Week 8: International Financial System Flashcards
If central banks sells $1bn of foreign assets to buy domestic currency. 2 ways to pay for the domestic currency
- What happens to monetary base?
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
- Monetary base = currency + reserves
So fall in either causes a fall in monetary base
Monetary base
Currency in circulation + reserves
MB=C+R
What causes a fall in international reserves and monetary base?
Selling foreign assets and buying domestic currency
(as shown in example)
What causes a rise in international reserves and monetary base?
Selling domestic currency to buy foreign assets
(Opposite of previous)
Unsterilised foreign exchange intervention
If sale or purchase of domestic currency has an effect on the monetary base and exchange rate
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?
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.
Sterilised foreign exchange intervention
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)
Gold standard exchange rate (2)
Fixed to gold
No control over monetary policy (since supply is ultimately fixed)
Bretton Woods system (2)
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)
Bretton Woods system characteristics (5)
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
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?
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
Pg 15: intervention under fixed exchange rate
A) if overvalued (fixed value is above true value)
B) if undervalued
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)
Policy trilemma - what are 3 choices (only allowed 2)
Fixed exchange rate
Independent monetary policy
Free capital mobility
Consider capital mobility:
Reasons against controls on capital outflows (moving funds abroad) (4)
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
Cons on controls on capital inflows (4)
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
What does this imply need for
Improved bank regulation and supervision
Monetary approach to BoP and ER:
What causes a BoP deficit and surplus under fixed ER
A BoP surplus - excess stock of money demanded.
Deficit - excess money supplied.
Are surpluses/deficits permanent?
No, surplus/deficits are temporary and self correcting in long run.
Does the nation have control over money supply under fixed E.R
No, only the currency reserve nation, not the nation itself.
Assumptions for demand for money (2)
Demand positively linked with income
Stable in long run
Demand for money equation
Md = kPy
k=1/v
Equation for money supply
Ms = m(D+F)
m = money multiplier
D = domestic component of base
F = international component of monetary base (international reserves)
D+F = monetary base
How can F be changed (important)
- Under fractional reserve banking, what does an additional dollar of D or F deposited cause
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)
- Increase in money supply of m(D+F)
What can influence Md, and why?
D and F
As in equilibrium Md = Ms.
What if D increases and Md remains unchanged?
F must’ve fallen
Since Md = Ms = m(D+F)
Conclusive questions under fixed exchange rates:
1. What does excess demand for money lead to, and how does it equalibrilise?
- What does excess money supply lead to, and how does it equalibrilise
- BoP surplus - more inflows>outflows so increase in F, increase Ms by the same amount (Md=Ms)
- BoP deficit (outflow>inflow so sell existing reserves to fund deficit) which reduces excess supply of money.
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?
Money multiplier formula
M = 1/legal reserve requirement
What happens to BoP disequilibriums under flexible exchange rates according to the “monetary approach”
GOOD REASONING ON FINAL PARA (suppose excess supply)
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
Does country control money supply and monetary policy under flexible ER
Yes, unlike fixed
A deficit in BoP
A surplus in BoP
Explain how equalibrilised in both situations
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)
Difference between fixed and flexible
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.
According to the monetary approach - what causes depreciation and appreciation
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)
A country with greater inflation will find its currency
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
Portfolio balance model - what do they say exchange rate is determined by? (3)
Exchange rate determined by money supply and demand (as in the monetary approach to BoP and ER)
But also inflation expectations and expected changes.
Portfolio balance model vs monetary approach
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
What makes domestic and foreign bonds imperfect subs? Why do they make this assumption violating the monetary approach ?
Domestic investors require a higher return to compensate risk of holding foreign bonds. (FER)
(Hold foreign bonds if wealthier, or better return)
Extended portfolio balance model, compare uncovered interest parity (Monetary approach to exchange rates).
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.
What are money demand, domestic bond demand, foreign bonds demand functions of ? (6)
Interest rate (both home&foreign)
Expected appreciation
Risk premium
Income
Price
Wealth
Money demand relationships with those functions
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)
Domestic bond demand relationship with those functions
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
Foreign bond demand relationship with those functions
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
Exchange rate overshooting
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
Why are models like the monetary approach and portfolio balance approach unsuccessful in predicting future exchange rates? (2)
Exchange rates are highly influenced by new info (unpredictable)
Expectations - are self fulfilling in SR. (Lead to bubbles, contrasting theory expectations)
