EK3301 LECTURE 11
REF: CHAPTER 18 OF MISHKIN “THE INTERNATIONAL FINANCIAL
SYSTEM”
Some Important Definitions:





Balance of Payment: A bookkeeping system for recording all RECEIPTS
and PAYMENTS that have a direct bearing on the movement of funds
between a nation and foreign countries
Current Account: Shows international transactions that involve currently
produced goods and services.
Trade Balance: The difference between merchandise exports and
imports; imports > exports  trade deficit; imports < exports  trade
surplus. Also included net receipts from investment income, service
transactions and unilateral transfers.
Capital account: Net receipts from capital transactions e.g purchases of
stocks and bonds, loans etc)
Official Reserve transactions balance: current account + capital account
hence the official reserve transactions balance indicates the amount of
international reserves that must be moved between countries to finance
international transactions.
EXCHANGE RATE REGIMES IN THE INTERNATIONAL FINANCIAL
SYSTEM
Exchange rate regimes in the international financial system are classified into 2
basic types: fixed and floating.
Fixed Exchange rate regime: the value of a currency is pegged relative to the
value of one other currency (anchor currency) so that exchange rate is fixed.
Floating/Flexible e.g Exchange rate regime: the value of a currency is allowed
to fluctuate against all other currencies. Higher demand for OR decrease supply
of a currency, all else equal, would lead to an appreciation of the currency while
lower demand for OR increase supply of a currency, all else equal, would lead
to a depreciation of the currency.
Past Exchange Rate Regimes:

Gold Standard ; Before World War 1, the world economy operated
under the gold standard; a fixed exchange rate regime under
which a currency is directly convertible to gold. After World War II,
the BWS and the IMF were established to promote a fixed
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
exchange rate system in which the U.S dollar was convertible to
gold
Bretton Woods System; The international monetary system in use
from 1945 to 1971 in which exchange rates were fixed and the
U.S Dollar was freely convertible into gold.
HOW A FIXED EXCHANGE RATE REGIME WORKS
During Overvaluation of Exchange Rate
In a situation in which the domestic currency is fixed relative to an anchor currency
while the DD curve has shifted to the left (due to increase in the interest rate of foreign
assetslowering the expected return of domestic assets)  Exchange rate is
overvalued to keep the exchange rate at par the central bank must intervene in the
FOREX market  CB purchase domestic currency by selling foreign assets  Both
monetary base and money supply decline interest rate on domestic assets increases
 increases the relative expected return on domestic assets  DD curve shifts to the
right  The CB will continue to purchase domestic currency until eventually Eqm
exchange rate is back at its par (fixed) value.
When the domestic currency is overvalued, CB must purchase domestic
currency to keep the exchange rate fixed, but as a result it loses international
reserves.
During Undervaluation of Exchange Rate
In a situation in which the domestic currency is fixed relative to an anchor currency
while the DD curve has shifted to the right (due to decrease in the interest rate of
foreign assetsincreasing the expected return of domestic assets)  Exchange rate is
undervalued to keep the exchange rate at par the central bank must intervene in the
FOREX market  CB must sell domestic currency and purchase foreign assets 
money supply increases interest rate on domestic assets decreases  decreases
the relative expected return on domestic assets  DD curve shifts to the left  The CB
will continue to sell domestic currency until eventually Eqm exchange rate is back at its
par (fixed) value.
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When the domestic currency is undervalued, CB must sell domestic currency to
keep the exchange rate fixed, but as a result it gains international reserves.
(Please refer to Figure 2, Pg 468, Chp 18)
MANAGED FLOAT
When countries attempt to influence their exchange rates by buying and selling
currencies, the regime is referred to as a Managed Float regime. A managed
floating rate systems is a hybrid of a fixed exchange rate and a flexible
exchange rate system. In a country with a managed float exchange rate system,
the CB becomes a key participant in the foreign exchange market.
Now, we have an International Financial System that has elements of
managed float and a fixed exchange rate system. Some exchange rates
fluctuate from day to day, although CB intervenes in the FOREX market,
while other exchange rates are fixed.
FIXED VS FLOATING EXCHANGE RATES
Advantages of floating exchange rates
Fluctuations in the exchange rate can provide an automatic adjustment for
countries with a large balance of payments deficit. If an economy has a large
deficit, there is a net outflow of currency from the country. This puts downward
pressure on the exchange rate and if a depreciation occurs, the relative price of
exports in overseas markets falls (making exports more competitive) whilst the
relative price of imports in the home markets goes up (making imports appear
more expensive). This should help reduce the overall deficit in the balance of
trade provided that the price elasticity of demand for exports and the price
elasticity of demand for imports are sufficiently high.
A second key advantage of floating exchange rates is that it gives the
government / monetary authorities flexibility in determining interest rates.
This is because interest rates do not have to be set to keep the value of the
exchange rate within pre-determined bands. For example when the UK came
out of the Exchange Rate Mechanism in September 1992, this allowed a sharp
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cut in interest rates which helped to drag the economy out of a
prolonged recession.
Advantages of Fixed Exchange Rates (disadvantages of floating rates)
Fixed rates provide greater certainty for exporters and importers and under
normally circumstances there is less speculative activity - although this
depends on whether the dealers in the foreign exchange markets regard a
given fixed exchange rate as appropriate and credible. Sterling came under
intensive speculative attack in the autumn of 1992 because the markets
perceived it to be overvalued and ripe for a devaluation.
Fixed exchange rates can exert a strong discipline on domestic firms and
employees to keep their costs under control in order to remain competitive in
international markets. This helps the government maintain low inflation - which
in the long run should bring interest rates down and stimulate increased trade
and investment.
Additional Information..
Countries with different exchange rate regimes
Countries with fixed exchange rates often impose tight controls on capital flows to and from
their economy. This helps the government or the central bank to limit inflows and outflows of
currency that might destabilise the fixed exchange rate target,
The Chinese Renminbi is fixed to the US dollar. Currency transactions involving trade in goods
and services are allowed full currency convertibility. But capital account transactions are
tightly controlled by the State Administration of Foreign Exchange.
The Hungarians have a semi-fixed exchange rate against the Euro with the forint allowed to
move 2.5% above and below a central rate against the Euro.
The Russian rouble is in a managed floating system but there is a 1% tax on purchases of hard
currency. In contrast, the Argentinian peso is pegged to the US dollar at parity ($1 = 1 peso)
but international trade transactions (involving current and capital flows) are not subject to
stringent government or central bank control
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EK3301 Lecture 12
From Chp 19 ‘The Demand for Money”
Quantity Theory of Money (Revisited)
• Irving Fisher (1911): examined the relationship between the total quantity of
money, and the total (nominal) amount of spent on final goods and services
• The Cambridge Equation (or “Equation of Exchange”) : MV = PY
• where M is money, V is Velocity, P is the average Price Level, and Y is real
GDP
Velocity
Recall our definition:
Velocity, V, represents the number of times per year that a dollar is used in
buying the total amount of goods and services produced in the economy
V
PxY
M
Classical View of Quantity Theory.........
• Irving Fisher: Velocity constant in the short run
• With V constant:
 Nominal income, PY determined by M
• Classical View: No rigidities in economy, i.e. wages and prices are flexible.
Hence aggregate output, Y, determined by real side of economy.
• Implication: Changes in M determines changes in P
Quantity Theory of Money Demand
M
1
x PY
V
• Re-writing the equation as above, shows how it is a theory of the demand for
money.
• Since in a money market equilibrium MS=Md, we can replace M in the
equation above for Md and rewrite is as: Md = k×PY
• Fisher’s Quantity Theory implies that the demand for money, is purely a
function of income; interest rates have no effect on the demand for money.
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Keynes’s Liquidity Preference Theory
Liquidity Preference Theory: why do people hold money?
Recall functions of Money:
• Medium of Exchange
• Unit of Account
• Store of Value
Demand for Real Money Balances
• Three motives for people holding money:
1. Transactions motive (arising from medium of exchange function):- related to
Y
2. Precautionary motive:- related to Y
3. Speculative motive (arising from store of wealth function):A. related to Wealth and Y
B. negatively related to i
Putting the three motives together.....
Liquidity Preference Function:
M
P
d
 f (i , Y )
 
Implication: Velocity not constant
P
1
d 
f (i, Y )
M
Multiply both sides by Y and substitute in M = Md
V
PY
Y

M
f (i, Y )
1. i ↑, f(i,Y) ↓, V ↑
2. Change in expectations of future i, change f(i,Y) and V changes
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Friedman’s Modern Quantity Theory
Theory of asset demand: Md function of wealth (YP) and relative Re of other assets
Md/P = f(YP, rb – rm, re – rm, πe – rm)
+
–
–
–
Differences from Keynesian Theories:
1. Other assets besides money and bonds: equities and real goods
2. Real goods as alternative asset to money implies M has direct effects on
spending
3. rm not constant: rb ↑, rm ↑, rb – rm unchanged, so Md unchanged: i.e.,
interest rates have little effect on Md
4. Md is a stable function
• Implication of 3:
Md
Y
 f (Yp )  V 
P
f (Yp )
• Since relationship of Y and YP predictable, 4 implies V is predictable: Get
Quantity theory view that change in M leads to predictable changes in nominal
income, PY
Empirical Evidence on Money Demand
Interest Sensitivity of Money Demand- is sensitive, but no liquidity trap
Stability of Money Demand
1. M1 demand stable till 1973, unstable after
2. Most likely source of instability is financial innovation
3. Cast doubts on money targets
Summary
1. Fisher’s Quantity Theory implies that the demand for money, is purely a
function of income; interest rates have no effect on the demand for money.
2. The demand for money depends on
– Transaction motive
– Precautionary motive
– Speculative Motive
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