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Chapter 16
The International Financial System and Monetary Policy
Brief Chapter Summary and Chapter Objectives
16.1 Foreign Exchange Intervention and the Monetary Base (pages 488–490)
Analyze how the Fed’s interventions in foreign exchange markets affect the U.S. monetary base.
International financial transactions affect the money supply when central banks or governments
try to influence the foreign exchange values of their currencies.
Foreign exchange intervention may be unsterilized or sterilized.
16.2 Foreign Exchange Interventions and the Exchange Rate (pages 490–494)
Analyze how the Fed’s interventions in foreign exchange markets affect the exchange rate.
An unsterilized intervention leads to a decrease in international reserves and in the monetary
base and an appreciation of the domestic currency.
With a sterilized intervention, the monetary base is unaffected and domestic interest rates will
not change, leaving the exchange rate unaffected.
Restrictions on capital inflows receive more support from some economists than do restrictions
on capital outflows, in part because such inflows often lead to domestic lending booms and
increased risk taking by domestic banks.
16.3 The Balance of Payments (pages 494–497)
Understand how the balance of payments is calculated.
The balance-of-payments account measures all flows of private and government funds between
a domestic economy and all foreign countries.
The current account summarizes purchases and sales of currently produced goods and services
between a country and its foreign trading partners.
The financial account measures trade in existing financial or real assets between a domestic
economy and foreign countries.
Official reserve assets are assets that central banks hold and use in making international
payments to settle the balance of payments and to conduct international monetary policy.
16.4 Exchange Rate Regimes and the International Financial System (pages 497–513)
Discuss the evolution of exchange rate regimes.
In the past, most exchange rate regimes were fixed exchange rate systems, in which exchange
rates were set at levels that were determined and maintained by governments.
The present international financial system can be described as a managed float regime, in which
central banks occasionally intervene to affect foreign exchange values.
With pegging, a country keeps its exchange rate fixed against another country’s currency.
Key Terms and Concepts
Balance-of-payments account A measure of all
flows of private and government funds between a
domestic economy and all foreign countries.
Bretton Woods system An exchange rate system
that lasted from 1945 to 1971, under which
countries pledged to buy and sell their currencies
at fixed rates against the dollar and the United
States pledged to convert dollars into gold if
foreign central banks requested it to.
Capital controls Government-imposed restrictions
on foreign investors buying domestic assets or on
domestic investors buying foreign assets.
Devaluation The lowering of the official value of
a country’s currency relative to other currencies.
Euro The common currency of 17 European
countries.
European Central Bank (ECB) The central
bank of the European countries that have adopted
the euro.
European Monetary Union A plan drafted as
part of the 1992 single European market initiative,
in which exchange rates were fixed and eventually
a common currency was adopted.
Exchange rate regime A system for adjusting
exchange rates and flows of goods and capital
among countries.
Fixed exchange rate system A system in which
exchange rates are set at levels determined and
maintained by governments.
Flexible exchange rate system A system in
which the foreign exchange value of a currency is
determined in the foreign exchange market.
Foreign exchange market intervention A
deliberate action by a central bank to influence the
exchange rate.
Gold standard A fixed exchange rate system under
which currencies of participating countries are
convertible into an agreed upon amount of gold.
International Monetary Fund (IMF) A
multinational organization established in 1944 by
the Bretton Woods agreement to administer a
system of fixed exchange rates and to serve as a
lender of last resort to countries undergoing
balance-of-payments problems.
International reserves Central bank assets that
are denominated in a foreign currency and used in
international transactions.
Managed float regime An exchange rate system
in which central banks occasionally intervene to
affect foreign exchange values; also called a dirty
float regime.
Pegging The decision by a country to keep the
exchange rate fixed between its currency and
another country’s currency.
Revaluation The raising of the official value of a
country’s currency relative to other currencies.
Sterilized foreign exchange intervention A
foreign exchange market intervention in which the
central bank offsets the effect of the intervention
on the monetary base.
Unsterilized foreign exchange intervention A
foreign exchange market intervention in which the
central bank does not offset the effect of the
intervention on the monetary base.
Chapter Outline
Teaching Tips
Most students are interested in the global economy. Of course, students born outside of the United
States have a particular interest. At least since the financial crisis, a discussion of monetary
policy seems incomplete without consideration of international financial linkages. The chapter
begins with an analysis of the effects of foreign exchange interventions by central banks. The
simple demand and supply model of exchange rates developed in Chapter 8 is used to analyze the
effects of sterilized and unsterilized interventions. The chapter includes a brief overview of the
balance of payments. The chapter concludes with an account of the evolution of the international
financial system. The authors’ experience is that students continue to have a fascination with the
gold standard and will find that section, including the Making the Connection on the gold
standard during the Great Depression, to be interesting.
Can the Euro Survive?
By 2012, 17 countries had adopted the euro. See Figure 16.4 on page 509 for a map showing these
countries. The financial crisis of 2007–2009 negatively affected some countries, such as Greece and
Spain, more than other countries, such as Germany. Individual countries that adopted the euro could not
pursue independent monetary policies to address their particular needs.
16.1 Foreign Exchange Intervention and the Monetary Base (pages 488–490)
Learning Objective: Analyze how the Fed’s interventions in foreign exchange markets affect the
U.S. monetary base.
International financial transactions affect the domestic money supply when central banks or
governments try to influence the foreign exchange values of their currencies. If the Federal Reserve
wants the foreign exchange value of the dollar to rise (fall), it can increase the demand (supply) for
dollars by selling (buying) foreign assets and by buying (selling) dollars in international currency
markets. A purchase of foreign assets by a central bank has the same effect on the monetary base as
an open market purchase of government bonds. When a central bank allows the monetary base to
respond to the sale or purchase of domestic currency in the foreign exchange market, the
transaction is called an unsterilized foreign exchange intervention. When a foreign exchange
intervention is accompanied by offsetting domestic open market operations that leave the monetary
base unchanged, it is called a sterilized foreign exchange intervention.
16.2 Foreign Exchange Interventions and the Exchange Rate (pages 490–494)
Learning Objective: Analyze how the Fed’s interventions in foreign exchange markets affect the
exchange rate.
A. Unsterilized Intervention
If nothing else changes, an unsterilized intervention in which the central bank sells foreign
assets in exchange for domestic currency leads to a decrease in international reserves and in the
monetary base and an appreciation of the domestic currency.
B. Sterilized Intervention
With a sterilized foreign exchange intervention, the central bank uses open market operations to
offset the effects of the intervention on the monetary base. Because the monetary base is
unaffected, domestic interest rates will not change. Therefore, the demand curve and supply
curve for domestic currency in exchange for foreign currency will also be unaffected, and the
exchange rate will not change.
C. Capital Controls
Capital controls are government-imposed restrictions on foreign investors buying domestic
assets or on domestic investors buying foreign assets. Capital controls have significant
problems. Restrictions on capital inflows receive more support from some economists than do
restrictions on capital outflows, in part because such inflows often lead to domestic lending
booms and increased risk taking by domestic banks. Other economists point out that problems
caused by capital inflows could be made less severe by improving bank regulation and
supervision in emerging-market countries.
16.3 The Balance of Payments (pages 494–497)
Learning Objective: Understand how the balance of payments is calculated.
The balance-of-payments account measures all flows of private and government funds between a
domestic economy and foreign countries. Inflows of funds are recorded in the accounts as positive
numbers and include payments from foreigners for purchases of U.S.-produced goods and services
(U.S. exports), for acquisition of U.S. assets (capital inflows), and as gifts to U.S. citizens
(unilateral transfers). Outflows of funds are recorded in the accounts as negative numbers and
include payments by U.S. households, firms, and governments for purchases of foreign goods and
services (imports), purchases of foreign assets by U.S. households and businesses (capital
outflows), and gifts to foreigners, including foreign aid (unilateral transfers).
A. The Current Account
The current account summarizes transactions between a country and its foreign trading partners
for purchases and sales of currently produced goods and services. In general, a current account
surplus or deficit must be balanced by international lending or borrowing or by changes in
official reserve transactions.
Teaching Tips
Discussion of a global savings glut can improve student understanding of why the United States tends to
run current account deficits as well as the interaction between financial flows and international trade.
Have students think through why funds may flow into or out of a country and the effect these flows have
on the country’s exchange rate and ultimately on its current account.
B. The Financial Account
The financial account measures trade in existing financial or real assets among countries. When
someone in a country sells (buys) an asset to (from) a foreign investor, the transaction is
recorded in the balance-of payments accounts as a capital inflow (outflow) because funds flow
into (out of) the country to buy the asset. The financial account balance is the amount of capital
inflows minus capital outflows—plus the net value of capital account transactions, which
consist mainly of debt forgiveness and transfers of financial assets by migrants when they enter
the country.
C. Official Settlements
Changes in asset holdings by governments and central banks supplement private capital flows.
Official reserve assets are assets that central banks hold and use in making international
payments to settle the balance of payments and to conduct international monetary policy. The
official settlements balance is sometimes called the balance-of-payments surplus or deficit
(when considering the balance of payments as only the sum of the current and financial
accounts).
D. The Relationship Among the Accounts
In principle, the current account balance and financial account balance sum to zero. In reality,
measurement problems keep this relationship from holding exactly.
16.4 Exchange Rate Regimes and the International Financial System
(pages 497–513)
Learning Objective: Discuss the evolution of exchange rate regimes.
A. Fixed Exchange Rates and the Gold Standard
In the past, most exchange rate regimes were fixed exchange rate systems, in which exchange
rates were set at levels that were determined and maintained by governments. Under a gold
standard, currencies of participating countries are convertible into an agreed-upon amount of
gold. The gold standard had an automatic mechanism, called the price-specie-flow mechanism,
that caused exchange rates to reflect the underlying gold content of countries’ currencies. One
problem with the economic adjustment process under the gold standard was that countries with
trade deficits and gold outflows experienced declines in price levels, or deflation. Another
consequence of fixed exchange rates under the gold standard was that countries had little
control over their domestic monetary policies. The gold standard finally collapsed in the 1930s,
during the Great Depression.
Teaching Tips
The Making the Connection, “Did the Gold Standard Make the Depression Worse?” which begins on
page 501 of the text points out that during the Great Depression, countries that abandoned the gold
standard earlier experienced less severe economic contractions. Discussion of this topic can help students
understand the role that monetary policy can play in stimulating or hindering an economy during difficult
economic times. The Fed’s efforts to defend the value of the dollar by maintaining the gold standard
appear to have deepened the Great Depression. You can draw parallels to the state of the economy during
and following the financial crisis of 2007-2009 regarding the desirability of maintaining a strong currency
when the domestic economy is weak. You may be able to base another interesting classroom discussion
around whether or not the United States should consider returning to a gold standard.
B. Adapting Fixed Exchange Rates: The Bretton Woods System
Despite the gold standard’s demise, many countries remained interested in the concept of fixed
exchange rates. Under the Bretton Woods system, which was established in 1944, the
United States agreed to convert U.S. dollars into gold at a price of $35 per ounce—but only in
dealing with foreign central banks. The central banks of all other members of the system pledged to
buy and sell their currencies at fixed rates against the dollar. Under this system, exchange rates
were supposed to adjust only when a country experienced fundamental disequilibrium—that is,
persistent deficits or surpluses in its balance of payments at the fixed exchange rate. In
principle, the International Monetary Fund (IMF) was to administer the Bretton Woods system and
to be a lender of last resort to ensure that short-term economic dislocations did not undermine the
stability of the fixed exchange rate system. In practice, the IMF—which survived the demise of the
Bretton Woods system—also encourages domestic economic policies that are consistent with
exchange rate stability and gathers and standardizes international economic and financial data to
use in monitoring member countries. There is some controversy among policymakers regarding the
role and actions of the IMF. Under the Bretton Woods system, a country could defend its fixed
exchange rate by buying or selling reserves or changing domestic economic policies, or it could
petition the IMF to be allowed to change its exchange rate. When investors came to believe that a
government was unable or unwilling to maintain its exchange rate, they attempted to profit by
selling a weak currency or buying a strong currency. These actions, known as speculative attacks,
could force a devaluation or revaluation of the currency. The system eventually collapsed because
the lack of U.S. commitment to price stability and the reluctance of other countries to revalue their
currencies against the dollar led to strong market pressures on fixed exchange rates.
C. Central Bank Interventions After Bretton Woods
Though the United States and many other countries officially follow a flexible exchange rate
system, the present international financial system can be described as a managed float regime,
in which central banks occasionally intervene to affect foreign exchange values. A central bank
often must decide between actions to achieve its goal for the domestic monetary base and
interest rates and actions to achieve its goal for the exchange rate. Because of the traditional
role of the dollar as an international reserve currency, U.S. monetary policy hasn’t been
severely hampered by foreign exchange market transactions.
D. Fixed Exchange Rates in Europe
One benefit of fixed exchange rates is that they reduce the costs of uncertainty about exchange rates
in international commercial and financial transactions. The countries that were members of the
European Economic Community formed the European Monetary System in 1979. Eight European
countries also agreed at that time to participate in an exchange rate mechanism (ERM) to limit
fluctuations in the value of their currencies against each other. As part of the 1992 single European
market initiative, European Community (EC) countries drafted plans for the European Monetary
Union, in which exchange rates would be fixed by using a common currency, the euro. The
European Central Bank (ECB), the common central bank for countries that use the euro,
commenced operation in January 1999 and is structured along the lines of the Federal Reserve
System in the United States. While in late 2012 the euro was battered by the sovereign debt crisis, it
appeared likely to survive the crisis.
E. Currency Pegging
With pegging, a country keeps its exchange rate fixed against another country’s currency.
Countries peg their currencies to gain the following advantages of a fixed exchange rate:
Reduced exchange rate risk
A check against inflation
Protection for firms that have taken out loans in foreign currencies
A currency’s equilibrium exchange rate, as determined by demand and supply, may be
significantly different than the pegged exchange rate. The result is that the pegged currency may
become overvalued or undervalued against the dollar. Countries may attempt to defend their pegs
by buying domestic currency with dollars, reducing their monetary bases, or raising their
domestic interest rates, which may send their economies into a recession.
F. China and the Dollar Peg
In the late 2000s, there was considerable controversy over the policy of the Chinese
government pegging its currency, the yuan, against the U.S. dollar. Pegging against the dollar
ensured that Chinese exporters would face stable dollar prices for the goods they sold in the
United States. By the early 2000s, many economists argued that the yuan was undervalued
against the dollar, possibly significantly so. In July 2005, the Chinese government announced
that it would switch from pegging the yuan against the dollar to linking the value of the yuan to
the average value of a basket of currencies, a policy abandoned temporarily during the financial
crisis. As China continued to run large trade surpluses with the United States, the controversy
over Chinese exchange rate policies seemed certain to continue.
