Week 8: International Financial System

Question 1

If central banks sells $1bn of foreign assets to buy domestic currency. 2 ways to pay for the domestic currency

2. What happens to monetary base?

Answer 1

Assets fall (Foreign assets/int reserves) fall by $1bn,

We can pay for domestic currency by:
Currency - fall by $1bn too
Or
Deposits with the Fed i.e reserves - fall by $1bn too

2. Monetary base = currency + reserves
   So fall in either causes a fall in monetary base

Question 2

Monetary base

Answer 2

Currency in circulation + reserves

MB=C+R

Question 3

What causes a fall in international reserves and monetary base?

Answer 3

Selling foreign assets and buying domestic currency

(as shown in example)

Question 4

What causes a rise in international reserves and monetary base?

Answer 4

Selling domestic currency to buy foreign assets

(Opposite of previous)

Question 5

Unsterilised foreign exchange intervention

Answer 5

If sale or purchase of domestic currency has an effect on the monetary base and exchange rate

Question 6

Scenario: Pg 7

Unsterilised purchase of dollars and sale of foreign assets

Effect on reserves, monetary base+supply, interest rates, exchange rate.

What’s does this look like on diagram?

Answer 6

Buying domestic currency:
Fall in reserves, money base and supply
Rising interest rates (since Ms falls)
Appreciation

Shown in diagram by shift upwards in demand for dollars.

Question 7

Sterilised foreign exchange intervention

Answer 7

CB intervene with open market operations to leave monetary base and exchange rate unaffected

E.g if selling foreign assets and buying domestic (causes a fall in Mb) , intervene by open market purchase (Fed buys bonds) which increases reserves and MB (C+R)

Question 8

Gold standard exchange rate (2)

Answer 8

Fixed to gold
No control over monetary policy (since supply is ultimately fixed)

Question 9

Bretton Woods system (2)

Answer 9

Fixed exchange rates - only adjust if disequilibrium (persistent BoP deficit)

Use US dollar as reserve currency

Also created IMF, World bank, and
General Agreement on Tariffs And Trade (GATT)

Question 10

Bretton Woods system characteristics (5)

Answer 10

Loans from IMF to cover loss in international reserves

IMF encouraged contractionary monetary policy

Devaluation only if IMF loans insufficient

No tools for surplus countries (since only adjust if bop deficit)

US cannot devalue currency

Question 11

How does a fixed exchange rate work:

A) an overvaluation in domestic currency, 2 ways

B) an undervaluation in domestic currency, 2 ways

Also what is the one important thing to add for one of the methods?

Answer 11

A) CB must purchase domestic currency to keep rate fixed at the new rate, but in doing so loses international reserves (since pays using currency or reserves!)

Or

Conduct a devaluation

B) Sell domestic currency meet lower rate which GAINS INTERNATIONAL RESERVES, or conduct revaluation

Question 12

Pg 15: intervention under fixed exchange rate

A) if overvalued (fixed value is above true value)

B) if undervalued

Answer 12

Graph a)
Domestic currency is overvalued at Epar, so buy domestic currency to meet new fixed rate.
(loses international reserves, since sell foreign reserves to buy domestic currency. Could also mention how fall in Mb and Ms increase interest thus increasing demand for our currency causing the appreciation to the new fixed rate!)

Graph b)
Keep at Epar by selling currency to lower interest rate, reduce demand for currency and depreciate it.
(And increases international reserves)

Question 13

Policy trilemma - what are 3 choices (only allowed 2)

Answer 13

Fixed exchange rate

Independent monetary policy

Free capital mobility

Question 14

Consider capital mobility:

Reasons against controls on capital outflows (moving funds abroad) (4)

Answer 14

Promote instability by forcing devaluation (since supplying pounds)

Rarely effective, can increase capital flight (people move their money out if lose confidence)

Corruption

Lose opportunity to improve economy

Question 15

Cons on controls on capital inflows (4)

Answer 15

Can lead to lending boom (excessive risk taking)

May block funds for production uses (domestic firms may not get the investments desired)

Distort and misallocate

Corruption

Question 16

What does this imply need for

Answer 16

Improved bank regulation and supervision

Question 17

Monetary approach to BoP and ER:

What causes a BoP deficit and surplus under fixed ER

Answer 17

A BoP surplus - excess stock of money demanded.

Deficit - excess money supplied.

Question 18

Are surpluses/deficits permanent?

Answer 18

No, surplus/deficits are temporary and self correcting in long run.

Question 19

Does the nation have control over money supply under fixed E.R

Answer 19

No, only the currency reserve nation, not the nation itself.

Question 20

Assumptions for demand for money (2)

Answer 20

Demand positively linked with income

Stable in long run

Question 21

Demand for money equation

Answer 21

Md = kPy

k=1/v

Question 22

Equation for money supply

Answer 22

Ms = m(D+F)

m = money multiplier
D = domestic component of base
F = international component of monetary base (international reserves)
D+F = monetary base

Question 23

How can F be changed (important)

2. Under fractional reserve banking, what does an additional dollar of D or F deposited cause

Answer 23

Through BoP surplus/deficits
e.g BOP surplus means inflows>outflows , so increased international reserves.

For a deficit more going out so CB sells existing reserves to finance the deficit. (F falls)

2. Increase in money supply of m(D+F)

Question 24

What can influence Md, and why?

Answer 24

D and F

As in equilibrium Md = Ms.

Question 25

What if D increases and Md remains unchanged?

Answer 25

F must’ve fallen

Since Md = Ms = m(D+F)

Question 26

Conclusive questions under fixed exchange rates:
1. What does excess demand for money lead to, and how does it equalibrilise?

2. What does excess money supply lead to, and how does it equalibrilise

Answer 26

1. BoP surplus - more inflows>outflows so increase in F, increase Ms by the same amount (Md=Ms)
2. BoP deficit (outflow>inflow so sell existing reserves to fund deficit) which reduces excess supply of money.

Question 27

Suppose that the velocity of circulation of money is V = 5 and nominal GDP is $200 billion.
a. What is the quantity of money demanded?
b. How much will the quantity of money demanded rise if the nation’s nominal GDP rises to $220 billions?
c. What happens to the nation’s demand for money if its nominal GDPincreases by 10% each year?

Question 28

Money multiplier formula

Answer 28

M = 1/legal reserve requirement

Question 29

What happens to BoP disequilibriums under flexible exchange rates according to the “monetary approach”

GOOD REASONING ON FINAL PARA (suppose excess supply)

Answer 29

Bop disequilibrium immediately corrected by automatic changes without moving currency or reserves.

Automatically corrected: e.g if excess money supply, it makes interest rates lower so less attractive causing depreciation, making exports cheaper thus so prices and demand for money rises until Md increases to Md = Ms where corrected

Question 30

Does country control money supply and monetary policy under flexible ER

Answer 30

Yes, unlike fixed

Question 31

A deficit in BoP
A surplus in BoP

Explain how equalibrilised in both situations

Answer 31

Deficit - excess money supply makes interest rates lower so less attractive causing depreciation, making exports cheaper thus so prices and demand for money rises until Md increases to Md = Ms where corrected

Surplus - means excess money demand so causes automatic appreciation (SPICED - exports become more expensive, so prices fall and demand for money fall)

Question 32

Difference between fixed and flexible

Answer 32

Under fixed exchange rates, BoP disequilibrium results from an international flow of money or reserves. (Excess money demand or supply)

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

Question 33

According to the monetary approach - what causes depreciation and appreciation

Answer 33

Currency depreciation results from excessive money growth. (So money supply - lowers interest > so on)

Currency appreciation results from inadequate money growth (excess demand i.e not enough supply)

Question 34

A country with greater inflation will find its currency

Answer 34

Depreciating, since it means excessive monetary supply (primary cause of inflation).

(Simple, more inflation also means we supply our currency to buy foreign goods, so our currency depreciates. Eventually WPIDEC means imports become more expensive and so eliminates BoP deficit

Question 35

Portfolio balance model - what do they say exchange rate is determined by? (3)

Answer 35

Exchange rate determined by money supply and demand (as in the monetary approach to BoP and ER)

But also inflation expectations and expected changes.

Question 36

Portfolio balance model vs monetary approach

Answer 36

Domestic and foreign bonds are imperfect subs - more realistic (unlike monetary approach which assumes perfect subs).

E.g Investors demand foreign assets if higher rates or if wealthier, depreciating the domestic currency.
Likewise, selling foreign bonds depreciate foreign currency, appreciating domestic currency

Monetary approach assumes perfect subs i.e i - i* = EA
EA is expected appreciation of foreign curren y

Question 37

What makes domestic and foreign bonds imperfect subs? Why do they make this assumption violating the monetary approach ?

Answer 37

Domestic investors require a higher return to compensate risk of holding foreign bonds. (FER)

(Hold foreign bonds if wealthier, or better return)

Question 38

Extended portfolio balance model, compare uncovered interest parity (Monetary approach to exchange rates).

Answer 38

Uncovered interest parity condition (Monetary)
i-i* = EA

Since dom and for bonds are imperfect

i-i*= EA - RP

RP risk premium for holding the foreign bond.

Question 39

What are money demand, domestic bond demand, foreign bonds demand functions of ? (6)

Answer 39

Interest rate (both home&foreign)
Expected appreciation
Risk premium
Income
Price
Wealth

Question 40

Money demand relationships with those functions

Answer 40

Domestic interest rate - negative rel (since opp. cost of holding money in hand increases)

Foreign interest rate - negative rel (same reason as above, could invest in foreign bonds rather than hold in cash)

Expected appreciation of foreign currency - negative rel (want to hold more foreign)

RP of foreign bond- positive rel (signifies greater risk, so keep money safe in domestic assets, or cash in this case!)

Income - positive rel

Price - positive rel (high price low interest so low opp cost)

Wealth - positive rel

(First 3 neg rest 5 pos TO REMEMBER)

Question 41

Domestic bond demand relationship with those functions

Answer 41

Domestic interest rate - positive rel

Foreign interest rate - negative rel

Expected appreciation of foreign currency - negative rel (foreign more attractive)

RP - positive rel (signifies foreign more risky so avoid)

Income - neg rel (invest in higher return investments instead of bonds)

Price - neg rel (p high yield low so demand less)

Wealth - positive rel

Question 42

Foreign bond demand relationship with those functions

Answer 42

Domestic interest rate - negative rel

Foreign interest rate - positive rel

Expected appreciation of foreign currency - positive rel

RP - negative rel (higher risk premium makes more expensive)

Income - neg rel (invest in higher return investments instead of bonds)

Price - neg rel (price-yield relationship, p high yield low so demand less)

Wealth - positive rel

Question 43

Exchange rate overshooting

Answer 43

Stock adjustments (in this portfolio balance model) are quick compared to flows, so exchange rate must overshoot past its long run equilibrium to reestablish equilibrium

Question 44

Why are models like the monetary approach and portfolio balance approach unsuccessful in predicting future exchange rates? (2)

Answer 44

Exchange rates are highly influenced by new info (unpredictable)

Expectations - are self fulfilling in SR. (Lead to bubbles, contrasting theory expectations)