ‘free’ of fully ‘liberalized’ exchange rate—effectively the exchange rate for one’scurrency is set by buyers and sellers of it in markets alone.

--(III) MANAGED FLOATregime(sometimes referred to as a‘dirty float)

--------Attempting toinfluence exchange rates by buying and selling currencies (central bank)

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The chapter then goes on to discuss the historical evolution of the international financial systemwith a more detailed analysis of different ‘regimes’ for exchange rates that have been practiced by countries.

pp.465-467

*PAST EXCHANGE RATE REGIMES

--Gold standard

--------Fixed exchange rates (since money linked to gold; but linkage/ratio could be changed by countries)

--------No control over monetary policy (banks depended on their issued banknotes being backed by gold so bullion, in effect acted as a sort of fundamental ‘monetary base’)

--------Influenced heavily by production of gold and gold discoveries (money restricted in being issued by current supplies of gold….led to movements to add other precious metals to bank reserves, like silver {e.g. movement of western US farmers in late 1800s to remove this ‘cross of gold’ that appeared to be a crucifix that was killing their opportunities)

--------At end of gold system (i.e. 1700s & 1800s; finally ending ca. 1913-1931) the British pound had become a sort of de facto international currency accepted nearly everywhere, since the British had trade surpluses until the 20th century and recycled much of their surplus into international investments (e.g. lending for mining, resource exploitation) and colonial activities.

--Bretton Woods System (1944 to Present)

--------Fixed exchange rates using U.S. dollar as reserve currency until 1970s (fixed rates) and with US dollars convertible into gold (by central banks, governments) but this gold-connection feature ended in 1971.

--------International Monetary Fund (IMF) as international lender of last resort for countries (originally to promote trade via rules for fixed exchange rates; also to help countries with loans when in balance of payments difficulties (deficits)).

-------Floating rates, began in 1970s and became standard practice by most major currencies by 1990s

--World Bank (Int’l. Bank for Reconstruction and Development; for post WW II rebuilding; then for ‘developing countries’ lending)

--General Agreement on Tariffs and Trade (GATT) (Mechanism to negotiate lower tariffs and reduced non-tariff barriers to international trade)

--World Trade Organization (1994-on; replaced GATT and added Enforcement mechanisms)

--EUROPE:

----European MonetarySystem (1979-1990)

--------Exchange rate mechanism (ERM) although in practice the members pegged their currencies to the very stable German (Deutsch) Mark.

--------Britain’s (and others’) currency overvalued by early 1990s and came under attack by financial investors, some of whom made billions by betting against the UK pound

EU and creation of the Eurozone and the Euro and the European Central Bank (ECB)

----Euro, ECB, and Maastricht Treaty of late 1980s put this into action

-------Euro currency introduced in 1999 (no more foreign exchange rates among the 17 members since all used a common currency, the ‘euro’.)

----Euro currency is common, but each of the 17 countries has a separate fiscal system (taxes and spending are national) while monetary policy is unified (with the highly independent ECB

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Then is a section on: how fixed exchange rate systems work.

pp.467-470

*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

--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

Fig. 2, p. 468: