Money, Banking and Digital Finance

The International Financial System

Yen-Chen Wu

Department of International Business

Chung Yuan Christian University
Preview
We examines how international financial transactions and the structure of
the international financial system affect monetary policy.

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Learning Objectives
 Use graphs and T-accounts to illustrate the distinctions between the effects of
sterilized and unsterilized interventions on foreign exchange markets.
 Interpret the relationships among the current account, the capital account, and the
official reserve transactions balance.
 Identify the mechanisms for maintaining a fixed exchange rate and assess the
challenges faced by fixed exchange rate regimes.
 Summarize the advantages and disadvantages of capital controls.
 Assess the role of the IMF as an international lender of last resort.
 Identify the ways in which international monetary policy and exchange rate
arrangements can affect domestic monetary policy operations.
 Summarize the advantages and disadvantages of exchange-rate targeting.
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A Day at the Federal Reserve Bank of New York
Foreign Exchange Desk
 Although the U.S. Treasury holds primary responsibility for foreign
exchange policy, decisions to intervene in the foreign exchange market
are made jointly by the U.S. Treasury and the Federal Reserve’s Federal
Open Market Committee.
 The manager of foreign exchange operations at the New York Fed
supervises the traders and analysts, who follow developments in the
foreign exchange market.

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The Fed's Balance Sheet
 Assets
‒ Treasury Securities: The largest component of the Fed's assets, consisting of U.S.
government bonds.
‒ Mortgage-Backed Securities: Securities related to mortgage loans purchased by the Fed
to support the housing market.
‒ Other Assets: Includes gold, foreign exchange reserves, and other financial assets.
 Liabilities
‒ Monetary Supply: Includes cash in circulation and bank deposits, which are the Fed's
primary liabilities.
‒ Bank Reserves: Deposits held by commercial banks at the Federal Reserve, which can
be used to meet reserve requirements.
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 19-1
Intervention in the Foreign Exchange Market (1 of 4)
 Foreign exchange intervention and the money supply

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Intervention in the Foreign Exchange Market (2 of 4)
 A central bank’s purchase of and corresponding
sale of in the foreign exchange market lead to an equal
decline in its and the

 A central bank’s of domestic currency to purchase foreign assets in

the foreign exchange market results in an equal in its international
reserves and the monetary base.

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Intervention in the Foreign Exchange Market (3 of 4)
 foreign exchange intervention:
‒ An unsterilized intervention in which is sold to
purchase leads to a gain in , an
increase in the , and a depreciation of the domestic
currency.

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Response to a Change in the Money Supply

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 Effect of an Unsterilized Purchase of Dollars
Figure 1 and Sale of Foreign Assets

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Intervention in the Foreign Exchange Market (4 of 4)
 foreign exchange intervention

 To counter the effect of the foreign exchange intervention, conduct an

open market operation.
 There is no effect on the and no effect on the .
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Active Learning 1
Suppose the reserve bank purchases $10,000,000 worth of foreign assets.
A. If the reserve bank purchases foreign assets with $10,000,000 in
currency, show the effect of this open market operation using T-
accounts. What happens to the monetary base? What happens to the
exchange rate?
B. If the reserve bank purchases foreign assets by selling $10,000,000 in
government bonds, show the effect of this open market operation
using T-accounts. What happens to the monetary base? What happens
to the exchange rate?
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Active Learning 1: Answer

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 19-2
Balance of Payments （國際收支）


‒ International transactions that involve currently produced goods and

services
‒ Trade Balance （貿易餘額）

 or
‒ Net receipts from capital transactions
 The sum of these two is the official reserve transactions balance （官方
儲備交易餘額）

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Global: Should We Worry About the Large and
Recurrent Trade Deficit?
 Persistent trade deficits are a concern for several reasons.
‒ Trade deficits may be seen as a lower demand, by foreigners, for a
country’s goods (exports) than domestic demand for foreign goods
(imports), might lead to a in the of that country’s
.
‒ A large might translate into a large
, which may, in turn, increase a country’s indebtedness to
foreigners.

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Exchange Rate Regimes in the International19-3
Financial System (1 of 3)


‒ The value of a currency is pegged relative to the value of one other

currency (anchor currency)


‒ The value of a currency is allowed to fluctuate against all other

currencies


‒ Attempt to influence exchange rates by buying and selling currencies

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Exchange Rate Regimes in the International
Financial System (2 of 3)
 Gold standard （金本位）
‒ exchange rates
‒ No control over
‒ Influenced heavily by the production of gold and gold discoveries

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Exchange Rate Regimes in the International
Financial System (3 of 3)
 Bretton Woods System
‒ exchange rates using the U.S. dollar as the reserve currency
（準備貨幣）

‒
‒
‒ General Agreement on Tariffs and Trade (GATT)


 European Monetary System

‒ Exchange rate mechanism
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Bretton Woods System
 Exchange Rates Adjusted for Fundamental Disequilibrium
 International Monetary Fund Loans for International Reserves
 Encouragement of Contractionary Monetary Policies
 Devaluation Conditional on International Monetary Fund Loans
 Lack of Tools for Surplus Countries
 U.S. Currency Devaluation Constraints

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How a Fixed Exchange Rate Regime Works
 When the domestic currency is , the central bank must:
‒ domestic currency to keep the exchange rate fixed (it
international reserves), or
‒ Conduct a
 When the domestic currency is , the central bank must:
‒ domestic currency to keep the exchange rate fixed (it
international reserves), or
‒ Conduct a
 The implications of perfect capital mobility 20
 Intervention in the Foreign Exchange Market
Figure 2 Under a Fixed Exchange Rate Regime

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Active Learning 2
What would be the effect of a devaluation on a country’s imports and
exports? If a country imports most of the goods in the basket of goods and
services used to calculate the CPI, what do you think will affect this
country’s inflation rate?

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Active Learning 2: Answer

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Speculative Attacks under a Fixed Exchange Rate

 Eight members of the

fixed exchange rates with one another and floated against the U.S.
dollar.
 The value of was tied to a
basket of specified amounts of European currencies.
 Fluctuated within limits.

 Led to foreign exchange crises involving speculative attacks （投機性攻擊）

. To illustrate, consider the British pound market in 1992.

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Exchange Rate Mechanism (ERM)
 The Exchange Rate Mechanism (ERM) refers to a system that manages
the exchange rates of currencies in relation to one another. It is
primarily designed to stabilize currency fluctuations and facilitate trade
among countries. (The central currency was initially the Deutsche
Mark, but later, ERM II started to peg currencies to the euro.)
‒ Fixed Exchange Rates
‒ Currency Bands
‒ Government Intervention
‒ Economic Coordination
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The Foreign Exchange Crisis of September 1992
(1 of 4)

 Background
‒ Following German reunification in October 1990, the Bundesbank
faced rising inflation, increasing from below 3% in 1990 to nearly
5% by 1992.
‒ Interest Rate Increase
 To control inflation, the Bundesbank raised German interest rates
to near double-digit levels.

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The Foreign Exchange Crisis of September 1992
(2 of 4)

 Impact on the Pound

‒ The increase in German interest rates lowered the expected return on
British pound assets, shifting demand to 𝐷2 .
 Exchange Rate Dynamics
‒ The equilibrium shifted below the lower exchange rate limit.

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The Foreign Exchange Crisis of September 1992
(3 of 4)

 Options to Restore Stability

‒ The Bank of England could implement a contractionary monetary
policy to raise British interest rates, shifting demand back to 𝐷1 .
‒ The Bundesbank could pursue an expansionary monetary policy to
lower German interest rates, restoring demand to 𝐷1 .
 Impasse
‒ The Bundesbank focused on fighting inflation, while the UK, facing
recession, resisted contractionary measures.
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The Foreign Exchange Crisis of September 1992
(4 of 4)

 Speculative Attack
‒ On September 14, following pressure from European Monetary System (EMS)
members, the Bundesbank only slightly reduced lending rates. Speculators
anticipated pound depreciation, leading to a drop in expected future exchange
𝑒
rates (𝐸𝑡+1 ) and a leftward demand shift to 𝐷3 .
 Massive Sell-off
‒ The excess supply of pound assets caused a significant sell-off, necessitating the
Bank of England intervention, which raised lending rates from 10% to 15%.
Despite this, the pound depreciated by 10% on September 16 after exiting the
Exchange Rate Mechanism (ERM).
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Figure 3 Foreign Exchange Market for British Pounds in 1992

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The Policy Trilemma
 A country (or a monetary union like the Eurozone) can’t pursue the
following three policies at the same time:
‒
‒
‒
 Economists call this result the policy trilemma （政策三難） (the
impossible trinity （不可能的三位一體）).

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Figure 4 The Policy Trilemma

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Application: How Did China Accumulate $4 Trillion
of International Reserves?
 By 2014, China had accumulated $4 trillion in international reserves.
 The Chinese central bank engaged in massive purchases of U.S. dollar
assets to maintain the fixed relationship between the Chinese yuan and
the U.S. dollar.

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Monetary Unions
A variant of a fixed exchange rate regime is a monetary (or currency)
union （貨幣同盟） , in which a group of countries decides to adopt a
common currency, thereby fixing the countries’ exchange rates in relation
to each other. The most recently formed monetary union is the European
Monetary Union (EMU) （歐洲貨幣同盟）.

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Global: Will the Euro Survive?
 The global financial crisis of 2007–2009 led to economic contraction
throughout Europe, with the countries in the southern part of the
Eurozone hit especially hard.
 This “straightjacket” （拘束衣） effect of the euro has weakened support
for the euro in the southern countries, leading to increased talk of
abandoning the euro.

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Managed Float
 Hybrid of fixed and flexible
‒ Small in response to market
‒ Interventions to
 hurts exporters and employment
 hurts imports and stimulates inflation
 Special drawing rights as a substitute for gold

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Active Learning 3
Suppose China's central bank pegs its currency to the euro and commits to
a fixed Renminbi/Euro exchange rate. Use a graph of the market for
Renminbi assets (foreign exchange) to show and explain how the peg
must be maintained if a shock in the European forces the European
Central Bank to pursue a contractionary monetary policy. What does this
say about the ability of central banks to address domestic economic
problems while maintaining a pegged exchange rate?

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Active Learning 3: Answer

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 19-4
Capital Controls (1 of 2)
 Controls on capital outflows:
‒ Promote by forcing a devaluation
‒ Seldom effective （很少有效） and may capital flight
‒ Lead to
‒ Lose the opportunity to the economy

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Capital Controls (2 of 2)
 Controls on capital inflows:
‒ Lead to a and excessive risk-taking by financial
intermediaries
‒ Controls may funds for production uses
‒ Produce substantial and
‒ Leads to
 Strong case for improving bank regulation and supervision

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 19-5
The Role of the IMF
 Emerging market countries with poor central bank credibility and short-
run debt contracts denominated in foreign currencies have limited
ability to engage in this function.
 May be able to contagion.
 The safety net may lead to excessive risk-taking (
).

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Should the IMF Act as an International Lender of
Last Resort?
 May not be tough enough.
 Austerity programs focus on tight macroeconomic policies rather than
financial reform.
 Too slow, which worsens the crisis and increases costs.
 Countries were restricting borrowing from the IMF until the recent
subprime financial crisis.

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 19-6
International Considerations and Monetary Policy (1 of 2)

 Direct Effects of the Foreign Exchange Market on Monetary Policy:

‒ When central banks intervene in the foreign exchange market, they
acquire or sell off and their is
affected.
‒ When a central bank intervenes in the foreign exchange market, it gives up
some control of its .
‒ Germany's actions to prevent mark appreciation against USD resulted in
high reserves, monetary expansion, and unwanted low that
risked .

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International Considerations and Monetary Policy (2 of 2)

 Exchange rate considerations:

‒ A monetary policy will the domestic interest
rate and the currency.
‒ An monetary policy will interest rates and
currency.

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To Peg or Not to Peg: Exchange-Rate Targeting as an19-7
Alternative Monetary Policy Strategy
 Advantages of exchange-rate targeting:
‒ Contributes to keeping inflation under
‒ The rule for the conduct of monetary policy
‒ and clarity
 Disadvantages of exchange-rate targeting:
‒ They to domestic shocks and shocks to anchor
countries are transmitted
‒ to speculative attacks on currency
‒ the accountability of policymakers as the exchange rate
loses value as a signal 45
When Is Exchange-Rate Targeting Desirable for
Industrialized Countries?
 Exchange-rate targeting for industrialized countries is desirable if
‒ Domestic and are not conducive to
good policy-making
‒ Other important benefits, such as integration arise from this strategy

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When Is Exchange-Rate Targeting Desirable for
Emerging Market Countries?
 Exchange-rate targeting for emerging market countries is desirable if
‒ Political and monetary institutions are (strategy becomes the
stabilization policy of last resort).

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Currency Boards （貨幣發行局） (1 of 5)
 Core Definition:
‒ 100% foreign currency backing of domestic currency
‒ Fixed exchange rate system
‒ Automatic currency exchange at a fixed rate
‒ More substantial commitment than the typical fixed exchange rate

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Currency Boards (2 of 5)
 Key Operational Features
‒ Monetary policy on "autopilot"
‒ No central bank discretion
‒ Money supply tied directly to foreign exchange reserves
‒ Cannot print money independently

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Currency Boards (3 of 5)
 Advantages
‒ Strong inflation control
‒ Reduced speculative attack risk
‒ Clear transparency
‒ Strong commitment mechanism
‒ Automatic monetary discipline

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Currency Boards (4 of 5)
 Disadvantages
‒ Loss of independent monetary policy
‒ Vulnerability to anchor country's shocks
‒ No lender of last resort capability
‒ Risk of sharp money supply contraction during speculative attacks
‒ Limited crisis management tools

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Currency Boards (5 of 5)
 More rigid than traditional fixed exchange rates
 Trades monetary policy independence for stability
 Requires strong institutional commitment
 It can be effective for inflation control but limits crisis response options

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Global: Argentina’s Currency Board (1 of 3)
 Background and Initial Success
‒ 800% inflation rate in 1990 prompted reform
‒ Implemented 1:1 peso-dollar fixed exchange rate in 1991
‒ By 1994, inflation dropped to 5%, and GDP grew 8% annually

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Global: Argentina’s Currency Board (2 of 3)
 System Collapse Process
‒ The first shock triggered by the 1995 Mexican crisis
‒ Entered severe recession in 1998
‒ Final system collapse in 2002
‒ Peso depreciated 70%
‒ Government defaulted on $150 billion debt

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Global: Argentina’s Currency Board (3 of 3)
 Currency Board can quickly control inflation but has high policy
rigidity
 Lacks monetary policy autonomy and lender-of-last resort function
 External shocks easily trigger systemic risks
 Requires a robust financial system and sufficient foreign reserves

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Dollarization （美元化） (1 of 4)
 Core Concept
‒ Adoption of a strong foreign currency (e.g., US dollar) as national
currency
‒ It is a more potent commitment mechanism than the currency board
‒ Complete elimination of speculative attacks on domestic currency
 Key Features and Implementation
‒ Used in emerging markets (e.g., Ecuador in 2000)
‒ Discussed by Argentina after Brazil's 1999 real devaluation
‒ Provides absolute value stability: one dollar always equals one dollar56
Dollarization (2 of 4)
 Advantages
‒ Eliminates currency speculation risk
‒ Provides maximum transparency
‒ Creates the strongest commitment to fixed exchange rate
‒ Enhances monetary credibility

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Dollarization (3 of 4)
 Disadvantages
‒ Loss of independent monetary policy
‒ Increased vulnerability to anchor country's economic shocks
‒ No lender of last resort capability
‒ Loss of seigniorage revenue
 Significant financial impact (US Fed earns >$30 billion annually)
 Particularly challenging for developing nations

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Dollarization (4 of 4)
 A more extreme form of fixed exchange rate system
 Offers the most substantial protection against currency crises
 Requires careful cost-benefit analysis
 Significant trade-off between stability and monetary independence

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 Exchange-Rate
Feature Currency Board Dollarization
Targeting

Monetary Policy Autonomy Partially Retained Very Limited None

Policy Credibility Lower High Highest

Exchange Rate Risk Present Very Low None

Foreign Reserve Requirements High Very High Not Required

Policy Flexibility Higher Low None

Shock Absorption Capacity Medium Weak Weakest

Ability to Defend Against
Weaker Stronger Complete Immunity
Speculative Attacks
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Active Learning 4
Calculate the overvaluation of the New Taiwan Dollar (NT$) if you can
get 34.6 NT$ per USD at the exchange counter, but a lunch menu that
costs 25 USD in New York sells for 948.25 NT$ in Taipei.

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Active Learning 4: Answer

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