11

The International Financial System

Chapter 18

Intervention in the FX MarketIntervention in the FX Market

22

What can a CB do to raise the value of the domestic currency?What can a CB do to raise the value of the domestic currency?

Demand domestic currency in the FX market.Demand domestic currency in the FX market.

What can a CB do to lower the value of the domestic currency?What can a CB do to lower the value of the domestic currency?

Demand international reserves in the FX market.Demand international reserves in the FX market.

International ReservesInternational Reserves Monetary BaseMonetary Base

FEDFED To raise the value of the currency the Fed To raise the value of the currency the Fed has to buy USD with international reserves has to buy USD with international reserves it has: both entries will be negative.it has: both entries will be negative.

To lower the value of the domestic currency, To lower the value of the domestic currency, the Fed has to buy international reserves the Fed has to buy international reserves with USD: both entries will be positive.with USD: both entries will be positive.

Sterilized InterventionSterilized Intervention

33

No change in MB.No change in MB.

International Reserves - $1 millionInternational Reserves - $1 millionSecurities + $1 millionSecurities + $1 million

Monetary Base 0Monetary Base 0

ΔΔMB = 0; MB = 0; ΔΔM = 0; M = 0; ΔΔi = 0; i = 0; ΔΔ(€/$) = 0(€/$) = 0

Unsterilized InterventionUnsterilized Intervention

44

International Reserves + International Reserves +

Monetary Base +Monetary Base +

Int’l Res + => MB + => Ms + => i - ; Int’l Res + => MB + => Ms + => i - ; ππ expexp + => €/$ - + => €/$ - but Y + and P + will raise Md + => i + => €/$ + but Y + and P + will raise Md + => i + => €/$ +

€€/$ /$

USDUSD

An effort to keep the An effort to keep the domestic currency value domestic currency value low (to support exports) is low (to support exports) is inflationary.inflationary.

Unsterilized InterventionUnsterilized Intervention

55

International Reserves -International Reserves - Monetary Base -Monetary Base -

Int’l Res - => MB - => Ms - => i + ; P - => €/$ +Int’l Res - => MB - => Ms - => i + ; P - => €/$ +

€€/$ /$

USDUSD

66

77

Fixed Exchange RegimeFixed Exchange Regime

88

If the market exchange rate diverges from the fixed exchange rate because of If the market exchange rate diverges from the fixed exchange rate because of inflation or interest rate or expectations, central bank will enter the picture.inflation or interest rate or expectations, central bank will enter the picture.

If the fixed exchange rate €/$ is If the fixed exchange rate €/$ is higher than the current rate, the higher than the current rate, the Fed will have to buy USD by using Fed will have to buy USD by using €. Fed loses international reserves.€. Fed loses international reserves.

If the fixed exchange rate €/$ is If the fixed exchange rate €/$ is lower than the current rate, the Fed lower than the current rate, the Fed will have to buy € using USD. Fed will have to buy € using USD. Fed gains international reserves.gains international reserves.

Blue broken line Blue broken line is the E-par.is the E-par.

Pegging Yuan to USDPegging Yuan to USD

99

Productivity and lower inflation rate requires appreciation of yuan.Productivity and lower inflation rate requires appreciation of yuan.Keeping yuan low (pegging to USD at 12 cents to the yuan meant the Keeping yuan low (pegging to USD at 12 cents to the yuan meant the Chinese had to buy a lot of USD assets.Chinese had to buy a lot of USD assets.

The Foreign exchange reserves of the People's The Foreign exchange reserves of the People's Republic of China are mainly composed of US dollar in Republic of China are mainly composed of US dollar in the forms of US government bonds and institutional the forms of US government bonds and institutional bonds, and excludes reserves held by Hong Kong and bonds, and excludes reserves held by Hong Kong and Macau. As of the end of March 2011, the reserve holds Macau. As of the end of March 2011, the reserve holds $3.0447 trillion.$3.0447 trillion.

Low yuan means it is almost impossible to compete with Chinese products; Low yuan means it is almost impossible to compete with Chinese products; countries threaten to erect trade barriers.countries threaten to erect trade barriers.

Chinese monetary base increased substantially, threatening Chinese monetary base increased substantially, threatening high inflation in the future.high inflation in the future.

European Monetary SystemEuropean Monetary System

1010

• 8 members of EEC fixed exchange rates with one 8 members of EEC fixed exchange rates with one another and floated against the U.S. dollaranother and floated against the U.S. dollar

• ECU value was tied to a basket of specified amounts of ECU value was tied to a basket of specified amounts of European currenciesEuropean currencies

• Fluctuated within limits: 2.25% up or downFluctuated within limits: 2.25% up or down

• Led to foreign exchange crises involving speculative Led to foreign exchange crises involving speculative attackattack

Collapse of British PoundCollapse of British Pound

1111

Emergent Market CrisesEmergent Market Crises

1212

Riskiness increases. Demand for local assets declines. Riskiness increases. Demand for local assets declines. Exchange rate drops.Exchange rate drops.

Current Account deficit increases. Devaluation is expected; Current Account deficit increases. Devaluation is expected; under floating regime depreciation is expected. Capital outlow: under floating regime depreciation is expected. Capital outlow: demand for local assets declines. demand for local assets declines.

Government budget deficit shows no indication of reducing. Government budget deficit shows no indication of reducing. Printing of money is expected. Inflation is expected. Printing of money is expected. Inflation is expected. Currency depreciation is expected. Demand for local assets Currency depreciation is expected. Demand for local assets declinesdeclines..