International Economics ECON 390
Lotta Moberg
Lecture notes – 18 November 14 - 17: International Monetary Policy
Fixed exchange rates
1.
The central bank must intervene in the foreign exchange markets
2.
To see how, we look at a simplified central bank balance sheet
 Double-entry bookkeeping: each transaction enters the balance sheet twice
3.


Assets
Foreign government bonds (official international reserves)
Gold (official international reserves)
 Domestic government bonds
 Loans to domestic banks (called discount loans in US)
4.
Liabilities
 Deposits of domestic banks
 Currency in circulation (previously central banks had to give up gold when citizens brought currency to exchange)
Assets, Liabilities, and the Money Supply
1.
Changes in the central bank’s balance sheet > changes in currency in
2.
circulation or changes in deposits of banks > changes in the money supply
An asset purchase by the central bank is paid for with central bank money
 These increase the supply of money in circulation
 With equal increases of assets and liabilities
3.
An asset sale by the central bank is paid with currency or a check
 The central bank puts the currency into its vault or reduces the amount of deposits of banks
 The supply of money in circulation shrinks
 There is an equal decrease of assets and liabilities
Foreign Exchange Markets
4.
Central banks trade government bonds and currencies

International Economics ECON 390
Lotta Moberg
 Both foreign currency and foreign bonds denominated in foreign currency are fairly liquid assets
To fix the exchange rate
5.
A central bank influences the quantities supplied and demanded of currency
6.
by trading domestic and foreign assets
To keep the value up, it must be able to sell foreign assets or currency
7.
Foreign exchange markets equilibrium:
R = R* + (E e – E)/E
8.
The exchange rate is fixed, and the market expects it to stay fixed at that level, then
R = R*
9.
If demand for money increases, the interest rate rises
 With fixed exchange rates, more people want to hold the domestic currency
 This increases its value, which cannot happen
 The central bank must buy foreign assets and issue money to prevent this
10.
If less people want to hold the currency, it must sell foreign assets
Sterilization
1.
To offset the effect on the domestic money supply when buying and selling
2.
foreign bonds in the foreign exchange markets
The central bank sells or buys domestic government bonds in bond markets to leave the amount of money in circulation unchanged
With fixed exchange rates, monetary policy cannot stabilize the economy
 The central bank wants to stimulate the economy, prints money and buys assets
 But the resulting decreased interest rate depreciates the currency
 The central bank must intervene and sells foreign assets
 Money supply falls back again

International Economics ECON 390
Lotta Moberg
3.
Under floating exchange rate regimes, the exchange rate can depreciate and the money be left in circulation
4.
With fixed exchange rates, fiscal policy is effective in stabilizing the economy
5.
Government investments increases money demand
6.
Pressure on interest rates to rise
7.
To prevent this, the central bank buys assets and prints money
The Chinese peg to the dollar
8.
Secured a stable inflation rate in China for many years
9.
The U.S. put political pressure on China to strengthen its currency
10.
The Chinese let its currency appreciate
 A victory for the U.S.?
Reserve currency system
11.
One currency acts as official international reserves.
12.
The U.S. dollar under the fixed exchange rate system from 1944 to 1973
13.
All countries except the U.S. held U.S. dollars as the means to make official international payments
14.
Central banks fixed the value of their currencies to the U.S. dollar by buying or selling domestic assets in exchange for dollar denominated assets
15.
Arbitrage ensured that exchange rates between any two currencies remained fixed
16.
The Federal Reserve could still conduct monetary policy
17.
The monetary policies of other countries had to follow that of the U.S., which was not always optimal for them
The Gold Standard
18.
From 1870 to 1914 and after 1918 for some countries
19.
Central banks fixed the value of its currency relative to a quantity of gold
 By trading domestic assets in exchange for gold
 They could only print money as an exchange for gold

International Economics ECON 390
Lotta Moberg
 So the rate of inflation was the rate of new gold discoveries minus the real growth rate
Arguments against the gold standard
20.
Central banks cannot stimulate the economy by printing money
21.
A new gold discovery means inflation
22.
Economic growth means deflation
23.
A new gold standard would require new discoveries of gold
24.
Russia, South Africa, the U.S., and other gold producers may get inordinate influence on international financial and macroeconomic conditions
Gold Exchange Standard
25.
Between a gold standard and reserve currency standard
26.
International reserves are both in currencies fixed to gold and gold itself
27.
The system from 1944 to 1973 was in fact like a gold exchange standard
Bimetallic Standard
28.
The value of currency based on e.g. both silver and gold
 The U.S. system from 1837 to 1861
Free banking
29.
Hayek proposes free trade in money
30.
Government monopoly of money has severe downsides
 No alternative for the people if the government abuses its powers
 No constraint on reckless money printing
31.
Private, competitive currencies could be denominated in currencies or commodities
 The most reliable will outcompete others
 Competition will incentivize a free bank to keep the value of its currency
 stable
People will disregards any currency with inflation
32.
If a bank over-issues, or fails to redeem the currency for valuable assets:

International Economics ECON 390
Lotta Moberg
 Its value will decrease
 Other banks will soon return its currency in exchange for assets
 It will go out of business
33.
No bank is systemically important
Bitcoin
34.
A private fiat currency
35.
Benefits
 Cap on its amount and hence inflation
 Easy to trade
36.
Problems
 Volatility
 No commodity backing it up