International Financial Systems Overview Flashcards
(26 cards)
What is the International Financial System
A framework enabling trade in goods/services and cross-border capital flows.
Vital as global economies (especially the U.S.) become more interdependent.
Modern global trade often involves complex supply chains (e.g., aircraft production with parts from multiple countries).
Trade/GDP ratios have increased, underscoring the need for a robust system to facilitate currency exchange and payments.
Exchange rates are crucial to ensuring smooth international trade and capital movement.
What is Intervention in the Forex Market
Intervention in the foreign exchange (forex) market refers to actions by central banks engaging in international transactions specifically to influence exchange rates.
Central banks believe they should have some influence over exchange rates because a currency that is too weak or too strong can negatively affect economic growth, inflation, and other economic objectives
Interventions are undertaken to prevent undesirable fluctuations that could impact economic stability.
How does Central Bank Intervention Impact Money Supply
When a central bank sells foreign currency reserves (e.g., $1.1 billion) and buys domestic currency (e.g., €1 billion), it reduces domestic commercial banks’ reserves.
This liquidity drain lowers the money supply, potentially causing domestic interest rates to rise.
Higher interest rates attract investors, increasing demand for domestic currency → currency appreciates in the short run.
What are the Two Types of Foreign Exchange Interventions
Unsterilised Intervention
Sterilised Intervention
What is Unsterilised Intervention
Occurs when a central bank buys or sells foreign currency and foreign assets without performing a matching open market operation.
This type of intervention directly affects the domestic money supply and, consequently, domestic interest rates and the exchange rate
If a central bank sells foreign currency (e.g., U.S. dollars) in exchange for its domestic currency (e.g., euros), it effectively “sucks in” liquidity from the commercial banking sector. Commercial banks pay for the foreign currency using their domestic currency reserves.
What is Unsterilised Interventions Impact on Money Supply, Interest Rates and Exchange Rates
Money Supply - This action leads to a fall in commercial bank reserves and a decrease in the domestic money supply
Interest Rate - When money becomes more scarce, banks become more reluctant to lend, causing domestic interest rates to rise.
Exchange Rate - As domestic interest rates increase, the domestic currency becomes more attractive to investors, leading to an appreciation of the domestic currency in the short run.
What is Sterilised Intervention
Occurs when a central bank engages in buying or selling foreign currency in the foreign exchange market
But simultaneously carries out offsetting open market operations to neutralise the impact on the domestic money supply.
The central bank performs an additional operation. For example, if it sells foreign currency (e.g., U.S. dollars) to reduce the domestic currency’s value, it will simultaneously purchase an equivalent amount of government bonds (or other domestic assets) from the commercial banking sector.
What is Sterilised Interventions Impact on Money Supply, Interest Rate and Exchange Rates
Money Supply - This offsetting operation ensures that the domestic currency reserves of commercial banks remain unchanged.
Interest Rate - As a result, the domestic money supply is not affected, and therefore, there is no change in domestic interest rates.
Exchange Rate - Because the domestic interest rate remains unchanged, the demand curve for domestic deposits does not shift, meaning the exchange rate is not affected by this combined operation from a monetary policy perspective.
What is Balance of Payments
An accounting system tracking all international financial transactions affecting a country’s economy.
Records all receipts and payments influencing the movement of funds between nations.
Tracks whether more money/wealth flows into or out of a country.
Helps measure a country’s economic financial health and currency demand.
Why is Balance of Payments Important
Determines demand for a country’s currency and its value trend:
Trade surplus (exports > imports) → currency appreciation.
Trade deficit (imports > exports) → currency depreciation.
Persistent negative BoP is unsustainable and can:
Lead to currency depreciation.
Impede economic growth.
Influences investors’ and policymakers’ views on the economy.
US 2015 Example
Merchandise Trade Deficit: In 2015, the U.S. imported more goods than it exported, resulting in a deficit of $762 billion. This meant Americans bought significantly more from abroad in terms of goods than they sold.
Services Trade Surplus: Conversely, the U.S. had a surplus in the export of services, exporting $262 billion more than it imported. This reflects the strength of U.S. service industries like investment banking and consulting.
Net Investment Income Surplus: The U.S. also recorded a net investment income of $182 billion. This occurred because Americans received more income from their investments abroad (like dividends from foreign subsidiaries) than they paid out to foreign companies with investments in the U.S..
Net Transfers to Foreigners Deficit: There was a negative net transfer of $145 billion. This typically includes money sent home by immigrants working in the U.S. to relatives in poorer countries.
What are Exchange Rate Regimes
The system by which a country manages its currency’s value relative to others.
Determines how exchange rates are established and maintained.
Two main types:
Fixed Exchange Rate Regime
Floating Exchange Rate Regime
What are Fixed Exchange Rate Regimes
Currency is pegged to another currency or basket (e.g., USD, Euro).
Goal: Stability in currency value, boosts investor confidence.
Requires central bank intervention to maintain the peg.
If overvalued, bank buys domestic currency (using reserves).
If undervalued, bank sells domestic currency (gaining reserves).
Costs: Requires sufficient international reserves, limits independent monetary policy.
Can lead to devaluation (lowering peg) or revaluation (raising peg) when defending fixed rates is unsustainable.
What is Floating Exchange Rate Regime
Currency value is determined by market forces (supply & demand).
Government/central bank usually does not fix exchange rates.
Managed float (dirty float): occasional interventions to smooth fluctuations.
Advantages:
More freedom for monetary policy.
Exchange rates adjust naturally to economic conditions.
What is the 1994 Bretton Woods Agreement
Established new global financial system post-WWII.
Created:
IMF: Enforced fixed exchange rates, provided loans to countries in difficulty.
World Bank: Funded long-term development projects.
Made the U.S. dollar the reserve currency backed by gold ($35/ounce).
Fixed exchange rates pegged currencies to the USD within ±1%.
Abandoned in 1971 due to economic pressures (Vietnam War, oil shock).
Transitioned to floating exchange rates by early 1970s.
Despite changes, the USD remains dominant in global finance.
Devaluation vs Revaluation (Fixed Exchange Rates)
🔁 Devaluation
Occurs when a currency is overvalued and the central bank runs out of reserves to maintain the peg.
The par exchange rate is reset lower, making the currency cheaper relative to the anchor currency.
Leads to more competitive exports but can fuel imported inflation.
🔁 Revaluation
Happens when a currency is undervalued and the central bank stops accumulating reserves.
The par exchange rate is reset higher, making the currency more expensive.
Less common in practice—often tied to sustained strong economic performance.
What is the Policy Trilemma
📉 A country cannot simultaneously achieve all three of the following:
Free Capital Mobility – unrestricted flow of investments across borders
Fixed Exchange Rate – maintaining a stable pegged currency
Independent Monetary Policy – setting domestic interest rates freely
📌 Must choose 2, sacrifice 1:
Fix exchange + free capital mobility → no independent monetary policy
Free capital + monetary independence → must allow floating exchange rate
Fix exchange + monetary independence → need capital controls
Trilemma and Floating Exchange Rate
Floating Exchange Rate: Countries like the Eurozone and the U.S. allow a floating exchange rate.
They choose to have free capital mobility and an independent monetary policy, giving up the fixed exchange rate.
Their currencies’ values are determined by market forces.
Trilemma and Dependant Monetary Policy
Jurisdictions such as Hong Kong and Belize have dependent monetary policies.
They opt for free capital mobility and a fixed exchange rate, sacrificing their ability to set independent monetary policy.
Their monetary policy effectively aligns with that of their anchor currency.
Trilemma and Capital Controls
China does not have free capital mobility. It employs capital controls to restrict the movement of capital across its borders, allowing it to maintain a fixed exchange rate and an independent monetary policy.
However, controls on capital outflows are often ineffective during a crisis and can even increase capital flight, leading to corruption.
There is some support for controls on inflows to reduce crisis likelihood, but they can block productive resources and also lead to corruption.
Floating Exchange Rate Systems
Exchange rates are determined by market forces of supply and demand without direct central bank intervention.
✅ Advantages:
Allows independent monetary policy
More flexibility to target inflation, growth, or employment
🌍 Examples:
U.S., Eurozone
Adopted widely after the Bretton Woods collapse in the 1970s
Benefits of Floating Exchange Rates
📈 Greater Policy Freedom:
Floating regimes give central banks the ability to focus on domestic economic objectives (like inflation control) rather than defending a currency peg.
🌐 Global Shift:
Post-1970s, most Western economies moved to floating systems after the end of gold convertibility and dollar pegs.
What are Managed Floats (Dirty)
🌀 Definition:
A hybrid regime where currencies float but the central bank occasionally intervenes if rates move too far from desired levels.
🎯 Why Intervene?
To avoid excessive currency appreciation or depreciation
Helps businesses plan for international transactions
Prevents competitive disadvantages for exporters/importers
How Central Banks Intervene in a Dirty Float
🏦 Mechanisms:
Buying/selling foreign assets to influence exchange rates
Intervening when rates deviate “too much” from targets
⚖️ Balancing Act:
Too strong currency? Sell domestic currency to weaken it
Too weak currency? Buy domestic currency to support it
