Topic 14 - International Financial System

• Monetary model of exchange rate


  How it works

  
• Unsterilized foreign exchange intervention


  Effect on money supply, international reserves, and exchange rate

  
• Sterilized foreign exchange intervention

  Effect on money supply and exchange rate

  
• Fixed exchange rate regime


  Value of currency pegged to another currency

  
• Floating exchange rate regime


  Value of currency allowed to fluctuate
• Managed float regime


  Attempt to influence exchange rates by buying and selling currencies
• Gold standard


  Fixed exchange rates, no control over monetary policy, influenced by gold production
• Bretton Woods System

  Fixed exchange rates using U.S. dollar as reserve currency, role of IMF and World Bank
• How the Bretton Woods System worked


  Exchange rate adjustments, IMF loans, devaluation, lack of tools for surplus countries, U.S. unable to devalue
• How a fixed exchange rate regime works

  Central bank actions when domestic currency is overvalued or undervalued
• Intervention in the foreign exchange market under a fixed exchange rate regime


  Central bank actions to maintain the fixed exchange rate

  
• Policy trilemma


  Relationship between capital controls, monetary policy, and exchange rate regime

  
• Monetary approach to the balance of payments


  Views the balance of payments as a monetary phenomenon
• Demand for money


  Factors that determine the demand for nominal money balances
• Supply of money


  Factors that determine the money supply
• Equilibrium in the money market


  Conditions for equilibrium, effects of changes in money demand and supply
• Monetary approach to the balance of payments and exchange rates

  Under flexible exchange rates, balance of payments disequilibria are immediately corrected by automatic changes in exchange rates without international flow of money or reserves. Nation retains dominant control over its money supply and monetary policy. Adjustment occurs as result of the change in domestic prices accompanying the change in exchange rate.

  
• Monetary approach to the balance of payments and exchange rates

  Under fixed exchange rates, balance of payments disequilibrium results from an international flow of money or reserves

  
• Monetary approach to the balance of payments and exchange rates


  Under flexible exchange rate systems, a balance of payments disequilibrium is immediately corrected by an automatic change in exchange rates and without international flow of money or reserves

  
• Monetary approach to the balance of payments and exchange rates


  A currency depreciation results from excessive money growth in the nation over time. A currency appreciation results from inadequate money growth in the nation. A country facing greater inflationary pressure compared to others, will find its currency depreciating.

  
• Portfolio balance model and exchange rates

  The exchange rate is determined not only by the relative growth of money supply and money demand but also by inflation expectations and expected changes. As long as domestic and foreign bonds are assumed to be perfect substitutes, (i-i*) = EA, where EA is the expected appreciation of the foreign currency.

  
• Portfolio balance model and exchange rates

  The portfolio approach assumes domestic and foreign bonds are imperfect substitutes. The exchange rate is determined in the process of equilibrating or balancing the stock or total demand and supply of financial assets (of which money is only one) in each country.

  
• Portfolio balance model and exchange rates

  If investors demand more of a foreign asset, either because of higher relative foreign interest rates or increased wealth, demand for foreign currency will increase, depreciating domestic currency. If investors sell foreign assets, either because of lower relative foreign interest rates or decreased wealth, supply of foreign currency will increase, appreciating domestic currency.

  
• Portfolio balance model and exchange rates

  Domestic and foreign bonds are assumed to be imperfect substitutes; domestic investors require a higher return to compensate for the risk of holding foreign bonds. The exchange rate is determined in the process of reaching equilibrium in each financial market.

  
• Extended portfolio balance model

  (i-i*) =EA - RP, where RP is the risk premium on holding the foreign bond.
• Extended demand functions

  M = f(i, i*, EA, RP, Y, P, W) (money demand)

  D = f(i, i*, EA, RP, Y, P, W) (domestic bond demand)

  F = f(i, i*, EA, RP, Y, P, W) (foreign bond demand)

  where Y is income, P is the price level, and W is wealth.
• Exchange rate dynamics


  Exchange rate overshooting: Stock adjustments in financial assets are usually much larger and quicker to occur than adjustments in trade flows. Most of the burden of adjustments in exchange rates comes from financial markets in short run. Thus, exchange rate must overshoot or bypass its long run equilibrium level for equilibrium to be quickly reestablished in financial markets.

  
• Models of exchange rates have not been very successful at predicting future exchange rates. Reasons: Exchange rates are highly influenced by new information. Expectations in exchange rate markets tend to be self-fulfilling (at least in the short-run). This may lead to speculative bubbles, generate movements in the market contrary to what is expected by theory.

  
• The Euro/Dollar Exchange Rate since the Introduction of the Euro has defied forecasts.