THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 578

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PA R T V I

International Finance and Monetary Policy
a country adopting dollarization no longer has its own currency, it loses the revenue
that a government receives by issuing money, which is called seignorage. Because
governments (or their central banks) do not have to pay interest on their currency,
they earn revenue (seignorage) by using this currency to purchase income-earning
assets such as bonds. In the case of the Federal Reserve in the United States, this revenue is on the order of US$30 billion per year. If an emerging-market country dollarizes and gives up its currency, it needs to make up this loss of revenue somewhere,
which is not always easy for a poor country.

S U M M A RY
1. An unsterilized central bank intervention in which
the domestic currency is sold to purchase foreign
assets leads to a gain in international reserves, an
increase in the money supply, and a depreciation of
the domestic currency. Available evidence suggests,
however, that sterilized central bank interventions
have little long-term effect on the exchange rate.
2. The balance of payments is a bookkeeping system
for recording all payments between a country and
foreign countries that have a direct bearing on the
movement of funds between them. The official
reserve transactions balance is the sum of the current
account balance plus the items in the capital
account. It indicates the amount of international
reserves that must be moved between countries to
finance international transactions.
3. Before World War I, the gold standard was predominant. Currencies were convertible into gold, thus
fixing exchange rates between countries. After World

War II, the Bretton Woods system and the IMF were
established to promote a fixed exchange rate system
in which the U.S. dollar was convertible into gold.
The Bretton Woods system collapsed in 1971. We
now have an international financial system that has
elements of a managed float and a fixed exchange
rate system. Some exchange rates fluctuate from day
to day, although central banks intervene in the foreign exchange market, while other exchange rates
are fixed.
4. Controls on capital outflows receive support
because they may prevent domestic residents and
foreigners from pulling capital out of a country during a crisis and make devaluation less likely.
Controls on capital inflows make sense under the
theory that if speculative capital cannot flow in, then
it cannot go out suddenly and create a crisis.
However, capital controls suffer from several disadvantages: They are seldom effective, they lead to
corruption, and they may allow governments to
avoid taking the steps needed to reform their financial systems to deal with the crises.
5. The IMF has recently taken on the role of an international lender of last resort. Because central banks

in emerging-market countries are unlikely to be
able to perform a lender-of-last-resort operation
successfully, an international lender of last resort
like the IMF is needed to prevent financial instability. However, the IMF s role as an international
lender of last resort creates a serious moral hazard
problem that can encourage excessive risk taking
and make a financial crisis more likely, but refusing
to lend may be politically hard to do. In addition, it
needs to be able to provide liquidity quickly during
a crisis to keep manageable the amount of funds

lent.
6. Three international considerations affect the conduct
of monetary policy: direct effects of the foreign
exchange market on the money supply, balance-ofpayments considerations, and exchange rate considerations. Inasmuch as the United States has been a
reserve currency country in the post World War II
period, U.S. monetary policy has been less affected by
developments in the foreign exchange market and its
balance of payments than is true for other countries.
However, in recent years, exchange rate considerations have been playing a more prominent role in
influencing U.S. monetary policy.
7. Exchange-rate targeting has the following advantages
as a monetary policy strategy: (1) It directly keeps
inflation under control by tying the inflation rate for
internationally traded goods to that found in the
anchor country to which its currency is pegged; (2) it
provides an automatic rule for the conduct of monetary policy that helps mitigate the time-inconsistency
problem; and (3) it is simple and clear. Exchange-rate
targeting also has serious disadvantages: (1) It results
in a loss of independent monetary policy; (2) it
leaves the country open to speculative attacks; and
(3) it can weaken the accountability of policymakers
because the exchange-rate signal is lost. Two strategies that make it less likely that the exchange-rate
regime will break down are currency boards, in
which the central bank stands ready to automatically
exchange domestic for foreign currency at a fixed
rate, and dollarization, in which a sound currency
like the U.S. dollar is adopted as the country s
money.