Lesson 17: The International Financial System & Monetary Policy

Upon completion of this lesson, you should be able to do the following:

  • Explain why governments intervene in the foreign-exchange markets.
  • Describe how the Fed's balance sheet and monetary base changes, when the Fed intervenes in the foreign-exchange market.
  • Identify the basic components of the balance-of-payment account for the United States.
  • Explain the three exchange rate regimes: The gold standard, Bretton Woods System, and flexible exchange rates.
  • Describe the International Monetary Fund and World Bank.

Foreign-exchange Markets

This lesson covers the international financial system. The financial system of the United States is linked to the international markets. Investors, savers, households, businesses, and governments in foreign countries can influence the financial markets in the United States. The Fed and central banks in other countries try to manage the value of their currencies in the international markets. The Fed and U.S. Treasury Department will intervene in the foreign-exchange markets, because they want to change the exchange rate value of the U.S. dollar. Usually the Fed and Treasury coordinate their policies together. It is difficult for a government to influence the exchange rate of its currency, because over $1 trillion in transactions occur daily in the foreign-exchange market.

Intervention in Foreign-exchange Markets

When the Fed tries to control the foreign-exchange rate of the U.S. dollar, economists call this foreign-exchange market intervention. The Fed holds foreign currencies, such as British pounds, German deutschmarks, and Japanese yen. The foreign currencies are an asset to the Fed and are called international reserves. If the U.S. dollar is weak compared to the yen and the Fed wants a stronger U.S. dollar, the Fed will sell yen and buy U.S. dollars, causing the dollar to become stronger (to appreciate in value). If the Fed wants the U.S. dollar to be weaker, then the Fed will sell U.S. dollars and buy yen. These transactions cause the Fed's balance sheet to change, which causes both the monetary base and money supply to change. Below is a summary of a strong and weak U.S. dollar.

Strong U.S. dollar
  • Foreign-produced goods are cheaper.
  • U.S. customers benefit.
  • U.S. produced goods are more expensive.
  • U.S. businesses are hurt in foreign markets.
  • The trade deficit worsens.
Weak U.S. dollar
  • Foreign-produced goods are more expensive.
  • U.S. customers are hurt.
  • U.S. produced goods are cheaper in foreign markets.
  • U.S. businesses benefit in international markets.
  • The trade deficit becomes smaller.
  • Let's suppose the Fed believes the dollar is too weak and wants the dollar to be stronger (appreciate). The Fed will sell foreign currency and buy U.S. dollars. The Fed sells $10,000 in foreign currency and the transaction is recorded below:

The Fed

Assets Liabilities
- $10,000 Foreign currencies -$10,000 Currency in circulation

This transaction removed $10,000 of U.S. currency out of the economy. (The Fed is holding the U.S. dollars). The monetary base decreases by $10,000 and the money supply will also decrease. This transaction causes the money supply to contract. The Fed's international reserves also decrease by $10,000. The Fed does not have to buy U.S. currency.

  • Instead, the Fed could have accepted a check for the foreign currency sales. When the Fed cashes a check, the Fed would be decreasing bank reserves. The transaction is listed below:

The Fed
Assets Liabilities
-$10,000 Foreign currencies -$10,000 Bank reserves

In this case, the monetary base still decreases by $10,000 and the money supply still decreases. It makes no difference if the Fed accepts a check or cash denominated in dollars. Both these transactions have the same impact on the monetary base.

  • If the Fed believes that the U.S. dollar is too strong, then the Fed can weaken (depreciate) the dollar by selling U.S. currency and buying foreign currencies. The Fed buys $30,000 of foreign currency and this transaction is listed below:

The Fed

Assets Liabilities
+$30,000 Foreign currencies +$30,000 Currency in circulation

The Fed's assets increase by $30,000, causing the monetary base to increase by $30,000 and the money supply also increases. There is also $30,000 more U.S. dollars in circulation. If the Fed allows these foreign exchange transactions to change the monetary base, then this is called unsterilized foreign-exchange intervention. The Fed can prevent the monetary base from changing, when influencing the U.S. dollar exchange rates. This is called sterilized foreign-exchange intervention.

  • For example, the Fed believes the dollar is too strong and wants to weaken it. The Fed buys $30,000 in foreign currencies and sells $30,000 in U.S. currency. This transaction causes the monetary base to increase. However, the Fed can do an open market sell by selling $30,000 in T-bills for cash. These two transactions cause the change in the monetary base to be zero. The change in the Fed's assets and liabilities is zero. The transaction is listed below:

The Fed
Assets Liabilities
+$30,000 Foreign currencies

-$30,000 T-bills
+$30,000 Currency in circulation

-$30,000 Currency in circulation

Balance-of-Payments Accounts

Economists use balance-of-payments accounts to compare the total flow of money between one country and the rest of the world. A balance-of-payments account is a record of all transactions between the households, businesses, and government of one country to the rest of the world. In the following example, the balance of payments will be examined for the United States.

  1. Deficit item (the number is negative) - this occurs when U.S. residents or government sends payment to another country. The number is negative, because money is leaving the United States. For example, U.S. residents are buying imported goods, sending money to relatives in foreign countries, or traveling abroad.

  2. Surplus item (the number is positive) - this occurs when a transaction leads to a receipt by country's residents or government. The the number is positive, because money is entering the United States. For example, U.S. businesses export goods to other countries, U.S. residents receive money from foreigners, or foreigners travel in the United States.

There are two major accounts for the balance of payments.

  • Current account - summarizes the purchases and sales of goods and services between the United States and the rest of the world. The current account is the summation of the following three items.

    1. Trade balance = Exports - Import

      • Trade surplus: Trade balance > 0

      • Trade deficit: Trade balance < 0

    2. Expenditures on sales of services from other nations.

      • Shipping, brokerage, and insurance.

    3. Unilateral transfers between nations.

      • Foreign aid and private gifts.

For the United States, the current account balance equaled -$155.2 billion in 1997. The current account is negative and means that $155.2 billion left the United States. This is called a current account deficit. For the United States to finance this deficit, it has to borrow from abroad. The current account deficit is large, because the United States imported more goods than what was exported. The trade balance was -$198.0 billion in 1997.

If the current account balance was positive, then it is called current account surplus. More money is flowing into the United States than money that is leaving. If this occurred to the United States, the U.S. as a whole could lend to foreign countries and purchase foreign assets.

  • Capital account - records all transactions in assets, such as stocks, bonds, and real estate between the United States and the rest of the world, and equaled $254.9 billion in 1997. If the capital account is positive, capital is flowing into the United States, which is called a capital inflow. Foreigners are buying more assets in the United States than the amount of foreign assets bought by domestic residents. If the capital account is negative, then capital is flowing out of the United States, which is called a capital outflow. The value of foreign assets bought by U.S. residents is greater than the amount of assets bought in the United States by foreigners. Putting the current and capital accounts together, the balance of trade equation can be derived:

Current Account + Capital Account = 0

If a country has a current account deficit, than it must be financed by a capital surplus. For example, the United States has had current account deficits for the last 30 years. The United State imports more goods and services than what it exports. This causes an outflow of U.S. dollars into the foreign exchange markets. International investors obtain U.S. dollars and use it to buy assets in the United States (i.e. a capital account surplus). Foreigners are buying government securities, stocks, bonds, and real estate in the United States.

The Federal Reserve can intervene in the flow of funds between the United States and the rest of the world. The Fed uses official reserve assets to settle international payments. Official reserve assets are gold, foreign currencies, foreign bank deposits, and Special Drawing Rights. Official reserve assets are recorded under the account called the official settlements balance. In 1997, the official settlements balance was $14.8 billion and this balance is already included in the capital account. The number is positive, but it indicates that this account is a deficit. This is called a balance-of-payments deficit. The Fed is collecting $14.8 billion in U.S. dollars by selling official reserve assets to foreign countries.

The United States is having a current account deficit and U.S. dollars are flowing into the foreign-exchange markets. Foreign countries are collecting U.S. dollars and investing them back in the United States. Eventually market forces will cause the U.S. dollar to weaken (depreciate), because there is a surplus of U.S. dollars on the international markets. A weaker U.S. dollar will cause the current account to become smaller. However, the Fed has to temporary finance this balance of trade deficit now by paying foreign central banks, because the foreign central banks do not want to hold too many U.S. dollars. The Fed will buy U.S. dollars by using official reserve assets. The Fed can do one or more of the following:

  • Sell gold to buy U.S. dollars.

  • Sell foreign currencies and buy U.S. dollars.

  • Borrow from foreign central banks.

  • Use reserves at the IMF.

  • Use Special Drawing Rights (SDRs).

The official settlements balance equaled $14.8 billion in 1997. When the Fed finances a balance of payments deficit, the Fed loses assets. Both the monetary base and money supply decreases. When you add up the current and capital accounts, the result is not zero. This is known as a statistical discrepancy and it equaled -$99.7 billion in 1997. The discrepancy results from measurement errors and some financial activities are not reported, such as revenue from illegal businesses and tax evasion.

Exchange Rate Regimes

Nations agree to a particular system that determines the foreign-exchange rates and the flows of goods and capital among countries. The system that nations adopt is called the exchange rate regime. Before World War I, countries used the gold standard. Central banks agreed to convert their currency to gold on demand. The central banks would set an exchange rate of their currency to gold. Using the U.S., Japan, and Britain as an example, look at the exchange rates below:

400 U.S. dollars = 1 ounce of gold.
1,000 Japanese yen = 1 ounce of gold.
800 British pounds = 1 ounce of gold.

If the central bank in the U.S. wants a money supply of $4 million, it has to buy and hold 10,000 ounces of gold ( = $4 million / 400). The gold standard causes the exchange rates to be fixed. This is called fixed exchange rate system. One U.S. dollar will equal 2.5 yen (1,000 / 400) or 2 pounds (800 / 200). Please look at the exchange rate below and reduce the ratios.

1 ounce of gold = $400 = 1,000 yen = 800 pounds.

$1 = 2.5 yens = 2 pounds

The U.S. has a payments deficit with Japan (current account + capital account < 0). U.S. dollars are flowing out of the United States and into Japan. Japan has surplus of U.S. dollars, so U.S. central bank exchanges gold for dollars. This causes gold to flow out of the United States and into Japan. The U.S. central bank has less gold, so it has to decrease the money supply. Remember, the money supply is a ratio to the amount of gold the government is holding. When the money supply decreases, prices in the economy will decrease. This is called deflation (i.e. negative inflation).

U.S. products become cheaper compared to other countries, so U.S. businesses export more goods abroad. However, the lower U.S. prices cause foreign products to become more expensive, so U.S. consumers buy less imported goods. Exports became larger and imports smaller, so the current account increases until it equals zero and gold stop flowing out of the United State. The exact opposite will occur in Japan.

The gold standard has two benefits.

  • High inflation rates were rare under the gold standard, because central banks have little control over the money supply. If a central bank wants to increase the money supply, the central bank has to buy gold. For example, the inflation rate average less than 1% in U.S. under the gold standard.

  • International investors have lower risk, because exchange rates will not fluctuate.

The gold standard does have two problems.

  • The central bank has little power to influence the money supply. The central bank cannot use monetary policy.

  • If one country experiences a recession, then the recession can easily spread to other countries. The gold standard broke down during World War I.

After World War II, a new international system was implemented, which is called the Bretton Woods system. The Bretton Woods system was an attempt to establish fixed exchange rates and lasted from 1945 until 1971. All other countries would fixed their exchange rates in terms of the U.S. dollar. The United States promised to convert U.S. dollars into gold by the official exchange rate of $35 for 1 ounce of gold. The U.S. dollar became the international reserve currency and the United States held much of the world's supply of gold. (The gold-dollar exchange rate was only for foreign governments and did not apply to the public) The Bretton Woods system was more flexible than the gold standard, because countries could adjust their exchanges rates relative to the U.S. dollar. The Bretton Woods system created two institutions: International Monetary Fund (IMF) and World Bank. The International Monetary Fund was created to be the lender of the last resort and granted loans to countries that were experiencing trade deficit problems. The World Bank grants long-term loans to developing countries. The loans are for economic development and help to build a country's infrastructure, such as highways, bridges, power plants, and water supply systems. World Bank sells bonds in the international markets in order to raise funds for its projects. The Bretton Woods system failed in 1971, but the World Bank and IMF still live on.

Since the demise of the Bretton Woods system, many industrial countries have followed a flexible exchange rate system. The governments allow the supply and demand in the foreign-exchange markets to determine the exchange rates. Occasionally, a government will intervene in the foreign-exchange market in order to achieve its policy goals. The U.S. dollar is still the international reserve currency. However, the Japanese yen and German mark are becoming more important as reserve currencies. Some countries like the United Arab Emirates, Bahamas, and Barbados peg their currencies to the U.S. dollar. Pegging currencies is a fixed exchange rate system and has been successful. For example, the government of the United Arab Emirates fixed the currency exchange rate as 3 Dirhams equal 1 U.S. dollar.

International Monetary Fund (IMF).

The International Monetary Fund was created to enhance stability in international payments and promote international trade. The IMF also collects and standardizes international economic data.

A country wants to join the IMF. This country has to contribute capital based upon a formula. One-fourth of the capital has to be gold and the three-fourths has to be the country’s own currency. This gives the IMF financial capital; it has gold and a pool of foreign currencies. The IMF can help countries that are experiencing payment deficits.

For example, Britain has a payments deficit and borrows from the IMF. The British needs U.S. dollars, so the British give pounds and receive dollars from the IMF to finance its payments deficit. U.S. dollars decrease and pounds increase in the IMF’s currency pool. When Britain pays back the loan (with interest), it needs a currency acceptable to IMF and Britain gets its pounds back.

The IMF created Special Drawing Rights (SDRs). SDRs were invented because of the belief of gold shortage and other reserve assets. Each member country of IMF gets a proportion of newly created SDRs. Between 1968 and 1971, $10 billion worth of SDRs was created. When a country has a payments deficit, it can use its SDRs as money to obtain foreign currencies from the IMF. The U.S. Treasury receives newly created SDRs, then it issues certificates that are claims to the SDRs, and sells these certificates to the FED. These SDR certificates are an asset to the FED.