THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 571

CHAPTER 20

The International Financial System

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IN T ERN ATI O NA L CO NSI DE RATI O NS AN D MO N ETARY PO LI CY
Our analysis in this chapter so far has suggested several ways in which monetary
policy can be affected by international matters. Awareness of these effects can
have significant implications for the way monetary policy is conducted.

Direct Effects
of the Foreign
Exchange
Market on the
Money Supply

When central banks intervene in the foreign exchange market, they acquire or sell
off international reserves, and their monetary base is affected. When a central bank
intervenes in the foreign exchange market, it gives up some control of its money
supply. For example, in the early 1970s, the German central bank faced a dilemma.
In attempting to keep the German mark from appreciating too much against
the U.S. dollar, the Germans acquired huge quantities of international reserves,
leading to a rate of money growth that the German central bank considered
inflationary.
The Bundesbank could have tried to halt the growth of the money supply by
stopping its intervention in the foreign exchange market and reasserting control over
its own money supply. Such a strategy has a major drawback when the central bank
is under pressure not to allow its currency to appreciate: the lower price of imports
and higher price of exports as a result of an appreciation in its currency will hurt
domestic producers and increase unemployment.

The ability to conduct monetary policy is typically easier when a country s
currency is a reserve currency. For example, because the U.S. dollar has been a
reserve currency, the U.S. monetary base and money supply have been less affected
by developments in the foreign exchange market. As long as other central banks,
rather than the Fed, intervene to keep the value of the dollar from changing, U.S.
holdings of international reserves are unaffected. However, the central bank of a
reserve currency country must worry about a shift away from the use of its currency
for international reserves.

Under the Bretton Woods system, balance-of-payments considerations were more
Balance-ofimportant than they are under the current managed float regime. When a non
Payments
Considerations reserve-currency country is running balance-of-payments deficits, it necessarily

gives up international reserves. To keep from running out of these reserves, under
the Bretton Woods system it had to implement contractionary monetary policy to
strengthen its currency. This is exactly what occurred in the United Kingdom before
its devaluation of the pound in 1967. When policy became expansionary, the balance of payments deteriorated, and the British were forced to slam on the brakes
by implementing a contractionary policy. Once the balance of payments improved,
policy became more expansionary until the deteriorating balance of payments
again forced the British to pursue a contractionary policy. Such on-again, off-again
actions became known as a stop-go policy, and the domestic instability it created
was criticized severely.
Because the United States is a major reserve currency country, it can run large
balance-of-payments deficits without losing huge amounts of international
reserves. This does not mean, however, that the Federal Reserve is never influenced by developments in the U.S. balance of payments. Current account deficits
in the United States suggest that American businesses may be losing some of their
ability to compete because the value of the dollar is too high. In addition, large
U.S. balance-of-payments deficits lead to balance-of-payments surpluses in other
countries, which can in turn lead to large increases in their holdings of international reserves (this was especially true under the Bretton Woods system). Because