The International Financial
System
FNCE 4070 – Financial Markets and
Institutions
Intervention in the Foreign Exchange
Market: the Money Supply
• The first step is to understand the impact
on the monetary base and the money
supply when a central bank intervenes in
the foreign exchange market.
• International reserves refers to a central
bank’s holdings in a foreign currency.
Unsterilized Foreign Exchange
Intervention
• An unsterilized foreign exchange intervention
describes when a central bank buys/sells
foreign assets in exchange for US currency
without correcting for the effect on the
monetary base.
Unsterilized Intervention in the Foreign
Exchange Market
 Suppose the Fed buys $1bn in bunds
 Before:
 After
Unsterilized Intervention in the Foreign
Exchange Market
• A central bank’s sale of domestic currency
and corresponding purchase of a foreign
assets leads to an equal increase in its
international reserves and the monetary
base.
Effect of an Unsterilized Intervention
• The Fed is selling USD and buying EUR. This
should weaken the dollar.
• The Fed is increasing the monetary base and the
money supply. An increase in the money supply
should weaken the dollar.
• As an open market operation the Fed is
increasing the supply of currency or reserves.
This should lower the Fed Funds rate which
should lower other rates and thus weaken the
dollar.
Problems with Unsterilized
Interventions
• The problem with an unsterilized intervention
is that the central bank is both affecting the
exchange rate but also affecting domestic
monetary policy.
Sterilized Foreign Exchange
Intervention
• An sterilized foreign exchange intervention
describes when a central bank buys/sells
foreign assets in exchange for US currency and
corrects for the effect on the monetary base
Sterilized Intervention in the Foreign
Exchange Market
 Suppose in addition to the previous unsterilized
intervention the Fed also sold $1bn of T-Bills.
 Before:
 After
Effect of a Sterilized Intervention
• The effect of a sterilized intervention is less
clear.
– The Fed is selling USD and buying EUR so it should
weaken the US dollar but
• The supply of US vs European assets does not
particularly change.
– The NY stock exchange is worth approx $14tr
– Global Bond Markets are worth approx $82tr
– The Monetary Base is approximately $2.5tr
Effect of a Sterilized Intervention
– The Fed is selling USD and buying EUR so it should
weaken the US dollar but
• The general supply of US vs European assets does not
change.
– The NY stock exchange is worth approx $14tr
– Global Bond Markets are worth approx $82tr
– The Monetary Base is approximately $2.5tr
• The monetary base does not change
• The Fed Funds rate does not change
Effect of a Sterilized Intervention
• There is not guaranteed to be an effect on the
currency
– Portfolio Balance Channel (weak)
• The intervention causes a shift in the relative weights of
domestic vs foreign assets for an average portfolio
– Signaling Channel (stronger)
• The intervention causes a shift in the market
perception of the central bank’s policy
Balance of Payments
• The balance of payments is a bookkeeping
system for recording all receipts and payments
that have a direct bearing on the movement
of funds between a nation (private and
government) and foreign countries.
The Current Account
• The current account – These are international
transactions that involve currently produced goods and
services. The current account includes data on:
– Imports and exports of goods – (the trade balance -$378bn
in 2009)
– Imports and exports of services – financial, legal, medical
etc (132bn in 2009)
– Income on financial assets (+121bn in 2009)
– Transfers between countries. Foreign aid, remittances,
international gifts etc (-125bn in 2009)
• Thus the current account showed a deficit of -250bn in
2009.
The Capital Account
• The Capital Account – This includes:
– Foreign direct investment – for example the purchase
or development of a Toyota plant in the US
– Investment in business, real estate, stocks and bonds
(these are often put in what is called the Financial
Account)
– Other financial transactions – for example, cross
border bank accounts.
• In 2009 the capital account was $140m. Thus
140m more capital flowed into the United States
then flowed out.
Official Reserve Transaction Account
• The sum of the current account and the
capital account is the official reserve
transaction balance (net change in
government international reserves).
• In 2009 the official reserve transactions
balance was -250bn+140m = -$249.86bn
Current Account Deficit
• if it is financed by the capital account then a
country is foregoing capital assets for goods
and services.
• If it is financed by borrowing money from
abroad then it can show up through the
official reserve transaction account