THE INTERNATIONAL FINANCIAL

Size: px

Start display at page:

Download "THE INTERNATIONAL FINANCIAL"

Matilda Gaines
6 years ago
Views:

1 Ch. 10 (Ch.18 in the text) THE INTERNATIONAL FINANCIAL SYSTEM 1 Exchange Rate (ER) refers to the price of one currency in terms of another. Direct quote: A foreign exchange rate quoted as the domestic currency per unit of the foreign currency Indirect quote: A foreign exchange rate quoted as the foreign currency per unit of the domestic currency. Depreciation: a decrease in the price or value of one currency in terms of another. Appreciation: an increase in the price or value of one currency in terms of another. 2 The foreign exchange market is the market in which international currency trades take place The Main Players: 1. Commercial banks 2. International corporations 3. Nonbank financial institutions 4. Central banks The integration of financial centers implies that there can be no significant arbitrage, the process of buying a currency cheap and selling it dear. The Demand in the Foreign Exchange Market is determined by: 1. The real rate of return relative to other assets 2. Risk: The variability it contributes to savers wealth 3. Liquidity: The ease with which it can be sold or exchanged dfor goods 3 4 To calculate the rate of return on foreign deposits you need to know: 1. How the money values of the deposits will change (nominal interest rate change) 2. How exchange rates will change The returns on deposits traded in the foreign exchange market ktdepend don interest trates and expected exchange rate changes. 5 Intervention in the Foreign Exchange Market In the current global environment, exchange rates experience daily fluctuations. Central Banks regularly engage in international financial transactions called foreign exchange interventions to influence their countries exchange rates by buying and selling currencies. Such interventions alter a central bank s holdings of international reserves, assets that are denominated in a foreign currency and used in international transactions. A purchase or sale of foreign assets by a central bank has the same effect on MB as an open market purchase or sale of government bonds. 6 1

2 Unsterilized Foreign Exchange Intervention The foreign exchange market intervention of central bank (CB) through buying or selling of domestic currency to have an effect on the monetary base (MB) is called unsterilized foreign exchange intervention. Suppose CB decides to sell BD1 billion of its foreign assets in exchange for BD1 billion of BD The CB purchase of dinars has 2 effects 1. It reduces CB holding of international reserves by BD1 billion 2. Because the CB purchase of currency moves it from the hands of the public, currency in circulation falls by BD1 7 Assets CB Foreign Assets (international reserves) BD1B Liabilities Currency in Circulation BD1B Because MB = C+R, C by BD1B MB by the same. If instead of paying for the foreign assets sold by the CB with currency, the persons buying pay by checks written on accounts at domestic banks, then the CB deducts the BD1B from the reserve deposits it holds for these banks 8 Assets CB Foreign Assets (international reserves) BD1B Liabilities Deposits with CB (reserves) BD1B A CB purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base By similar reasoning, a CB sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base 9 An unsterilized intervention in which domestic currency is purchased by selling foreign assets leads to a drop in international reserves, a decrease in the money supply, and a appreciation of the domestic currency An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency 1 0 Sterilized Foreign Exchange Intervention But what if the CB does not want the purchase or sale of domestic currency to affect MB? To counter the effect of the foreign exchange intervention, CB should conduct an offsetting open market operation in the government securities market. For example, in the case of one billion dinar purchase of domestic currency which decreases MB by one billion, the CB can conduct an open market purchase of a BD1B of government bonds, which would increase MB by BD1BS 11 CB Assets Liabilities Gov Bonds +BD1B Currency in Circulation +BD1B The resulting T account for the foreign exchange intervention and the offsetting open market operation leaves MB unchanged Assets Foreign Assets Government Bonds CB BD1B +BD1B Liabilities MB

3 There is no effect on the monetary base and no effect on the exchange rate A foreign exchange intervention with an open market operation that leaves the MB unchanged is called a sterilized foreign exchange intervention If domestic and foreign assets are perfect substitutes, a sterilized foreign exchange intervention ti doesn t affect the money supply, domestic interest rates, or the exchange rate. Most studies by economists have concluded, a sterilized intervention has virtually no effect on the exchange rate. 13 Balance of Payments The balance of payments is a book keeping system for recording all receipts and payments that have a direct bearing on the movement of funds between a nation (private sector and government) and foreign countries. The current account shows international transactions ti that t involve currently produced dgoods and services The trade balance is the difference between the value of merchandise exports and imports of a country in a given period. Exports > imports trade surplus Exports < imports trade deficit 14 Additional items included in the current account are the net receipts from investment income, service transactions, and unilateral transfers such as gifts, pensions, and foreign aid. Net receipts refers to the cash flows received from abroad minus cash flows sent abroad. The sum of investment income, service transactions, ti and unilateral l transfers plus the trade balance is the current account balance Another important item in the balance of payments is the capital account, which refers to the net receipts from capital transactions such as purchase of stocks and bonds, bank loans, etc. 15 The sum of the current account and the capital account equals the official reserve transaction balance, which refers to the net change in government international reserves

Prepared by Iordanis Petsas To Accompany. by Paul R. Krugman and Maurice Obstfeld

Chapter 13 Exchange Rates and the Foreign Exchange Market: An Asset Approach Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy, Sixth Edition by Paul R. Krugman and Maurice