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CHAPTER 28
Monetary Policy in a Globalized Financial System
Learning Objectives
 How international trade and capital flows affect monetary policy in a global financial system
 The limitations of domestic monetary policy under fixed and flexible exchange rate systems
 Why monetary policy will most likely require increased global coordination in the future
regardless of the exchange rate system
Chapter Outline
I.
II.
III.
IV.
Monetary Policy and the Globalization of Finance
Monetary Policy under Fixed Exchange Rates from 1944 to 1973
Monetary Policy under Flexible Exchange Rates since 1974
The Globalization of Monetary Policy
Answers to Review Questions
Briefly explain the Bretton Woods exchange rate system. When was it created? When and
why did the system collapse?
The Bretton Woods Accord of 1944 established fix ed exchange rates among major world
currencies. The U.S. Dollar backed by gold served as the official reserve asset and other
countries defined their currency in terms of the dollar. Divergen t monetary and fiscal policy
led to the ultimate collapse of the system in 1971 as the United States was no longer able to
redeem dollars with gold.
Under the Bretton Woods system, the U.S. dollar was the official reserve asset. How did
this affect the U.S. balance of payments on current and capital accounts? Could the
United States experience large balance of payments deficits on current and capital
accounts indefinitely?
Unlike other countries, the United States was in the unique position of being able to run
persistent balance of payments deficits on the current and capital accounts. The deficit in the
current and capital accounts could persist because foreign countries demand the excess dollars
to serve as international reserves. However, once foreign central banks had acquired sufficient
reserves (dollars), the ability of the United States to run chronic deficits in the balance of
payments on current and capital accounts was also limited.
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Assume you work at the central bank of a small country that is considering an
expansionary monetary policy to speed up the level of economic activity. Given fixed
exchange rates, advise the president of your country what will happen to net exports
if the country pursues a policy of monetary expansion. What action will the central
bank have to take to support the agreed-upon exchange rate? How will that action
affect the expansionary policy?
A monetary expansion by a central bank in a small country would lead to a rise in domestic
income causing imports to increase and net exports to decrease. Also, the monetary expansion
would affect interest rates. The decrease in interest rates leads to capital outflows that would
further contribute to the deficit in the balance of payments on current and capital accounts. The
central bank of the deficit country would have to buy its own currency to maintain the
agreed-upon exchange rate. The act of buying back its own currency would thwart the
monetary expansion.
Argue that fixed exchange rates are preferable to flexible exchange rates. Then present
the opposite argument.
Supporters of fixed exchange rates believe that the system offers many advantages. First, the
system allowed for inflation and unemployment to self -correct. Second, the fixed exchange rate
system minimized exchange rate risk arising from currency fluctuations. However, there are
some attendant disadvantages to fixed exchange rates. The system impeded the ability of
countries to pursue an independent monetary policy. For instance, if a country wished to
pursue a contractionary monetary policy, higher domestic interest rates would result in a
surplus in the balance of payments. The commitment to fixed exchange rates would necessitate
a central bank sell domestic currency, which would in turn thwart the effects of the
contractionary policy. Over time this would result in a rev aluation of domestic currency with
its attendant destabilizing effects on financial markets and the local economy. Such
destabilizing influences are likely to be sharper for smaller countries with lower growth rates.
With a flexible exchange rate system, countries in some ways do have more independence in
establishing their own monetary polices. A monetary objective or policy would not be
compromised by the need for a country to maintain the agreed upon exchange rate as under the
Bretton Woods Accord. Under flexible exchange rates, a country does not have to support its
domestic currency if market forces were causing the currency to depreciate or appreciate.
For each of the following situations, assuming fixed exchange rates, tell what will happen
to the balance of payments on current and capital accounts in the United States:
a.
b.
c.
d.
e.
f.
Domestic income increases.
Domestic interest rates fall.
Foreign income increases.
Foreign interest rates fall.
Domestic inflation increases.
Foreign inflation increases.
a. Current account moves toward deficit as imports increase.
b. Capital account moves toward deficit as capital outflows increase and capital inflows
decrease.
c. Current account moves toward surplus as exports and net exports increase.
d. Capital account moves toward surplus as capital outflows decrease and capital inflows
increase.
e. Current account moves toward deficit as exports decrease and imports increase.
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f. Current account moves toward surplus as exports increase and imports decrease.
For each of the situations in question 5, tell what will happen to the exchange rate,
assuming flexible exchange rates.
a. The exchange rate will decrease because the current account deficit increases.
b. The exchange rate will decrease because the capital acc ount deficit increases.
c. The exchange rate will increase because the current account surplus increases.
d. The exchange rate will increase because the capital account surplus increases.
e. The exchange rate will decrease because the current account defic it increases.
f. The exchange rate will increase because the current account surplus increases.
Explain whether you agree or disagree with the following statement: Flexible exchange
rates allow nations to pursue their own monetary policies.
Flexible exchange rates do allow nations to pursue their own monetary policies because they
do not need to defend the value of their currencies as required under a fixed exchange rate
system. However, nations can pursue their own monetary policies only to the extent tha t they
are willing to accept the ramifications to capital flows and exchange rates that can then
feedback to the domestic economy.
What are the advantages of fixed exchange rates? What are the disadvantages? Does it
matter if the country is large or small?
One advantage of fixed exchange rates is that under some conditions, inflation and
unemployment could be self-correcting. If inflation or unemployment accelerated in one
country relative to the rest of the world, market forces in international markets wou ld come
into play and cause the inflation and unemployment to be reduced.
Under a fixed exchange rate system, when a country experienced higher inflation than its
trading partners, its balance of payments would go into a deficit position as net exports f ell and
capital outflows increased. Net exports would fall because the country’s domestic prices were
relatively higher than prices in the rest of the world. If the inflation was due to increases in the
money supply, lower interest rates initially could al so lead to a capital outflow. The inflationridden country would be forced to buy back its currency to maintain fixed exchange rates. The
act of buying back its currency tended to reduce the country’s domestic money supply and the
inflationary pressures and to improve the trade imbalance. Thus, inflation would be self correcting.
If unemployment in a country increased, income would fall causing imports to decrease and net
exports to increase. The balance of payments would move into a surplus position, and the
country would experience an increase in international reserves. If policymakers allowed the
increase in international reserves to also increase the domestic money supply, the level of
economic activity would speed up, and employment would increase.
Another advantage of a fixed exchange rate system was that it minimized exchange rate risk.
Under a fixed rate system, such as the Bretton Woods Accord, currency values did not change
under normal circumstances. Exchange rate risk was therefore very small a nd related only to
the probability that the monetary authorities would redefine the currency in terms of the
official reserve asset.
Despite these advantages, fixed exchange rates also entail some disadvantages. The ability of
foreign countries to pursue their own monetary policies is limited because each country had to
support its currency if market forces were causing the currency’s value to deviate from the
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agreed-upon exchange rate. If a country wanted to pursue a more expansionary policy, its
monetary authorities would increase the supply of reserves available to the banking system.
Interest rates would fall and the monetary and credit aggregates would increase. This policy
might result in a deficit in the balance of payments on current and capital ac counts. The
central bank of the deficit country would then have to use its supplies of dollars to purchase its
own currency to maintain the agreed-upon exchange rate. The act of buying back its currency
would at least partially undo the stimulatory effect s of the injection of reserves and would limit
the monetary authorities’ ability to pursue an expansionary policy. If the country ran out of
dollars, it might have to devalue its currency. Devaluation entails discreet changes in the
official exchange rate by the central bank but can destabilize financial markets and the
domestic economy.
If a country wished to pursue contractionary policies relative to the rest of the world, its
balance of payments on current and capital accounts would move toward a surplu s position.
Net exports would increase as imports fell relative to exports. The higher interest rate would
also lead to a capital inflow. Both factors would put upward pressure on the exchange rate. The
ability of the monetary authorities to limit the grow th of the money supply would be reduced
by the necessity to supply the country’s currency to maintain fixed exchange rates. The
supplying of the currency would at least partially undo the contractionary effects. After a time,
if the trade surplus and capital inflow persisted, the country would be under pressure to revalue
its currency.
Under normal circumstances exchange rate risk is less with fixed exchange rates. When the
situation is not normal, however, this advantage can turn into a major disadvantag e. If a
country is running a deficit in the balance of payments and devaluation seems likely, market
participants will attempt to supply more of the currency to the central bank in exchange for
dollars, the official reserve asset. But by supplying more of the currency, they will further
deplete the country’s international reserves and make devaluation, which may have been only a
possibility, a necessity. Thus, the expectation of devaluation may become a self -fulfilling
prophecy.
Smaller countries would be least able to run policies that were divergent from the rest of the
world.
Briefly explain how interest rates on instruments of comparable risk and maturity will
tend to be equalized in a world without capital barriers.
With high capital mobility, investors will keep moving funds to where they can obtain the
highest return. The back and forth movement of funds will result in risk -adjusted interest rates
being equalized. If instruments in one country pay a higher return, investors will lend funds in
that country pushing the return down. Likewise, funds will be moved out of countries where
returns are lower, pushing up returns. In equilibrium, risk -adjusted returns around the globe
would be equalized.
Under a flexible exchange rate system, what effect does contractionary monetary policy
have on the exchange rate?
Under a flexible exchange rate system, contractionary monetary policy will cause the exchange
rate to increase and vice versa. Changes in exchange rates then affect net exports and feed
back to the domestic economy.
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Why is a country limited in executing its own monetary policy under a fixed exchange rate
system? How is it limited under a flexible exchange rate system?
A country is limited in executing its own monetary policy under a fixed exch ange rate system
because it needs to maintain an agreed-upon exchange rate. Under a flexible exchange rate
system, if a country chooses to run a monetary policy far different from its neighbors, it is
limited to the extent to which it can do so because of the offsetting effect of capital flows.
How can monetary policy coordination among countries increase the degree to which
monetary policy can be used to pursue macroeconomic goals under fixed exchange
rates? Under flexible exchange rates?
If monetary policy is coordinated between countries, it is possible for large benefits to be
reaped from the increased trade and integration that fixed exchange rates could encourage. Not
only would increased trade allow countries to enjoy a higher standard of living, but also capital
flows would allow for surplus funds to flow to their highest return.
Under flexible exchange rates, since capital flows limit the abilities of countries to execute
policies that deviate significantly from the rest of the world, incentive exists for nations to
coordinate their policies so that a workable policy acceptable to all can be found.
Could high U.S. interest rates affect investment spending in foreign countries? Explain.
High U.S. interest rates could affect investment spending in foreign countries. If interest rates
are higher in the United States, there will be capital outflows from other countries into the
United States. The capital outflows from the foreign countries will result in less available
funds for investment spending in foreign countries. Also, higher U.S. interest rates will reduce
U.S. investment in foreign countries.
What is the Eurosystem? Briefly discuss how the Eurosystem conducts monetary policy.
The Eurosystem consists of the European Central Bank and the c entral banks of the 12
countries that participate in the euro, Europe’s single currency. As such, the Eurosystem
implements and carries out monetary policies for the eurozone, with the primary goal of
achieving price stability. To do this, the Eurosyste m decides on a quantitative definition of
price stability, such as 2 percent inflation or less that is to be met over a medium time period.
In addition, “two pillars” are used to achieve the goal. The first pillar is a quantitative
reference value for the growth rate of a broad-based monetary aggregate, such as M2 in the
United States. The second pillar consists of a broad collection of indicators that policymakers
look at to make an assessment of the outlook for price developments in the area as a who le.
To achieve its goals, the Eurosystem uses tools similar to the Fed’s including open market
operations, a lending facility like the discount window called a standing facility, and reserve
requirements. The 12 national central banks hold the required reserves, carry out open market
operations, and operate the standing facility. The Eurosystem must approve of the financial
instruments that are allowed to be used in open market operations. The system also sets
reserve requirements and interest rates on standing facility loans. It also take actions that
nudge interest rates and the monetary aggregates in one direction or the other as part of
monetary policy.
What is full dollarization? How does it differ from a currency board? What is
seigniorage?
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Full dollarization occurs when a country abandons its own currency to adopt another country’s
currency as its official currency. Since 1999, El Salvador, Ecuador, and Guatemala have
dollarized by adopting the U.S. dollar and abolishing their domestic curre ncies. (Panama
dollarized in the early 20 th century.) A currency board is an organized body within a country
with the sole responsibility and power to defend the value of a country’s currency. The
currency board pegs or fixes the currency value to the va lue of the currency of the dominant
trading partner. The country commits to a fixed exchange rate and the currency is fully
convertible with the pegged currency. The government cannot print money unless it is backed
by reserves of the currency to which it is pegged.
Seigniorage is the difference between the cost of producing and distributing currency and any
revenues earned through the distribution. For example, the Fed issues currency by purchasing
government securities that earn interest. The inter est goes to the Fed and eventually to the
government. On the other hand, the currency issued by the Fed does not pay interest. The
amount of interest earned on the government securities less the cost of producing the Federal
Reserve notes is seigniorage. If a country fully dollarizes with U.S. dollars, that country
forgoes earning seigniorage and the United States earns additional seigniorage that is related to
the amount of U.S. dollars circulating in the foreign country.
A currency board can achieve many of the benefits of full dollarization. In addition, the value
of the seigniorage from issuing one’s own currency is not lost.
Answers to Analytical Questions
Use graphs to demonstrate what will happen to the value of the dollar in terms of t he
Japanese yen in each of the following situations:
a.
b.
c.
d.
e.
f.
U.S. income increases.
Japanese income increases.
U.S. interest rates fall.
Japanese interest rates fall.
U.S. inflation increases.
Japanese inflation increases.
a. If U.S. income increases, the dollar supply curve shifts from S to S1 resulting in a
depreciation of the dollar. The new equilibrium at point B shows the depreciation of the
dollar.
b. If U.S. interest rates fall, the dollar supply curve shifts from S to S1 and the dolla r demand
curve shifts from D to D1, causing a depreciation of the dollar at the new equilibrium point
B.
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c. If Japanese income increases, the dollar demand curve shifts from D to D1 causing the dollar
to appreciate from equilibrium point A to poi nt B.
d. If Japanese interest rates fall, the dollar supply curve shifts from S to S1 and the dollar
demand curve shifts from D to D1, causing the dollar to appreciate from equilibrium point A
to point B.
e. If U.S. inflation increases, the dollar supply curve shifts from S to S1 and the dollar demand
curve shifts from D to D1, causing the dollar to depreciate from equilibrium point A to point
B.
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f. If the Japanese inflation increases, the dollar supply curve shifts from S to S1 a nd the dollar
demand curve shifts from D to D1, causing the dollar to appreciate from equilibrium point A
to point B.
If the nominal U.S. interest rate is 10 percent and U.S. inflation is 6 percent, what is the
real U.S. interest rate? What is the real U.S. rate in terms of foreign interest rates?
The real interest rate in the United States is the difference between the nominal interest rate
and inflation. In this case, the real interest rate is 4 percent (10 percent – 6 percent = 4
percent). To know the real U.S. rate in terms of foreign interest rates, you need to know the
foreign nominal interest rate and the foreign rate of inflation.
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The Fed exchanges $1 million for 139 million yen. If the Fed sells $1 million worth of T bills in the open market, what will happen to domestic interest rates and the money
supply? If the Fed does not do the open market sale, what will happen to domestic
interest rates and the money supply? In which case is the foreign exchange
transaction sterilized?
When the Fed exchanges dollars for yen, it is in effect propping up the value of the yen. When
this exchange is accompanied by an open market sale of T -bills, the transaction is said to be
sterilized. This will prevent monetary base from changing. If the Fed di d not conduct open
market sales (i.e., the transaction was not sterilized), the exchange of dollars for yen would
increase the monetary base, the domestic money supply, and cause interest rates to decline.