Chapter 19 The International Financial System

The Market for Foreign Exchange

When U.S. residents buy foreign goods or services or assets they

must purchase foreign currency..

Total foreign expenditures by U.S. residents = demand for

foreign exchange

= Supply of U.S. dollars in exchange markets..

When foreign residents buy U.S. goods or services or assets they

must purchase dollars.

Total expenditures by foreign residents for U.S. things =

demand for dollars

= Supply of foreign currency in exchange markets..

The exchange rate

number of dollars $ #
p= =
1 F currency units F1

Note : In other places the exchange rate is defined to be

# of foreign currency units F #

E= =
dollar $1
we will use p

Suppose that the cost of a pair of shoes in the U.S. is $100, the price in the
foreign country is F50 and the exchange rate is p = 2 . In that case for $100
you can buy the pair of shoes in the U.S. or use the $100 to get F50 and
buy the shoes in the foreign country (we ignore things like shipping costs or
excise taxes or assume them to be incorporated in the cost of the good).
Suppose that the exchange rate falls to p = 1 . Now you could take $50 of
your $100 and purchase F50, get the shoes and still have $50 left over. In
other words the foreign shoes just became cheaper. As usual, when things
get cheaper the demand for these goods increases and hence the demand
for F will increase (while it is possible that the exchange rate could decrease
enough that we could buy all we desire at such a low price that the demand
for foreign currency might actually decrease we will ignore such a
possibility)..

Result: p demand for F

Figure 1. The demand for foreign exchange.

The demand for foreign exchange is shown in Fig. 1 where D f is the

demand for foreign exchange and Q f is the quantity of foreign exchange.

Is the exchange rate increases U.S. goods will become cheaper to foreign
resident. They will want to purchase dollars to purchase U.S. goods and
must supply foreign currency units to do so. So

p S f
 Figure 2. The supply of foreign exchange
The supply of foreign exchange is shown in Fig. 2 and is indicated by S f .
Equilibrium in the foreign exchange market determines the exchange rate
as shown in Fig. 3..

Figure 3. Exchange rate determination in the foreign exchange market

If
p then it will take more $ to buy a foreign currency unit and we
would say that the dollar has depreciated and that the foreign currency
unit has appreciated.

p then it takes fewer $ to buy a foreign currency unit and we

would say that the dollar has appreciated and the foreign currency unit
has depreciated.
Floating (Flexible) exchange rates

Suppose now that U.S. residents decide that they want to buy more foreign
goods for some reason other than exchange rate consideration. Perhaps
they think that foreign good suddenly become cool. Then the demand for
foreign currency will increase and the demand curve will shift to the right as
shown in Fig 4.

Figure 4. An autonomous increase in the demand for foreign goods.

In this case the exchange rate will increase and the dollar will depreciate. At
p 0 the initial demand for foreign currency is Q f 1 . After the autonomous
change the demand for foreign currency is Q f 3 while the supply remains at
Q f 1 . This will force the exchange rate up until supply and demand are in
equilibrium again at Q f 2 .
 Figure 5. An autonomous increase in foreign demand for U.S. goods.

Fixed exchange rates

The exchange rate was determined by the market for foreign exchange in
the previous section. Interest rates have often been determined by
agreements between various governments. Suppose that the U.S. and
some other country (call it F) agree that the exchange rate should be
maintained at p 0 .

Figure 6. An increase in the demand for foreign exchange

Suppose that U.S. residents increase the demand for foreign goods. This is
represented in Fig. 6 by the shift from D f to D
f . Under floating exchange

rates the exchange rate will increase as shown in Fig. 6. Under fixed
exchange rates some action will have to be taken to keep the exchange rate
at p 0 . What is needed is an increase in the supply of foreign exchange.
Suppose that the supply of foreign exchange shift from S f to S f so that the

exchange rate does not increase. This is shown in Fig. 7.

Figure 7. Pegging the exchange rate at p 0 .

So an increase in the supply of foreign currency will keep the exchange rate
at p 0 . The action of keeping the exchange rate fixed at a certain value is
also called pegging. The only catch is where is it supposed to come from?
Clearly the central bank of the foreign country can always create new
money and supply the foreign currency market that way (the central bank
creates the money and uses it to buy dollars). But why should they agree to
do that. The U.S. is the country that created the problem. One way of
looking at this is that the U.S. consumer is controlling the foreign countries
money supply. Further we would be forcing the other country to maintain
the purchasing power of the dollar. Again the other country might not be so
accommodating.

The central bank of the U.S. could use its reserve holdings of the other
counties money to purchase dollars. That increases the supply of foreign
exchange. In this case we would say the FED has intervened to peg the
exchange rate.

Intervention in the foreign exchange market

Suppose the Fed decided that it needed to increase the supply of foreign
currency. The Fed will have some assets denominated in a foreign currency
(international reserves) that it can use to buy dollars. This will increase the
supply of foreign currency in the currency markets.

Federal Reserve System

Assets Liabilities
Foreign Assets -$1billion Currency in circulation -$1billion

If the Fed uses $1 billion of foreign assets to purchase $1 billion U.S. dollars
then the Feds holdings of international reserves (foreign assets) will
decrease by $1 billion and the volume of U.S. dollars in circulation will
decrease by the same amount. But this also has an effect on the U.S.
money supply.

MB = R + C
and because C has declined the monetary base will decline as well and so
will the U.S. money supply.

If the Fed increases the supply of foreign currency the U.S. money
supply will decline.
 Figure 8. U.S. residents decide to buy more foreign goods.

Suppose that U.S. residents want to purchase more foreign goods. They
will buy more foreign currency driving the exchange rate from p 0 to p 1 . If
exchange rates are fixed, then someone must increase the supply of foreign
exchange to drive the exchange rate back to p 0 . This will be the
responsibility of some central bank. The other countries central bank could
print some money and purchase U.S. dollars. That would increase the
supply of foreign currency. The other central bank would increase its
holdings of foreign (i.e. U.S.) assets. This would also increase the supply of
currency and hence the monetary base of the other country. The other
countrys central bank may not want to do this. This would mean that U.S.
residents would be determining monetary policy of the other country. The
other countrys central bank may take the position that the problem has
been caused by U.S. residents, so it should be solved by the U.S. central
bank.

If the foreign countrys central bank uses its currency to purchase

dollars then the money supply of the foreign country will increase.

The operations where central banks purchase each other countries

currencies thereby changing the monetary base are called
unsterilized foreign exchange interventions.
Sterilized Intervention

The Fed can keep the monetary base fixed after the purchase or sale of
international assets by using open market operations. In the following
example the Fed uses foreign assets to buy dollars and then follows this
with an open market purchase. The initial action reduces currency and the
subsequent one increases reserves.

Federal Reserve System

Assets Liabilities
Foreign Assets -$1billion Currency in circulation -$1billion

The initial action

Federal Reserve System

Assets Liabilities
Foreign Assets -$1billion Currency in circulation -$1billion
Government bonds +1 billion Reserves +$1billion

The subsequent action

The decrease in currency is now just offset by the increase in reserves, so

the monetary base and money supply remain unchanged.

Suppose that the Fed used dollars to buy foreign assets. In this case the
demand for foreign assets increases and the exchange rate increases. That
is the D f curve shifts to the right as shown in Figure 8. The difference here
is that the Fed wants the exchange rate to increase. The unsterilized result
is

Federal Reserve System

Assets Liabilities
Foreign Assets +$1billion Currency in circulation +$1billion
and the sterilized result
is

Federal Reserve System

Assets Liabilities
Foreign Assets +$1billion Currency in circulation +$1billion
Government bonds -1 billion Reserves -$1billion

An unsterialized intervention where the Fed uses U.S. dollars to

purchase of foreign currency results in a gain of international reserves,
an increase in the monetary base and in the money supply and a
depreciation of the domestic currency (if p increases then it takes
more dollars to purchase a foreign currency unit).

An unsterialized intervention where the Fed uses foreign assets to

purchase U.S. dollars results in a loss of international reserves, a
decrease in the monetary base and in the money supply and an
appreciation of the domestic currency ( S f shifts to the right decreasing
p . If p decreases, then fewer dollars are needed to purchase a
foreign currency unit).

The purpose of sterilization

An unsterilized intervention changes a nations money supply. Because the

money supply changes interest rates will change as well. Sterilization
leaves the money supply and interest rates unchanged. The problem is that
the sterilization will set forces in motion that will offset the intervention. The
bad news is that only an unsterilized intervention can change exchange
rates.

Consider again an unsterilized intervention where the Fed uses foreign

currency assets to buy dollars (lowering the exchange rate) This reduces
currency in circulation and the U.S. money supply thus raising interest rates
(this raise in interest rates is why someone would consider a sterilizing the
intervention). This action will increase the value of the dollar. Note that
U.S. financial assets will cost foreigners more, but they will get a higher
interest rate than they did before the intervention.

Now comes the sterilization to reduce U.S. interest rates. Now U.S. assets
cost more but U.S. interest rates have gone back to their previous level.
Foreign financial assets have become cheaper and U.S. financial assets are
more expensive. We would expect people to buy assets where they are
cheapest. That is the demand for foreign currency will increase which will
offset the intervention (the exchange rate goes back up).

The balance of payments

The balance of payments records all movement of funds between

countries.

The current account

Measures trade flows between countries. If the U.S. exports more

than it import, then the U.S. will have a trade surplus. If the U.S.
imports more than it exports, the U.S. has a trade deficit.

The capital account.

For years the U.S. has had a balance of trade deficit with Japan and a
number of other countries. The Japanese do not just set on the dollars
they have accumulated. They will use these dollars to purchase U.S.
financial assets. U.S. residents purchase of foreign assets and
foreigners purchase of U.S. assets are recorded in the capital account.

If the current account shows a trade deficit then the capital account will
likely show a surplus (foreigners using these funds to buy U.S.
financial assets). The offset will not be perfect and any difference must
be made up by a change in government reserve assets.

current account + capital account = change in government

reserves.
 The U.S. Balance of payments, 1998 (billions of dollars)
Current account Receipts(+) Payments(- Balance
)
(1) Merchandise exports 671
(2) Merchandise imports -919
Trade balance -248
(3)Net investment -23
Income
(4)Net Services +79
(5)Net Unilateral transfers -41
Balance -233
(1)+(2)+(3)+(4)+(5)

Capital account
(6) Capital outflows -305
(7) Capital inflows +564
(8) Statistical discrepancy -3
Banalce +256
(6)+(7)+(8)
Balance of payments +23
Method of financing
(9) Increase in U.S. official -1
reserve assets ($)
(10) Increase in foreign -22
official assets

The official reserve transactions balance is equal to the loss of

reserves that the central bank must provide to make up for balance
of payments deficits or the increase in reserves it will receive if
there is a surplus.

Methods of financing the balance of payments deficit

The U.S. dollar is a widely accepted form of international exchange,

so in many cases the Fed will receive dollars in the case of a
surplus with a particular country. A foreign country may be quite
willing to accept dollars in the case of a deficit.

The currencies of other countries are not so readily accepted.

These countries may have to use international reserves as a
means of settling balance of payments deficits.
Evolution of the international financial system

Using gold as money. This is a hypothetical exercise, but a good way to

think of the workings of a fixed exchange rate system. Suppose that all
nations used exactly the same money and that this money is gold coins.
Further assume that these gold coins can be transported from one place to
another at no cost. If goods were cheaper in Great Britain than in the U.S.
people would tend to buy the goods in Great Britain. Gold would flow from
the U.S. to Great Britain. Note that the monetary base of the U.S. is falling
and the monetary base of Britain is increasing. So what is determining a
nations money supply? International trade.

But what will the increase in the money supply do to prices in Britain?
Prices in Britain will increase and prices in the U.S. will drop. Eventually the
gold flow will reverse and money will flow from Britain to the U.S. So we
have this nice, self regulating system.

Gold standard

Most nations operated on the gold standard before WWI. A nation on a gold
standard will be willing to trade a fixed number of units of its currency for an
ounce of gold. Say that Britain set its conversion ratio at ounce of gold
for 1 sterling and that the U.S. would exchange 1 20 ounce of gold for for
$1. So the U.S. resident could take $20 and get 1 ounce of gold. The one
once of gold could then be used to purchase 4 sterling. So we have
essentially a fixed exchange rate system. In this case

=$20/4=5.

Suppose that the British pound appreciated so that it now cost American
residents more to purchase British goods. An importer could convert U.S.
dollars to gold, however, and still buy British pounds at the five to one
exchange rate. So gold (international reserves) will flow from the U.S. to
Britain, increasing the British money supply and British prices. The U.S.
money supply will decline and so will U.S. prices.

The Bretton Woods Treaty

The gold standard collapsed during the first World War. Most countries
went far into debt to pay for fighting the war and did not have enough gold to
begin to pay their war debts much less to be able to convert to foreign
exchange. Nations tried to reestablish the gold standard after the war but
the Great Depression finished it off.

The Bretton Woods treaty was signed after World War II. This treaty tried to
establish a fixed exchange rate system that did not use gold. Instead
countries agreed to maintain the exchange ratio between their currencies at
a fixed ratio.

The Bretton Woods treaty also established the International Monetary Fund
(IMF) and the World Bank. The IMF was supposed to promote world trade
by setting the rules for exchange rate maintenance and by making loans to
countries with balance of payments problems. The World Bank is an
organization that is supposed to encourage economic development in lesser
developed countries. The bank provides long term loans to countries for
projects like dam building, road building and agricultural projects.

The U.S. played a pivotal role in the founding of the Bretton Woods system,
particularly in the early days. The economies of almost all of Europe and
much of the far East had been devastated by World War II. The U.S. was
the dominant economic power in the world by far. The U.S. dollar became
an international reserve currency. Almost any country would be willing to
accept dollars as payment for international debt. This became a feature of
the Bretton Woods system and dollars have remained an international
currency ever since.

The breakdown of the Bretton Woods system.

In the 1960s the U.S. was fighting a war in Vietnam and also the war on
poverty. The U.S. paid for both of these wars by borrowing money. This
drove interest rates up and the Fed conducted large open market purchases
of government securities to try to force them down again. This lead to
prices increases for U.S. goods (the Fed is essentially printing money).
Foreign goods became relatively cheaper and U.S. citizens started
purchasing an increasing volume of foreign, particularly German, goods.
This meant a increase in the demand for foreign currency (particularly
German marks) driving the exchange rate up (that is the Mark appreciated
and the dollar depreciated). Under floating exchange rates this would have
made German goods more expensive to U.S. residents, but the Bretton
Wood system required that the U.S. take action to reduce the exchange
rate. The U.S. used its reserves of German marks to buy dollars. But U.S.
prices rose even more, this forced further increases in the exchange rate
which had to be offset by a Fed purchase of dollars using marks.
This works until the U.S. runs out of marks. We cant supply any more
marks. Not only that, but we are supposed to be the reserve currency. The
German central bank could print up marks and use them to buy dollars. The
German central bank refused because this would drive up German prices.
They took the attitude that we were exporting our inflation to them and
werent too wild about the prospect. So the Bretton Woods system fell apart
in 1971 and currencies were allowed to float.

Managed float.

Exchange rates are now market determined to a certain extent. Central

banks do tend to influence them in certain cases. Recall that a country that
has an appreciating currency will find that the cost of its goods will be
getting more expensive to foreigners while the cost of foreign goods will be
getting cheaper. This could mean that the sale of domestically produced
output will fall leading to reduced income and employment.

On the other hand countries with a depreciating currency will find that
imports will start costing more and this will be inflationary. Voters dont like
that. Central banks are often encourages to take actions to prevent rapid
changes in the exchange rate.

Some foreign exchange crises

September 1992

The British were worried about a recession and the Germans were worried
about inflation. The British were trying to keep interest rates low by
increasing the money supply. The Germans were keeping their money
supply steady which lead to interest rates substantially higher than those in
Britain. So where do you want to put your money? Speculators anticipated
that the mark would appreciate in value, so they purchased marks. Sure
enough this made the problem worse. The British tried an intervention that
resulted in a substantial increase in British interest rates. The British finally
gave up and let the pound devaluate by about 10%. Other European banks
tried to help, but generally all of them lost money to the speculators.

The Mexican peso crisis of December 1994

The Presidential candidate of the ruling party (at that time the person who
would have been elected) was assassinated. Investors became concerned
that the government might devalue the peso. Speculators smelled this out
and borrowed pesos that they used to buy other currencies. This was a self
fulfilling prophecy. The peso fell in value, and the speculators were able to
pay off loans with devalued pesos.

To combat this the government tried to buy pesos with dollars, an action that
drove up Mexican interest rates. The government did not have sufficient
foreign reserves to prevent devaluation and in the end the peso was worth
half what it had been worth. Bad news for those people buying imported
goods.

The East Asian crisis of 1997

Thailand was experiencing a large merchandise trade deficit. This might

have been offset by inflows to purchase Thai financial securities, but these
did not seem particularly attractive. Again speculators anticipated a
devaluation and took actions that help cause the anticipated devaluation.
But this generated fear in the rest of East Asia and people began dumping
the currencies of Asian nations. Many countries in that part of the world
were forced to devalue their currencies. The currencies of Hong Kong,
Singapore, and Taiwan were also attacked but were strong enough to avoid
devaluation.

Capital outflow controls

The flight of investment capital from a country experiencing economic

difficulties will result in a devaluation of the countrys money. One way to
prevent the flight of capital is to prohibit money from leaving the country.
There are several drawbacks to this sort of policy:
1. Individuals find ways to avoid the controls
2. Imposition of the control might weaken confidence in the government
and hasten the flight of capital.
3. The controls lead to corruption (individuals bribe government officials
to ignore the controls).
4. The controls may make government officials ignore other reforms
they should make.
5. It may inhibit capital inflows would you like to invest somewhere
that you werent sure you would get your money back.
Capital inflow controls

These are an alternative to outflow controls. Limiting the amount of funds

that come into a country limits how much can flow out. In particular if they
can be used to keep speculators out. Excessive capital inflows in Asia lead
to a lending boom and excessive risk on the part of banks.

This sort of policy may lead to a country not having sufficient funds available
for productive investment opportunities. There is also the chance for
corruption. Government officials can be bribed to let funds enter the
country.

The IMF

The IMF was established by the Bretton Woods treaty to help countries
maintain fixed exchange rates and to lend funds to countries experiencing
balance of payments problems. It not longer has the exchange rate
function.

The IMF as a lender of last resort.

The central bank of many industrialized countries can serve as a lender of

last resort to prevent financial panics. Part of the reason that these banks
are successful is that they have a good deal of credibility. When the stock
market crashed on Oct 19, 1987 the Fed immediately assured the financial
community that it would be willing to provide sufficient discount loans to
banks that would enable the banks to lend enough to prevent a financial
meltdown. Because of the prompt action of the Fed and because people
believed the Fed was serious, very little money was actually needed.

Emergent countries are not blessed as to have central banks with such
reputations. In certain countries the sudden action of a central bank to
make money available for loans would be seen as inflationary. Such an
action may frighten rather than reassure investors.

The IMF may, in such cases, serve as a lender of last resort with greater
credibility than the emergent countrys central bank. This can give investors
reassurance that inflationary action will not occur. This reassurance has its
own problems, however. In particular this may create a moral hazard
problem where the emergent country may take risks assuming the IMF will
bail it out.
The IMF may also be blackmailed into providing assistance because of the
human suffering that will occur if such loans are not provided. The IMF
often makes loans available only if the borrowing country agrees to certain
economic and financial reforms. Politicians are often able to use the IMF
insistence on economic reform as the cause of failed economic policies.

Questions

1. If the Fed wishes to increase the value of the dollar in foreign

exchange markets it would
A) Use its foreign currency reserve assets to buy dollars
B) Use dollars to buy foreign currency assets
C) Use foreign assets to buy U.S. government securities
D) Use dollars to buy U.S. government assets.

2. If the Fed wishes to decrease the value of the dollar in foreign

exchange markets it would
A) Use its foreign currency reserve assets to buy dollars
B) Use dollars to buy foreign currency assets
C) Use foreign assets to buy U.S. government securities
D) Use dollars to buy U.S. government assets.

3. If the Fed used its foreign currency assets to purchase dollars this
would
A) Increase the money supply and raise interest rates
B) Increase the money supply and lower interest rates
C) Decrease the money supply and lower interest rates
D) Decrease the money supply and raise interest rates.

4. A foreign exchange intervention with an offsetting open market

operation that leaves the monetary base unchanged is called
A) an unsterilized foreign exchange intervention.
B) a sterilized foreign exchange intervention.
C) an exchange rate feedback rule.
D) a money neutral foreign exchange intervention.
 5. An unsterilized intervention in which domestic currency is used to
purchase foreign assets leads to
A) a gain in international reserves.
B) an increase in the money supply.
C) a depreciation in the domestic currency.
D) all of the above.
E) only (a) and (b) of the above.

6. An unsterilized intervention in which foreign assets are used to

purchase domestic currency
A) a decrease in international reserves.
B) a decrease in the money supply.
C) an appreciation in the domestic currency.
D) all of the above.
E) only (a) and (b) of the above.

7. Because sterilized interventions mean offsetting open market operations,

then
A) there is no impact on the monetary base.
B) there is no impact on the money supply.
C) there is no effect on the exchange rate.
D) all of the above occur.
E) only (a) and (b) of the above occur.

8. Sterilized interventions are used in an attempt to

A) Make open market operations more efficient
B) Increase exports
C) Insulate the domestic economy from exchange rate interventions
D) A) and C) above
E) None of the above

9.) The difference between merchandise exports and imports is called the
A) current account balance. B) capital account balance.
C) official reserve transactions balance. D) trade balance.
10. Which of the following does not appear in the current account part of
the balance of payments?
A) A loan of $1 million from Chase Manhattan bank to Brazil.
B) Foreign aid to El Salvador.
C) An Air France Ticket bought by an American.
D) Income earned by General Motors from its plants abroad.

11. Which of the following appears in the capital account part of the balance
of payments?
A) A gift to an American from his English aunt
B) A purchase by the Honda corporation of a U.S. Treasury bill
C) A purchase by the Bank of England of a U.S. Treasury bill
D) Income earned by the Honda corporation on its automobile plant in
Ohio

12. In its March 30, 1991 issue, The Economist reported that the $40-50
billion promised by foreign governments to the United States to help pay
for the cost of the Persian Gulf war could potentially have the effect of
A) turning America's current account deficit into a surplus.
B) turning Japan's current account deficit into a surplus.
C) turning America's current account surplus into a deficit.
D) none of the above.

13)The account that shows international transactions involving currently

produced goods and services is called the
A) trade balance. B) current account.
C) balance of payments. D) capital account.

14)Which of the following appear as credits in the U.S. balance of

payments?
A) merchandise exports
B) payments from foreign tourists
C) foreign aid, gifts and pensions paid to foreigners
D) only (a) and (b) of the above
15)Which of the following appear as credits in the U.S. balance of
payments?
A) American purchases of foreign products
B) payments from foreign tourists
C) foreign aid, gifts and pensions paid to foreigners
D) only (a) and (b) of the above

16)Holding other factors constant, which of the following would increase the
size of the U.S. current account deficit?
A) An increase in the amount of services purchased from foreigners
B) An increase in unilateral transfers from Americans to foreigners
C) An increase in American's net investment income.
D) Only (a) and (b) of the above

17)A balance of payments _____ is associated with a _____ of international

reserves.
A) deficit; loss B) deficit; gain
C) surplus; loss D) balance; gain

18)A balance of payments _____ is associated with a _____ of international

reserves.
A) surplus; loss B) surplus; gain
C) deficit; gain D) balance; loss
19) Which of the following are true statements about the gold standard?
A) Before World War I, the world economy operated under a gold
standard, under which the currencies of most counties were
convertible directly into gold.
B) Tying currencies to gold resulted in an international financial system
with fixed exchange rates between countries.
C) If a country's currency appreciated, the country would gain
international reserves (gold), causing its monetary base to rise and
putting downward pressure on its currency.
D) All of the above are true.

20) Before World War I, the economy operated under a gold standard.
Under this international financial system if the British pound began to
appreciate relative to the dollar,
A) American importers would increasingly purchase British imports with
gold.
B) Britain would gain international reserves.
C) the British monetary base would begin to rise.
D) all of the above.
E) only (a) and (b) of the above.

21. When gold production was low in the 1870s and 1880s, the money
supply grew _____ causing _____.
A) rapidly; inflation B) rapidly; disinflation
C) slowly; deflation D) slowly; disinflation

22. The Bretton Woods system was one in which central banks
A) bought and sold their own currencies to keep their exchange rates
fixed.
B) agreed not to intervene in the foreign exchange market to maintain
a fixed exchange rate regime that had existed prior to World War I.
C) agreed to limit domestic money growth to the average of the five
largest industrial nations.
D) agreed to limit domestic money growth to the average of the seven
largest industrial nations.
 23. The Bretton Woods system broke down because
A) The German government kept appreciating the value of the
mark
B) The U.S. government kept buying German marks
C) The U.S. ran out of foreign currency reserves
D) Goverments went off the gold standard
E) None of the above

24. If a central bank does not want to see its currency fall in value, it may
pursue _____ monetary policy to _____ the domestic interest rate,
thereby strengthening its currency.
A) expansionary, raise B) contractionary, raise
C) expansionary, lower D) contractionary, lower

25. Policy makers in a country with a balance of payments surplus may not
want to see their country's currency appreciate because
A) this would hurt consumers in their country by making foreign goods
more expensive.
B) this would hurt domestic businesses by making foreign goods
cheaper in their country.
C) this would increase inflation in their country.
D) this would decrease the wealth of the country.
26. Under the current managed float exchange rate regime, countries with
balance of payments deficits frequently do not want to see their
currencies depreciate because it makes _____ goods more expensive
for _____ consumers and can stimulate inflation.
A) foreign, foreign B) foreign, domestic
C) domestic, foreign D) domestic, domestic

27. Although capital controls sound like a good idea, they suffer from several
disadvantages including:
A) They are seldom effective during a crisis because people find ways
to evade controls and move funds out of the country.
B) Capital flight may increase after controls are put into place because
confidence in the government is weakened.
C) They often lead to corruption, as government officials get paid to
look the otherway when domestic residents try to move funds
abroad.
D) All of the above.
E) Only (a) and (b) of the above.

28. In the 1990s this agency has acted like an international lender of last
resort to cope with financial instability.
A) World Bank
B) European Central Bank
C) IMF
D) International Bank for Reconstruction and Development

29. An international lender of last resort creates a serious _____ problem

because depositors and other creditors of banking institutions expect
that they will be protected if a crisis occurs.
A) moral hazard
B) adverse selection
C) public choice
D) strategic choice