World Financial Infrastructure and Money

World Financial Infrastructure and Money : Sukumar Nandi
World Financial Infrastructure and Money
Sukumar Nandi
Indian Institute of Management Lucknow Lucknow 226013, India mail!! nandi"iiml#ac#in
$%a&ter 1 Money! 'istory and (olution
One major event of human civilization is the invention of money as a medium of exchan e! Money in circulation" #oth $a$er and metallic currency" is the interest free lia#ility of the overnment1 and a ainst this there are claims to virtually nothin ! %his is #ecause $resent& day money is hardly #acked #y old and other forei n asset #y the overnment ! %his is fiat money and it is a le al tender" 'hich the citizens of the country are le ally #ound to acce$t as a medium of exchan e! So money in circulation is not #acked #y overnment lia#ility and the overnment has virtual mono$oly on the $rovision of fiat money! Further" the overnment also controls the (uantity of money!) In the historical context" fiat money is very recent in ori in 'ith a lifes$an of a fe' decades! Its earlier form 'as commodity money! From history 'e find that use of old as money #e an in the sixth century *! +! in %urkey! ,um$s of old found in the river #ed 'ere melted and converted into $ieces of uniform sizes and then stam$ed to ive it le al sanction! %his is the early form of commodity money 'ith face value e(ual to its intrinsic value! %he commodities chosen 'ere enerally $recious metals 'ith li hter 'ei ht for the convenience of carryin to distant $laces ! *ut sometimes seashells" cattle 'ere also used as money! %he technical characteristics of commodities selected to serve as money are of minor im$ortance! *ut the im$ortant thin is that there should exist social institutions condoned #y customs and-or la' that ena#le the economic a ents to trade efficiently #y follo'in the s$ecific rule that one commodity traded in every exchan e should #e socially sanctioned as an exchan e intermediary! In the money usin economy the rule of the ame is very $recise that commodities #uy money and vice versa "#ut commodities do not #uy commodities in any or anized market . +lo'er"1/0/1! Money in t%e arly )eriod %he emer ence of money in the early $eriod can #e kno'n from the follo'in : 2In $rimitive traffic the economic man is a'akin #ut very radually to an understandin of the economic advanta e to #e ained #y ex$loitation of existin o$$ortunities of exchan e3 +onsider ho' seldom this is
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Here the central bank's role is not neglected. Actually the central bank works on behalf of the government of the country. The concept of money as a fiduciary issue and a legal tender is true for all countries irrespective of the level of development . ) The central bank enjoys hardly any autonomy except in a few countries and so it is taken as granted that the central bank follows the wishes of the government. Technically the currency in circulation are the liability of the central bank.
the case" that a commodity o'ned #y some#ody is of less value in use than another commodity o'ned #y someone else4 5nd for the latter just the o$$osite relation is the case! *ut ho' much more seldom does it ha$$en that these t'o #odies meet4 3! 6ven in the relatively sim$le and so often recurrin case" 'hen an economic unit 5 re(uires a commodity $ossessed #y *" and * re(uires one $ossessed #y + " 'hile + 'ants one that is o'ned #y 5 &&&&&even here" under a rule of mere #arter " the exchan e of oods in (uestion 'ould as a rule #e of necessity left undone !2 7 $a e )8)9 +arl Men er .1:/)1 In the early da'n of history 'hen $eo$le realized the $ro#lem of #arter" they started usin $recious metal as medium of exchan e! In );<< *+! the $eo$le in 6 y$tians $roduced metal rin s for the use as money! *y =<< *+! a >rou$ of seafarin $eo$le called the ,ydians #ecame the first in the 'estern 'orld to make coins %he ,ydians .of 'estern %urkey" =<< ? 0@= *+!1 used coins to ex$and their vast em$ire ! %he >reeks and Aomans continued to make coins and they $assed that tradition to later enerations! >reek Brachma 'as found in 8<<& @88 *+ at %hessaly in 6astern >reece! In the ei hteenth century trade and commerce increased in 6uro$e and coins #ecame 'ide in circulation! One of the most 'idely used coins 'as the S$anish : Aeal and it 'as s$lit into fraction like half a coin or 8 #its" a (uarter 'as ) #its etc! Metallic coins made of $recious metal are the exam$le of commodity money and it 'as acce$ta#le #ecause it had the intrinsic value! 5t times the metal value used to differ 'ith the face value leadin to lar e scale hoardin or meltin do'n of the coins as the situation 'arranted! Ca$er money 'as first invented #y the +hinese and it #e an in the %Dan Bynasty . 01:& /<= 5B!1! Burin the Min Bynasty in 1@<< 5B! " the +hinese $laced the em$erorDs seal and the si nature of the treasurer on a crude $a$er ! %he latter 'as made of mul#erry #urke and it 'as of the size of a note#ook $a$er! 5fter the +hinese the $a$er currency the ex$eriment s$read to other countries ! 5lso representative money 'as develo$ed in some countries 'hich are token or $ieces of $a$er that could #e exchan ed for a s$ecific commodity such as old or silver! In the later years of 1/th century" the overnment of the ES5 and some 6uro$ean countries issued old and silver certificates! %his ty$e of money 'as very useful to make lar e $ayments! %hus is seems that the authorities in those early years realized the need for hi h denomination currencies to facilitate trade and commerce! * +ta,le -umeiraire One im$ortant as$ect of commodity money is that it is a sta#le numeraire and it hel$s kee$in the $rice sta#ility! 6ven 5ristotle" in his #ook" 6thics" noted that commodity money 'as 'ell suited for the $rice sta#ility! 5ccordin to him: FMoney" it is true" is lia#le to the same fluctuation of demand as other commodities" for its $urchasin $o'er varies at different timesG #ut it tends to #e com$aratively constant!H .6thics" translation 1/8@1
%he commodity money system delivers a nominal anchor for the $rice level" and this is realized throu h the $rofit&maximization $rinci$le! %his 'as a$$lica#le in the case of mint $roducin coins in the middle a es and later! %he mechanism can #e as follo's! Su$$ose there is a 'ay to convert oods into silver and silver into oods at a constant cost" that is" in ounces of silver $er unit of oods! %his can #e considered as .11 the extraction cost of silver" or .)1 the 'orld $rice of silver in case of small o$en economy! %he mint converts silver into coins after the $urchase of silver in #ulk from the market" it also decides 'hen to melt the coins to make it into silver #ars! %his is a $rivate sector activity" and the rule of the overnment is limited to t'o actions! It s$ecifies ho' much silver oes into a coin and it collects a sei niora e tax .Sar ent I Jelde" 1//=1! %he $rofit maximization $rinci$le 'ill dictate the $rivate sector mint to adjust the revenue 'ith the cost " the latter #ein the cost of #uyin silver #ars from the market alon 'ith the cost of $roduction! %his includes a ain the cost of la#our! 5 ain the mint itself can #e en a ed in the extraction of silver" 'hich determines the unit $rice of silver! %he revenue of the mint is the value of the coins $roduced and" assumin that each coin is of the same 'ei ht" the revenue de$ends on the num#er of coins and their denominations! %he mint 'ill find e(uili#rium 'hen the follo'in e(uality holds:: Market Jalue of +oins .or" the Inverse of Crice level 1 K +ost of Silver L Sei niora e %ax L +ost of Croduction %he a#ove rule 'ill ensure that the mint 'ill continue mintin coins! When this is violated" i!e! the market value of coins is less than the com#ined total of the ri ht hand side" mintin of coins 'ill sto$! %his also determines 'hether the mint 'ill $roduce ne' coins or start meltin the existin coins" and this ultimately de$ends on ho' the $rice level relates to the follo'in $arameters : the cost of silver content" cost of $roduction and sei niora e rate! %he $rice level can not o too lo'" or the mint could not make unlimited $rofits #y mintin ne' coins and s$endin them! 5 ain" the $rice level cannot o too hi h" or the mint 'ould make $rofits #y meltin do'n the coins! %hus the a#sence of ar#itra e facility for the mint $laces restriction on the $rice level and this remain 'ithin an interval determined #y the mintin $oint and the meltin $oint "as sho'n in the fi ure .Fi ure 11!
Figure 1# )rice le(el wit%in a domain Mintin Coint Meltin Coint ....../..............I....................../.......... Crice ,evel
%he system descri#ed a#ove has some uni(ue features! Mere the (uantity of money is not controlled #y the overnment! %he additions or deductions to existin money stock . stock of coins 1 are made #y the mint run in the $rivate sector on the #asis of the movement of $rice level! %he $rice incentive in the market o$erate and this makes the system self&re ulatory! When coins #ecome too fe'" their value increases and $rice level falls! %he mint $oint is reached and more coins are added to the existin stock! %his increases the su$$ly of money" and the $rice level .i!e!" $rice of coins falls 1! When
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the num#er #ecomes too lar e " the market value reaches the intrinsic metal value and even #elo'" and it #ecomes im$erative for the mint to melt the coins and reduce the num#er! Within the interval the $rice level de$ends on ho' the money stock is related to the volume of transactions and this follo's the famous Nuantity of Money 6(uation of Irvin Fisher C% K M J 3! .11 Where C" %"M and J are $rice level" total transactions " money stock and velocity of circulation res$ectively! 5s lon as the $rice level remains 'ithin the interval " the stock of money .the num#er of coins 1 does not chan e! %he chan es in the volume of transactions or income 'ill shift the $rice level u$ or do'n 'ithin the interval! When the $ush is severe so that it touches the meltin $oint or the mintin $oint " money su$$ly chan es! One im$ortant im$lication of the a#ove system of $rivate sector mintin of coins is that run&a'ay inflation of the ty$e seen in the t'entieth century is not $ossi#le in the commodity money re ime! Inflation is the $roduct of the fiat money system! Mac%ines and $%ange in )roduction )rocess! 5round 1;;< 5B a major shift in mintin technolo y took $lace in >ermany! %'o $rocesses 'ere develo$ed to mechanize the mintin $rocess usin machines to cut into sha$e uniform #lanks and im$ress these 'ith a desi n! %he scre'&$ress technolo y had #een $roved to #e #etter than the alternative" kno'n as the cylinder& $ress technolo yG #ut #ecause of cost consideration" the latter #ecame $o$ular in many countries! %he Oin of S$ain heard a#out the cylinder ?$ress technolo y and installed the technolo y in his state mint! %he coins $roduced in the mint had #een smooth and uniform %his ex$eriment then s$read to other states in 6uro$e ! 0%e laisse1 .faire 2&eriment: Aoyal +harter created $rivate mono$olies durin 101@& 88 5B and various individual firms 'ere allo'ed exclusive ri ht to issue token coina e " thou h these 'ere not made le al tender and the (uantities 'ere limited! %he laissez&faire re ime 'as ty$ified #y the a#sence of overnment& issued small denomination coins and #y the issue of tokens #y $rivate $arties and local overnments! In the late sixteenth century a#out @<<< ,ondon merchants issued tokens ! Burin the $eriod 1088 ? 10=)" more than 1)=<< different ty$e of tokens 'ere catalo ued and these 'ere issued in 1=<< 6n lish to'ns! %hou h $rivately issued" some of these issues 'ere authorized #y the overnment! %he ex$eriences in France and other $arts of 6uro$e 'ere more or less similar ! In 10=) $rivate tokens 'ere declared ille al and overnment mono$oly 'as asserted! %he Aoyal mint started mintin co$$er coins! With the invention of steam en ine the mintin technolo y 'as further u$ raded and scale of $roduction increased! *oultonDs steam $resses $roduced co$$er coins for the overnment in France" and the *ritish overnment also entrusted the com$any for the same task! *ut the overnment later #ou ht the technolo y and esta#lished state mono$oly in mintin in 1:1=! What ha$$ened in 6n land (uickly s$read to other $arts of 6uro$e!
With the s$read of technolo y" the kin s realized the need of issuin coins of small denominations usin different metal .co$$er1 and maintainin a fixed exchan e relation #et'een the value of t'o metals! Sometimes" smaller amount of metal 'as used to make coins of smaller denominations! *ut the advanta e of lar e scale $roduction $aved the 'ay for de#asement of metallic currency #y the use of inferior (uality metals 'hose face value 'as much hi her that the metal value! %he a#ove issue relates to the value of money and lon a o N! W! Senior.1/0/1 'rote: P3 3the value of money3 does not de$end $rimarily #y the (uantity of it $ossessed #y a iven community " or in the ra$idity of its circulation" or on the $revalence of exchan es" or on the use of #arter or credit"33 exce$tin the cost of its $roduction!27 $! =:9 %he need for increased volume of $hysical money 'ith an increase of trade and commerce alon 'ith an im$rovement in technolo y made it $ossi#le for the overnment to look for metal or non&metal o#jects 'hich could #e used as token money servin the $ur$oses of money as a medium of exchan e! Mere the face value of money 'as much hi her com$ared to the intrinsic value and the cost of $roduction of money 'ill #e much lo'er! %hus" the cost of $roduction 'as no lon er a hindrance to the ex$ansion of money su$$ly if the situation 'arranted! %his 'as the #e innin of the emer ence of fiat money and the states realized the $otential of this mechanism to command resources from the society 'ithout much effort! Fiat Money In modern 'orld" money is the ty$ically $a$er currency 'ith no intrinsic value of its o'n! Ceo$le hold this currency #ecause money is the only asset that $rovides exchan e services 'hich other assets cannot $rovide! %he emer ence of fiat money has #een due to the fact that commodity money is not a cost less affair and 'hen $a$er money 'as introduced "it 'as realized that the cost of the $roduction of money had #een much less com$ared to commodity money! %he $roduction and maintenance of money re(uires the use of economic resources! So the 'elfare as$ect of the resource usin money "'hich is much hi her in case of commodity money " increases 'hen $a$er money is used! For this reason society should have an incentive to re$lace hi h&cost commodity money #y lo' cost $a$er money! *ecause the latter re(uires fe' resources for $roduction and maintenance" its use increases 'elfare! %his 'elfare as$ect of money is sometimes missed in the academic discussions! Money is not really a veil in the modern 'orld4 %he need for money and its evolution has #een studied from different an les! In the search&theoretic literature" trade results from chance encounters ! In such a situation "need for money arises #ecause it minimizes the cost of transactions due to a dou#le coincidence of 'ants! In the a#sence of the latter" money is used in exchan e or nothin takes $lace "and they chan e commodities 'hen dou#le coincidence of 'ants are satisfied . Oiyotaki and Wri ht" 1//@" %hronton" )<<< 1!
%his cha$ter introduces money in the historical $ers$ective and there is indication that money as a commodity is lo#al in nature ! %he exchan e of commodities may also ha$$en #et'een t'o individuals 'ho #y the 'hims of history no' #elon to t'o different nations4 %hat induced mankind to make some arran ement for facilitatin international movement of money! %he historical evolution of the lo#al financial architecture and its conse(uence on the demand for money in the domestic economy on the one hand and the $rice of the domestic money in the international field on the other is a com$lex (uestion! %his is discussed in the next cha$ter!
$%a&ter 2 *lternati(e Monetary 3egimes and World Financial *rc%itecture
" oney! " consider is a device which facilitates the working of markets." 7 Sir Qohn Micks "1/:/" $! )!9
2 As science joins with technology to reduce man's ignorance and appease his wants at appalling speed! human institutions lag behind! the victim of memory! convention and obsolete education in man's life cycle. #e see the conse$uence of this lag %. At the nerve center of national sovereignties& international economic arrangements". 7 Ao#ert Mundell" 1/0: 9 %he 'orld has seen a num#er of financial systems de$endin on the level of inte ration of the 'orld economy and the level of technolo y! Aecent history has documented the old standard" old exchan e standard" dollar standard and the recent flexi#le exchan e rate system! 6ach system evolved de$endin on the need of the time and the 'ill of the leadin nations of the 'orld 'ho 'ere a#le to carry the P#urdenP of
the 'orld currency! *ut the major characteristics of the financial system determine the dynamics of the money su$$ly of the countries 'ho are the $artners of trade and the common 'orld system! We need to kno' a#out the different financial system that $revailed in the 'orld to understand the evolution of 'orld money! 5 #etter understandin of the 'orld monetary system 'ould hel$ understand ho' the domestic money su$$ly in mem#er countries 'as affected #y the chan e in the 'orld financial system! %hou h 'e are a'are today that the domestic financial system can not #e fully insulated from the lo#al $henomenon" the situation in the immediate $ost&'ar $eriod 'as not much different in the >rou$&of&ten countries@!8 %he level of economic inte ration amon these countries made them inter&de$endent! Sometimes a distinction is dra'n #et'een a monetary system and a monetary order and as Crofessor Ao#ert Mundell $ut it : 25 system is an a re ation of diverse entities united #y re ular interaction overnin the interactions #et'een tradin nations" accordin to some forms of control! When 'e s$eak of international monetary system 'e are concerned 'ith the mechanisms and in $articular the money and credit instruments of national communities in forei n exchan e" ca$ital" and commodity markets! %he control is exerted throu h $olicies at the national level interactin 'ith one another in that loose form of su$ervision that 'e call co&o$eration! 5n order " as distinct from a system " re$resents a frame'ork and settin in 'hich the system o$erates! It is a frame'ork of la's" conventions" re ulations" and mores that esta#lish the settin of the system and the understandin of the environment #y the $artici$ants in it! 5 monetary order is to a monetary system some'hat like a constitution is to a $olitical or electoral system! We can think of the monetary system as the modus o$erandi of the monetary order!2 7 Mundell" 1/=)" $!/)!9! %he distinction Crofessor Mundell makes #et'een a monetary system and a monetary order is im$ortant in the sense that the chronolo ical order that is follo'ed here 'ill facilitate the understandin of the 'orkin of the 'orld financial architecture and its im$act on the domestic monetary $olicies of the mem#er countries!
@
'.The group of ten were (elgium! )anada! *rance! #est +ermany! "taly! ,apan !-etherlands! .weden! /nited 0ingdom and the /nited .tates.
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45L6 +0*-6*36 %he classical old standard emer ed as a true international standard #y 1::<
'hen majority of inde$endent countries a reed to s'itch from #imetallism" silver monometallism and $a$er to the 'as maintenance of adhered to the fixed $rice of old as the #asis of their currencies! %he key rule When the countries old converti#ility at the esta#lished $ar!
old vis&a vis their currencies and maintained it" it
amounted to a fixed exchan e rate! 5ccordin to recent evidence" the exchan e rates throu hout the $eriod 1::<& 1/18 'ere characterized #y hi h de ree of fixity of the main countries" and violations of old&$arity $oints and devaluation 'as rare! %he sta#ility in the $rice of old and the ease of the su$$ly of old com$ared to 'orld demand did facilitate this situation! %he $eriod 'as an ideal exam$le of classical full& em$loyment e(uili#rium situation in the industrial 'orld 'ith real income chan in very little and so the increase in the demand for monetary old 'as small enou h to #e met #y availa#le $roduction and su$$ly! 5ccordin to esta#lished literature" a time& consistent credi#le commitment old converti#ility rule $rovided such a old standard and the mechanism is necessary for an international monetary arran ement to #e effective amon the countries! %he adherence to the mechanism! 5lso" a$art from the re$utation of the domestic
constitutional $rovisions re ardin the same" some other mechanism like im$roved access to international ca$ital market" the o$eration of the rules of the ame" and the he emonic $o'er of 6n land mi ht have enforced the countries to adhere to the international old standard rules! %he main countries at the time realized that old standard did $rovide the
im$roved access to the international ca$ital markets and for this the su$$ort for the re ime increased! 5lso countries #elieved that old converti#ility 'ould #e a si nal to creditors of sound overnment finance! 5 ain this had #een the case for #oth develo$in and develo$ed countries seekin access to lon & term ca$ital" such as 5ustria&Mun ary
and ,atin 5merica! 5lso Qa$an used short &term loans to finance Ausso&Qa$anese 'ar durin 1/<;&<0! %he exam$le of 6n land #ein on the old standard 'as an added attraction for other countries to #e on the same standard! In fact 6n land had #een the center of the 'orld monetary system #ecause of her economic mi ht and $olitical influence !%he fixed relation of *ritish $ound 'ith old assured the countries to stick to the old standard! %he success of the old standard had #een lar ely due to the commitment
mechanism the $artici$atin countries used to follo' re ardin the internal adjustment of $olicies faced 'ith external shocks! Since rules 'ere follo'ed sincerely and adjustment facilitated" the commitment to the converti#ility of old 'as stren thened and there 'as less the chance of leavin the old standard! Further the he emonic $o'er of 6n land acted as an anchor! %he literature mentions that the classical old standard of 1::< & 1/18 'as a *ritish & mana ed standard! %here 'ere several reasons for this! 5t that time ,ondon 'as the centre for the 'orldPs old " commodities and ca$ital markets! Second" many countries su#stituted sterlin for old as an international reserve sterlin &denominated asset currency ! %hird" there had #een extensive outstandin
outside *ritain! Fourth" the *ank of 6n land could attract 'hatever old it needed #y the mani$ulation of its #ank rate and other central #anks 'ould adjust their discount rates accordin ly!! In this 'ay" the *ank of 6n land did exert a stron influence on the money su$$ly and $rice level of the mem#er countries! %he central #anks of other countries acce$ted the leadershi$ of the *ank of 6n land #ecause they #enefited from usin sterlin as a reserve asset " even thou h they mi ht have #een constrained from follo'in standard! >old standard 'as an asymmetric system 7>iovannini"1/:/9!6n land 'as the centre country and the *ank of 6n land used the #ank rate to maintain old converti#ility! While *ritain could follo' an inde$endent monetary $olicy" other countries like France" >ermany etc! acce$ted the dictates of fixed $arities and allo'ed their money su$$ly to adjust $assively! 6n land" as the leader" had #een #enefited in inde$endent discretionary $olicies that mi ht have hurt the cause of old
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multi$le 'ays! It enjoyed the sei niora e earned on forei n &held sterlin location and easy access to international ca$ital markets!
#alances!
5lso financial institutions in ,ondon used to have handsome returns for the central In an influential study Crofessor Nurkse . 1/881 has ar ued that in crucial times the $rinci$al mem#er countries did not #ehave $ro$erly in the sense that they $artially sterilized their old inflo's " and the results had #een that domestic and forei n assets of these countries moved in o$$osite directions durin this $eriod of old standard! %he rules of the ame dictated that they should not interfere 'ith the influence of old flo's on the money su$$ly! Cerha$s they #ecame concerned a#out the $otential inflation and thus #ecame $ro&active in the control of money su$$ly!
0' 6 MI+ 5F $L*++I$*L 45L6 +0*-6*36 World War I created a massive shock that the financial system could not endure and the classical old standard ended! %he 'ar reduced the economic stren th of the main 6uro$ean countries in eneral" and 6n land in $articular! %he anchor role 6n land used to $rovide for the sta#ility of the system ended as the Enited States $ushed 6n land #ack from the leadershi$ role! 5 reformed system&& old exchan e standard .. $revailed for a short $eriod 1/)<& 1/)/G it 'as an attem$t to restore the salient $ositive features of the classical old standard 'hile allo'in a si nificant role of domestic sta#ilization $olicy in res$onse to s$ecific needs! *ut frictions emer ed as the conflict #et'een adherence to old standard rule and discretion of $olicy for domestic com$ulsion could not al'ays #e resolved! 5lso there 'as an attem$t as a su#stitute for old! %he old exchan e standard 'as destined to #e a failure as it suffered from a num#er of defects! First" the use of t'o reserve currencies&&& sterlin and ES dollar&&& 'as creatin $ro#lems as there 'as an a#sence of leadershi$ as a he emonic $o'er unlike the earlier $eriod 'hen *ritain shouldered the role! Second" there 'as little coo$eration amon the key mem#ers & *ritain" France and Enited States! %'o stron to economize the use of old as reserve #y restrictin its use to central #anks and also #y encoura in the use of forei n exchan e
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mem#ers" i! e!" France and the Enited States" 'ere reluctant to follo' the rules of the ame! %hey created deflationary $ressures in the 'orld #y $ersistent sterilization of their #alance&of&$ayments sur$luses! %he system could not #ear it and ultimately it colla$sed 'ith the >reat Be$ression! *ut #y that time it had transmitted deflation and de$ression across the 'orld 76ichen reen"1/:/G Friedman and Sch'artz"1/0@G %emin" 1/:/ 9
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73 005- W556+ I-0 3-*0I5-*L M5- 0*38 +8+0 M
With the end of the World War II" the victors assem#led at *retton Woods" Ne' Mam$shire" ES5 to #uild u$ the World Monetary System" 'hich came to #e kno'n as *retton Woods International Monetary System .*WIMS1! %he $rinci$al o#jectives 'ere to remove the ills from the financial system and to create a sta#le 'orld monetary order! For this several measures 'ere ado$ted! First" the floatin exchan e rate system 'as sto$$ed! Second" the old exchan e standard 'as scra$$ed as it 'as thou ht to #e res$onsi#le for the international transmission of deflation in the early 1/@<s due to its vulnera#ility to the $ro#lems of adjustment" li(uidity and confidence! %hird" the ne' system sou ht to sto$ the #e ar&thy&nei h#our devaluation" trade restrictions" exchan e controls and #ilateralism $revalent after 1/@@! 5 rou$ of economists led #y Q! M! Oeynes" 6!N! White and Aa nar Nurkse ar ued for an adjusta#le $e system" 'hich had #een ex$ected to com#ine the oods features of sta#ility of the exchan e rate under the fixed exchan e rate old standard" on the one hand" and the monetary and fiscal inde$endence under the flexi#le exchan e rate standard" on the other! 5lso the coordination role of an international monetary a ency 'as $lanned! %he latter 'as su$$osed to have considera#le control over domestic financial $olicy of the mem#ers! *ut the t'o sides had differences over minor details! %he Oeynes $lan contained more domestic $olicy autonomy than the White $lan" and the latter $ut more em$hasis on exchan e rate sta#ility! While #oth the teams & the *ritish and the 5merican & 'ere not in favour of a rule&#ased system" the *ritish team 'as
1)
$rimarily interested to $revent the deflation of the 1/@<s" and it attri#uted that $artly to the deflationary monetary $olicies of the Enited States and $artly to the constraints of the old standard rules! %hus the *ritish team 'as in favour of an ex$ansionary system! *ut the 5merican team led #y the ES 5ssistant Secretary of the %reasury" Marry Bexter White $resented a system 'hich 'as closer to the old standard as it $ut em$hasis on the fixity of the exchan e rates! %he nature of the $ro$osed system 'ere as follo's! %hou h the im$ortance of rules as a credi#le commitment mechanism 'as not formally mentioned #ut they $ro$osed strict re ulations on the linka es #et'een unitas.the $ro$osed international measure account1 and old! In case any mem#er country did face fundamental dise(uili#rium in the external sector" it could chan e the exchan e rate $arity 'ith a$$roval from three (uarter majority of all the mem#ers of the ne' institution! Eltimately the $rescri$tion of #oth the teams $revailed as the 5rticles of 5 reements of the International Monetary Fund incor$orated the elements of #oth the Oeynes $lan and the White $lan" 'ith an em$hasis on the latter! %he acce$tance of the Clan #ecame in conformity 'ith the round reality that it 'as the Enited States 'ho 'as oin to sha$e the international financial system! %'o institutions emer ed out of the *retton Woods 5 reement &&& the International Monetary Fund .IMF1 and the International *ank for Aeconstruction and Bevelo$ment .I*AB1! %he latter 'as $lanned to take care of the lon run ro'th of the 'ar rava ed economies of the 'orld and the IMF 'as assi ned the role of maintainin the 'orld monetary order and sta#ility of the exchan e rate system! & & & & & %he creation of $ar value system Multilateral $ayments %he use of FundPs resources %he $o'ers of IMF %he nature of the or anisation With these o#jectives in mind the articles of the IMF 'ere 'ritten! %he main $oints of articles 'ere :
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0%e )ar 9alue +ystem 5rticles IJ of IMF defines the numeraire of the international monetary system as either ES dollar or old of the 'ei ht and fineness on Quly 1" 1/88! 5ll the mem#ers of the Fund 'ere asked to declare a $ar value of their currencies and maintain it 'ithin 1 $er cent mar in on #oth sides! If any country faces fundamental dise(uili#rium" she can exchan e the $arity after consultation 'ith other mem#ers! If the chan e of $arity is 'ithin 1< $er cent" the decision of the mem#ers 'ill not #e rejected! Mo'ever" if the chan e is more than 1< $er cent" the country concerned needs to have a$$roval of the IMF! In case a decision is made for a uniform chan e in $ar value of all currencies in terms of old" it is to #e done #y the a$$roval #y a majority of all votin mem#ers of the Fund and #y each mem#er se$arately 'ith votin (uota more than 1< $er cent! %he 5rticle IJ" Section I .a1 of the 5 reement reads as 6x$ression of $ar values! %he $ar value of the currency of each mem#er country shall #e ex$ressed in term of old as a common denominator or in terms of the Enited States dollar of the 'ei ht and fineness in effect on Quly 1" 1/88! %he im$ortance of old as the numeraire 'as o#scured mostly 'hen most of the countries excludin the ES5 had chosen to define their $ar values in terms of ES dollar! Williamson su Qohn ested that the neutral old numeraire had #een chosen to ive the Enited
States the symmetrical o$tion to chan e its exchan e rate of dollar alon 'ith other countries! >old 'as chosen as a conveniently neutral numeraire for definin $ar values of the exchan e rates of the currencies" #ut old 'as not $erceived as the fundamental asset 'hich 'ould act as a #rake on the issue of currencies and hel$ in the determination of the common $rice level of the commodities in the mem#er countries the 'ay it had #een in the nineteenth century . Williamson" 1/== 1! 6ven no sin le currency" nor even ES dollar" had #een reco nized as the 2key2 currency linkin the $rinci$al currencies in the 'orld in 1/8;!
18
Multilateral )ayments Mec%anism 5rticle JIII of the IMF states that mem#ers are su$$osed to make their currencies current account converti#le thou h they can kee$ ca$ital control as stated in 5rticle JI.@1! %he mem#ers are to avoid discriminatory currency and multi$le currency arran ements! 5 ain 5rticle RIJ allo's the countries to kee$ their currencies not converti#le for a $eriod of three years and" durin this $eriod" exchan e control can #e maintained! In fact" it had taken a lon time for the develo$in countries to make their currencies converti#le in current account transactions! +ountries 'ould adjust their exchan e rates de$endin on the domestic e(uili#rium for 'hich the current account #alance is one im$ortant $arameter! Mere Crofessor Mundell raised one interestin issue 'hen he stated the follo'in : Only .N&11 inde$endent #alance of $ayments instruments are needed in an N& country 'orld #ecause e(uili#rium in the #alance of e(uili#rium in the #alance of $!1/;: 1! *ecause of the demonetization of old in all $rivate transactions" as 'ell as its virtual demonetization in official transactions too" the redundancy $ro#lem as stated #y Mundell had arisen in a very stron form after 1/8;! 5ll currencies o$eratin in the system 'ere $otentially inde$endent national fiat monies! %he amount of these fiat monies 'ere not related to their #ase of monetary old" neither the exchan e rates of these monies 'ere tied to the traditional old $arity! 5s old failed to act as the Nth currency" ES dollar slo'ly took its $lace! %his created the conditions for the Fixed&Aate Bollar Standard! .N&11 countries im$lies Nth country! %he redundancy $ro#lem is the
$ro#lem of decidin ho' to utilize the extra de ree of freedom . Mundell" 1/0:"
3esources of IMF
1;
%he size of the total fund of IMF" contri#uted #y the mem#ersP (uota in the form of ); $er cent in old and =; $er cent in national currencies" 'as initially ES S :!: #illion" and the amount could #e increased every five years if the majority of the mem#ers 'anted! Ender the scheme of White Clan" mem#ers could o#tain resources from IMF to hel$ finance short and medium term $ayments" dise(uili#rium in external transactions! IMF esta#lished a num#er of conditions on the use of its resources #y the countries sufferin from #alance of $ayments deficits! It sets the re(uirements and conditions for the re$urchase" i!e! the re$ayment of loan! 5ll these are to facilitate the mana ement of currencies 'hich are of reater demand for the $ayments of international o#li ations! %he conditions im$osed on the mem#er country seekin resisted #y the countries! 0%e )owers of IMF %he articles in the a reement delineated the $o'ers of the t'o institutions created for the creation and sustaina#ility of the system! %he International Monetary Fund has the $o'ers to a$$rove the chan es made in the $arity #y the mem#ers to a$$rove or other'ise on the use of multi$le exchan e rates or other discriminatory $ractices! %he fund has considera#le $o'er to influence the international monetary system and it exercises its $o'er in consultation 'ith national and international monetary authorities! 0%e +tructure of 5rganisation IMF is overned #y a *oard of >overnors 'ho are a$$ointed on the votin stren th of the mem#ers! %he *oard makes the $olicy decision re ardin the actions of the mem#ers! 5lso a num#er of 6xecutive Birectors and one Mana in Birector are selected #y the mem#ers! %he $o'er of the mem#ers is reflected in the votin ri hts" 'hich are $ro$ortional to the mem#ersP (uota .of contri#ution1 loans from IMF are derived from a monetarist model of Crofessor Colok" and in many cases this has #een
10
Ender the a reement the ES5 had to maintain a fixed $rice of old at ESS@; $er ounce" and 'hen the mem#ers are maintainin fixed $arity" the old $rice used to #e an anchor of the system" 'hich converted the old standard into a dollar standard! %he architects of the *retton Woods 5 reement 'ere not very much s$ecific a#out the system of the functionin of the system! %he evolution of the system 'as $artly #ased on su#se(uent inter$retations of the economists 'ho 'ere en a ed in research! Several im$ortant features 'ere mentioned .%e' 1/::G Williamson" 1/:;1! One such feature is that all currencies 'ere treated as e(ual in the articles of a reement" 'hich im$lies that each country 'as re(uired to maintain its $ar value #y intervenin in the currency of other countries! %his $osition dictated #y theory 'ould not have #een meanin ful" as other countries can fix their $arities in terms of ES dollar as the Enited States 'as the only country that $e ed her currency in terms of old!
'istorical +tages of t%e 7retton Woods *greement! 1:;6.1:60 %he $eriod of transition from the 'ar to $eace in the $ost World War II 'as very lon and $ainful and the functionin of the *retton Woods system had not #een on the desired lines! %he system started functionin normally #y 1/;; and till 1/;: full converti#ility of the currencies of the major industrial countries could not #e achieved! Ender the 5rticle RIJ of the *retton Woods 5 reement" the countries could continue to use exchan e controls for an indefinite $eriod of transition after the esta#lishment of the IMF in March" 1/8=! %he countries used exchan e control to $reserve their forei n exchan e and also every country had ne otiated a series of #ilateral $ayments a reements 'ith each of its tradin $artners! %he countries in 'ar rava ed 6uro$e 'ere in des$erate need for the im$orts of ra' materials and ca$ital oods and thus the allocation of scarce forei n exchan e had come under the control of the overnment! 6ven #efore the start of the World War&II" $olitical uncertainty in 6uro$e induced massive ca$ital fli ht from 6uro$e to the Enited States! In 1/@8" 5merican administration resorted to the devaluation of dollar and the $rice of old 'as raised from
1=
S)<!0= $er ounce to S@;!<<! %hese $henomena induced the flo' of old to the ES5 from rest of the 'orld and 'hen the War came to an end" the Enited States had #ecome the holder of the t'o&thirds of the 'orldPs monetary old stock! Simultaneously" 6uro$e ex$erienced de$letion of the dollar and old stock and the economy had #een runnin 'ell #elo' ca$acity! %he Or anisation for 6uro$ean 6conomic +oo$eration .O66+1 ex$erienced a hu e trade deficit 'ith its trade 'ith the Enited States! O66+ 'as esta#lished in 1/8: to coordinate the fundin of the Marshall Clan" and the latter facilitated hu e inflo' of ca$ital to the economies of 6uro$e for reconstruction and develo$ment! In fact" hu e amount of forei n ca$ital " mainly from the Enited States" 'as invested in the countries of 6uro$e to lead the economies to'ards reconstruction and develo$ment! %he $eriod 1/80&1/0< sa' some events 'hich 'ere #oth dynamic and havin si nificant effect on the international financial system! In 1/8/" >reat *ritain devalued $ound sterlin #y @<!; $er cent and after this )@ countries reduced their $arities 'ith ES dollar #y more or less similar ma nitude! %his s$ate of devaluation hel$ed the 6uro$ean countries to adjust their external sector efficiently and" as a result" they could eliminate their lar e trade deficit! *ut lar e scale chan es in the $arity conditions #y a num#er of countries created the im$ression that monetary authorities could $er$etuate their dise(uili#rium situation for some time and that 'ould create condition for s$eculation! In any case" there 'ere $erce$ti#le resistance from the monetary authorities to chan e their $arity and slo'ly the *retton Woods system had #een reduced to a fixed exchan e rate re ime even thou h it 'as an adjusta#le $e system in the initial thinkin sta e! It is interestin from academic stand$oint that the authorities $referred the s$ill over of domestic dise(uili#rium into the external sector in their adverse #alance of $ayments rather than correctin their exchan e rates! 6ven #efore the *ritish devaluation of $ound" France devalued French franc in Qanuary 1/8:" and this created a multi$le exchan e rate system" 'hich created $ro#lem in
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the form of #roken cross rates #et'een $ound and dollar! %he system 'as rectified 'ith the devaluation of $ound! In 1/;<" +anada also floated its dollar and this situation continued till 1/01! %here 'as another $ro#lem to'ards the end of 1/;<s and it 'as the inade(uacy of the IMFPs resources to meet the li(uidity $ro#lem of the 'orld" 'hich the ro'th of the 'orldPs monetary old stock could not meet! %he a$ 'as #rid ed #y the holdin of ES dollar! %he su$$ly of the latter 'as due to the #alance&of&$ayments deficits of the Enited States! Burin this $eriod the latter used to have sur$lus in the current account" #ut o'in to hu e investment a#road and the outflo' of ca$ital in the ca$ital account" the #alance of $ayment #ecame ne ative! %he im$ortant thin 'as that dollar su#stituted old in a si nificant 'ay and the $ro#lem of the shorta e of old 'as taken care of! 0%e )eriod 1:60..6< From the year 1/0< the *retton Woods system started functionin normally as the $rinci$al mem#ers started intervention in the forei n exchan e market to #uy or sell ES dollars for the maintenance of $arity of their currencies! 5lso the ES %reasury started #uyin or sellin old 'ith the central #anks of other countries at the $e ed $rice of S@; $er ounce! %he mem#er countries on their $art $e currency #ein anchored to ES dollar had #een indirectly $e ed their currencies 'ith ES ed to old!
dollar at fixed rate 'ithin a #and of ) $er cent on either side of the $arity! %hus each
%he evolution of the system in the sixties turned out to #e a #it different com$ared to the ideal situation the architects had visualized! Instead of the ori inal system of e(ual currencies" the mechanism evolved into a variant of the old exchan e standard in a sort of old&dollar system! %he *ritish $ound lost its im$ortance in the international field and ES dollar #ecame the sin le im$ortant international currency! %he decline of $ound ha$$ened #ecause of multi$licity of reasons" the $rinci$al reason #ein of sixties dollar 'as used as a currency of international reserve! the relative decline of the *ritish economy in the 'orld! 5s it had #een fully converti#le" #y the end
1/
Further" 'hile the intention of the *retton Woods 5 reement had #een the adjusta#le $e system in the exchan e rate mechanism" the system that evolved over time could #e called a fixed rate system! %he reason that monetary authorities #ecame too much conservative re ardin the adjustment of the $arities 'as $erha$s they 'ere un'illin to take the risks of chan in the $arities as that mi ht lead to the $ossi#ility of s$eculative ca$ital flo's and follo' u$ #ehaviour #y others! %hus the resultin system took the sha$e of a fixed exchan e rate dollar old standard! %his evolution created some $ro#lems in the international financial systems 'hich 'ere not uncommon in the inter&'ar $eriod also and these can #e $laced into t'o cate ories: li(uidity and confidence! 0%e Li=uidity )ro,lem %o'ards the end of sixties the Enited States started ex$eriencin deficit in its #alance of $ayments and this 'as mainly due to hu e ca$ital outflo' in the ca$ital account transactions! Since the ES5 is a reserve currency country" it did not have to adjust its domestic $olicies to the chan es in the #alance of $ayments! %he dollar outflo's had #een sterilized #y the federal reserve as a matter of routine! %he outflo's of dollar meant that other countries" $articularly 6uro$ean countries" had #een holdin dollar reserve! %his created different $erce$tion in some main 6uro$ean countries and there 'as resentment a ainst the do&nothin attitude of the ES federal reserve on the deficit #alance of $ayment situation! In 1/0; France #e an to convert outstandin dollar lia#ilities into old throu h the old 'indo'! %hat created some $ressure on the $rice of old! Mean'hile ES monetary authorities res$onded to the emer in 'orld situation #y initiatin measures to im$rove the #alance of trade" chan in the fiscal&monetary $olicies" im$osin cur# on the ex$ort of ca$ital and takin measures to $revent the conversion of outstandin dollars into old! *ut these $olicies could not chan e the situation much and the li(uidity $ro#lem continued! %he li(uidity $ro#lem in the international scene 'as due to the maladjustment of the demand and su$$ly of old" as the short&fall of the latter #e an to #e felt in the early
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1/0<s! 5ll throu h the forties" the $rice of old had #een declinin " and this reduced the $roduction and su$$ly of old! %he sta nant $rice of old also reduced its $roduction in the mid&sixties and it 'as a$$arent that the su$$ly of old from the Soviet Enion 'ould not #rid e the excess demand a$! Mean'hile" the demand for old had #een increasin ! 5$art from a si nificant increase of $rivate demand" the demand 'as increasin also due to increased volume of trade and commerce amon the countries! %he $ros$ect of the 'orld monetary old stock ro'in fast enou h to finance the ro'in 'orld real out$ut and the value of international trade seemed to #e im$ossi#le! 6ven durin 1/;=&&;:" the a$ #et'een the t'o in the rou$ of seven countries had #een si nificant! Crofessor Ao#ert %riffin .1/0<1 $ointed out that the su$$ly of dollars arisin out of the ne ative #alance of $ayments of the Enited States could not su#stitute monetary old on a $ermanent #asis as the ES monetary old reserve 'ould decline si nificantly relative to the dollar lia#ility held in forei n countries! %he level of the 'orld monetary old stock held in >rou$ of %en countries did not ro' in $ro$ortion to the ro'th of real ross domestic $roduct and volumes of trade! %he a$ #et'een the demand for monetary old .to su$$ort the increasin money su$$ly1 and the availa#le su$$ly had #een #rid ed #y the dollar reserve! So lon the dollar& old converti#ility at fixed rate had #een there" dollar 'as considered as a su#stitute for ES5 not adherin to the old&dollar converti#ility! +&ecial 6rawing 3ig%ts > +63 ? %he discussion on the li(uidity $ro#lem as stated in the $revious $ara ra$h im$lies also that there had #een a feelin that the ro'th of international reserves had not #een ade(uate enou h to su$$ly reasona#le li(uidity to the ro'in international trade and commerce! %hou h a$$arently no real strain 'as visi#le" there 'as a fear that the lack of li(uidity mi ht act as a constraint on the economic ro'th of the 'orld! Moreover" the mechanism of increasin runnin the international reserve 'as too much de$endent on the of deficit #alance of $ayments on the $art of the Enited States! %his 'as old! *ut everythin has a limit and this 'as no exce$tion" and some countries started thinkin a#out the a$$rehension of the
unsta#le #y desi n" as Crofessor %riffin had sho'n ! So the mem#ers of the IMF felt the
)1
need to create a su$$lementary reserve 'hich 'ould #olster international trade and commerce!! %he results had #een the First 5mendment of the IMF 5rticles of 5 reement in 1/0= and this em$o'ered the IMF to create a S$ecial Bra'in 5ccount to su$$lement its (uota system that o$erates under its >eneral 5ccount! Ender the ne' scheme a reserve asset 'as to #e created #y the IMF and that 'ould #e called S$ecial Bra'in Ai hts .SBA 1" and this 'ill not #e #acked #y the de$osits of the mem#ers" #ut the value of SBA as a reserve asset 'ill rest on it #ein re arded as an acce$ta#le means of exchan e #et'een the IMF and the central #anks of the mem#er countries! %he value of SBA 'as initially set e(uivalent to S1 or set at 1-@; th of an ounce of old! Ender the scheme each mem#er 'as allocated a s$ecified annual amount of SBA in $ro$ortion to their (uota 'ith the IMF" and the country could dra' u$on its SBA allocation if it ex$eriences a #alance of $ayments difficulties! %he mem#er is re(uired to consult the IMF in the case of dra'in the (uota" #ut in dra'in the SBA allocation the mem#er need not consult 'ith IMF! Further there is no conditionality attached 'ith SBA dra'in and it is not su#ject to re$ayment! %he last thin im$lies that SBA has increased the amount of international reserve! %he cumulative total holdin s of SBA allocated to a country is kno'n as the Pnet cumulative allocationP of the country and over a ;&year $eriod the mem#er has to maintain its SBA #alance at an avera e of @< $er cent of its net cumulative allocation! %his $ercenta e 'as reduced to 1; in 1/=/! %he first allocation of SBA durin the $eriod 1/=< && =) 'as to the amount of ES S /!; #illion! In Quly 1/=0" the value of SBA 'as chan ed from S1 to a 'ei hted #asket of 10 currencies! ,ater in Qanuary 1/:1" the value of SBA 'as redefined and $e ed to a #asket of ; currencies and these currencies are Cound sterlin " French franc" Qa$anese yen" ES dollar and >erman mark! 5 country u$on dra'in the SBA can exchan e the same 'ith other forei n currency and can increase its reserve! 5ll mem#ers of the IMF are #ound to acce$t the SBA in exchan e for their currencies u$ to three times their net cumulative allocation! %he country that dra's its SBA allocation is to $ay rate of interest to the Fund and the country that exchan es the allocated SBA 'ith its currency ets the rate of interest! %hus the SBA is an indirect loan mechanism throu h the international li(uidity increases!
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Market )rice of 4old and $onfidence Issues! >old had #een the anchor of the system and it 'as su$$osed to ive sta#ility to it! *ut the $e in of the official $rice of old at S@; $er ounce #y the ES %reasury attracted attention of the s$eculators" 'ho $ushed the free market $rice of old in ,ondon market to S8< $er ounce from the ES %reasury #uyin $rice of S@;!)<! *ut old served as #ackin to the ES dollar 'ith a ); $er cent old reserve re(uirement a ainst federal reserve notes! So" ES monetary authority a$$rehended that the s$eculation in the old market mi ht s$ill over to the official demand for the conversion of dollar into old! 5s a remedial measure" ES %reasury su$$lied old to the *ank of 6n land to restore sta#ility and re(uested the monetary authorities of >rou$ of %en countries not to #uy old at $rices hi her than S@;!)< $er ounce! In Novem#er 1/01" the ,ondon >old Cool 'as formed #y the Enited States and seven other countries" and it could sta#ilize the $rice of old! %he central #anks of the seven countries su$$lied 8< $er cent of the old stock in this $ool! %he sixties 'itnessed t'o $henomena not conducive to the sta#ility of the financial system! First" there had #een a ro'in scarcity of the old as the $roduction of the yello' metal leveled off #y 1/0;&00! 5lso the demand for old increased mainly from the $rivate sector! Second" there had #een a $erce$ti#le increase in the E!S! inflation rate as the money su$$ly increased $artly due to Jietnam 'ar! Some economists think that the ES5 follo'ed an inflationary $olicy at home that time #ecause of domestic com$ulsion! %he t'o $henomena cited a#ove created a crisis of confidence re ardin ES dollar and durin 1/0=&0:" the ,ondon >old Cool #ecame a net seller of old" losin of a#out S@ #illion e(uivalent at the $e old ed $rice! %here 'as a$$rehension a#out the
devaluation of dollar" thou h the scarcity of old in the 'orld 'as one reason .>il#ert" 1/0:" Qohnson" 1/0:1! %he resultin situation had its conse(uences! In March 1/0: the ,ondon >old Cool 'as a#olished and it 'as re$laced #y a t'o&tier arran ement! %he monetary authorities of old $ool sto$$ed #uyin and sellin sold in the market" #ut
)@
instead they started transaction of old only amon themselves at fixed $rice S@; $er ounce! 5lon 'ith that the Enited States removed the ); $er cent old reserve re(uirement a ainst Federal Aeserve currency! %hus" the link #et'een old $roduction and other market resources of old and official reserves 'as severed! %he result of these ne' arran ements 'as that old had #een demonetized at the mar in! %he system evolved into a de facto dollar standard" thou h old converti#ility remained! *y 1/0: the system also reduced to a de facto fixed exchan e rate system! %he major industrial countries a reed not to convert their hu e dollar reserve into old! Mean'hile 6uro$ean countries and Qa$an #ecame economic $o'er houses and they #ecame increasin ly reluctant to a#sor# more dollar lia#ilities! %hese countries also 'ere not ready to readjust their exchan e rate u$'ards as they ex$ected the Enited States to make the readjustment! Faced 'ith these contradictory $ulls and $ressures the International Monetary Fund found itself hel$less as its resources 'ere not enou h to $revent devaluation #y major industrial countries #y $rovidin them ade(uate assistance for adjustment .Bomin uez" 1//@1! %he esta#lishment of the t'o&tier system after the closure of the ,ondon >old Cool could not maintain the sta#ility of the old&dollar $arity for lon and the Enited States 'as forced to close the old 'indo' in 5u ust 1/=1! With this the *retton Woods System colla$sed" #ut the institutions created as a result of the a reement &&& IMF and I*AB &&& survived! IMF still had an im$ortant role as a clearin house for different vie's on monetary $olicies" as a centre of information" as the $rimary source of adjustment of the countries outside the >rou$ of %en and as a monitor of the 'orld financial system! Carticularly" the develo$in countries need the uidance and hel$ of the IMF to standardize their financial system!
4res%am@s law in International Le(el
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In the 1/0<s the adverse $rice movements in the international level #rou ht asymmetry in the intrinsic values of t'o $rinci$al assets&&& old and ES dollar! Ender the *retton Woods System" old and ES dollar $arity 'as fixed at S@; $er ounce of old and at this rate ES authorities 'as committed to #uy and sell old 'ith forei n central #anks! 5s the ES economy ex$erienced inflation #y a$$roximately 8< $er cent durin the 1/0<s" it 'as $resumed that $rice of old too had risen! %here 'as $ersistent u$'ard $ressure in the old market! %he market $erce$tion of old #ein officially under& valued" ES authority secured an a reement from the forei n central #anks not to convert their ES dollar reserve into old! *ut that could not save the situation and ES $resident Nixon announced the sus$ension of dollar& old converti#ility in 1/=1! %hus ES dollar had driven out old from the market 'hich 'as stated in a ,a' #y %homas >resham in the sixteenth century! %he ,a' states that 'henever there exists a discre$ancy in the $rices of t'o assets #y market $erce$tion" and if the nominal values are the same" the asset 'hich is undervalued 'ill disa$$ear from the market and the asset 'hich is over valued 'ill remain! %his is an ex$lanation of the decline of the *retton 'oods System iven #y Qur Niehans .1/:81 and Caul Be >rau'e .1/:/1!
6ecline of t%e +ystem! %he *retton Woods 5 reement had the desi n of makin the Enited States the centre country so that it could $erform the anchor role for the sta#ility of the system! Enfortunately the Enited States could not $erform that role #ecause of a set of reasons! %he Enited States 'as to fix the $rice of old at S@; $er ounce and also to maintain domestic $rice sta#ility to safe uard the intrinsic value of dollar! Of course" the $rice of old could #e adjusted 'ith the consent of the majority of the mem#ers havin (uotas in IMF at 1< $er cent or more! *ut there 'as no enforcement mechanism for the ES5 and only the credi#ility of the country and a commitment to old converti#ility had assured the sustaina#ility of the system! %he rest of the 'orld" the .n&11 countries" had to acce$t the $rice level set #y the Enited States throu h their commitment to fixed $arities of their
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currencies vis&T&vis ES dollar! %his had the im$lication that the .n&11 countries had to follo' a definite set of fiscal and monetary $olicies 'hich 'ere consistent 'ith the fixed $arities! *ut the countries could chan e their $arities #ecause of the adjusta#le $e ! In the $rocess dise(uili#rium in the domestic economy mi ht ha$$en #ut this contin ency 'as not s$elled out in the sense that there had #een no constraints $laced on the mem#er countries re ardin the extent to 'hich the domestic monetary and fiscal $olicy could deviate from the $attern set #y the Enited States .>iovannini" 1//@G Mundell" 1/0:1! %he crisis of li(uidity in the 'orld financial system had not #een $ro$erly addressed! %he countries 'ere to kee$ reserves a ainst their currencies either in the form of old" or in some $rinci$al currencies such as dollar! *ut in reality ES dollar had #een the main currency 'hich 'as used as the reserve currency #ecause of the old converti#ility! %here had #een the old converti#ility clause and a crisis of confidence too and these $revented the Enited States to su$$ly the monetary reserve demanded #y the .n&11 countries! In addition to it" the ES5 follo'ed an inflationary $olicy in the late sixties" #ut 'as un'illin to devalue the dollar! %his reinforced the confidence $ro#lem re ardin ES dollar! So 'hen some countries tried to li(uidate their dollar lia#ilities and transform that into old" the Enited States ot $anicky and closed the old 'indo' in 1/=1" si nalin the colla$se of the system! )ost 7retton Woods ra! Managed Floating 2c%ange 3ate %he $eriod #et'een 1/=1 and 1/=@ had #een one of the shock and adjustment for the major countries of the 'orld and in March 1/=@ the 'orld turned to a eneralized floatin exchan e rate! In the ne' system the monetary authorities started extensive intervention to influence #oth the levels of volatility and the exchan e rates of their currencies! *y 1/:<" the dynamism of the system sta#ilized and mem#ers started intervenin only to control the volatility of the system! %he >rou$ of Seven countries started a coordinated attem$t of exchan e market intervention to #rin sta#ility! %he decade follo'in 1/:< 'itnessed enormous ca$ital flo's across $olitical #oundaries and a relative dis&intermediation of the international #ankin system! %his had an im$act on
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the 'orld financial system" $articularly on the via#ility of the international #ankin system! Some #anks in Qa$an could mo#ilize enou h ca$ital and #ecame very lar e in terms of the asset size! %he countervailin $o'er emer ed and the *asle +ommittee introduced ca$ital ade(uacy norms for all #anks o$eratin in the international market! %he ca$ital ade(uacy ratio .+5A1 initially $ro$osed as : $er cent of the risk&'ei hted assets acted as a constraint on the ex$ansion of credit $ortfolio of the #anks! %he latter had an im$ortant im$act on the money su$$ly of the mem#er countries!
0%e +econd *mendment of IMF *rticle %he Second 5mendment of the IMF 5rticles came into effect on 5$ril 1/=: and it formally ave the IMF mem#ers a lar e de ree of discretion in the selection of their exchan e rate arran ements! IMF had #een ur ed to ado$t a $olicy of 2 firm surveillance2 over the exchan e rate $olicies of the mem#ers! %he Second 5mendment 5rticle IJ defined the res$onsi#ility of the mem#ers! 6ach mem#er 'as o#li ed to notify the IMF of its exchan e rate arran ement! %he mem#ers 'ere free to select the exchan e rate arran ement they 'ould think ri ht for their interest" #ut they 'ere to su$$ly information to the Fund! 5lso a mem#er 'as to avoid mani$ulatin exchan e rates in order to $revent effective #alance of $ayments adjustments or to ain an unfair com$etitive advanta e over other mem#er 'hich mi ht hurt the interest of the latter! In a 'ay the Second 5mendment reduced the $o'er of the IMF drastically! *&&reciation of A+ dollar Burin the $eriod 1/:< & 1/:;" ES dollar ex$erienced su#stantial a$$reciation a ainst major currencies! %he nominal effective exchan e rate a$$reciated #y ;< $er cent and the same thin ha$$ened 'ith the real rate! %his 'as the results of the diver ent macroeconomic $olicies $ursued #y the Enited States" Qa$an and 6uro$ean countries! %he ES authorities follo'ed a relaxed fiscal $olicy #ut a ti ht monetary $olicy" 'ith the
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#ud et deficit skyrocketin from ESB 10 #illion in 1/=/ to ESB )<8 #illion in 1/:0! 5s the ES real interest rate increased relative to other countries" ca$ital from other countries flo'ed in the Enited States to finance the ro'in current account deficits and dollar a$$reciated! %he ES overnment ar ued that the dollar a$$reciation 'as the reflection of the ro'in stren th of the domestic ES economy! %he a$$reciation of dollar hurt the ex$ort and im$ort com$etin industries of the ES5 and this increased the #alance of $ayments $ro#lems! %he $u#lic sentiments 'ent in favour of $rotection and the trade $artners of the Enited States 'ere convinced that the ne ative #alance of $ayments of the Enited States 'as the reflections of its ro'in #ud et deficits! *ut a $arallel thinkin also develo$ed that ES dollar should #e allo'ed to have its true level! 0%e )la1a *ccord Finance ministers of >&; countries &&&France" West >ermany" Qa$an" Enited States" Enited Oin dom&& met at Claza Motel in Se$tem#er 1/:; and after the deli#erations of their res$ective vie' $oints" they issued a +ommuni(ue 'hich is kno'n a Claza 5ccord! 5ccordin to the 5ccord" the exchan e rate of ES dollar did not accurately reflect the chan es in the economic fundamentals like the measures Qa$an 'as to take to stimulate domestic demand" or the ES commitment to reduce #ud et deficits! %here 'as also a reement for the de$reciation of dollar and the countries a reed to coo$erate on this issue! %he dollar started to decline and the extent of the decline of dollar caused concern amon the mem#ers! In Fe#ruary 1/:=" the >&= countries .+anada and 5ustralia to ether 'ith >&; rou$1 met in Caris to consider the situation of declinin ES dollar and reached an a reement kno'n as ,ouvre 5ccord! In this" the >&= countries a reed that further decline of dollar 'as not desira#le and the then exchan e rates 'ere true reflections of the economic fundamentals! Im$licit had #een the a reement that the ES dollar should #e ke$t 'ithin a ; $er cent tar et #and a ainst the deutschmark and the yen! *ut the accord could not com$letely $revent the decline of dollar! In Octo#er 1/:=" there had #een a colla$se in the stock markets around the 'orld and as a conse(uence the dollar came under $ressure as the crash in the stock market induced
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the fear of 'orld recession! %he overnments of some industrialized countries started the loosenin of their monetary $olicies and reducin the interest rates! In Qanuary 1/::" the trade deficits of the Enited States sho'ed the si n of im$rovements" and ES dollar started the recovery $hase! International $a&ital Flows %he flexi#le exchan e rate system in the 'orld had #een associated 'ith an increasin stren th of the international money mana ers 'ho 'ere a#le to make lar e scale ca$ital movement from one country to another 'ithin a very short time! %he trans& #order ca$ital flo's had #een effected to make $rofit either from the $ossi#le fluctuations of the exchan e rates due to the $otential chan es in the short&term interest rates or the $otential chan es in the $rices of the stocks in 'ell&inte rated stock exchan es of different countries! %he first reason had #een man&made on some occasions leadin to a $re&$lanned attack on a currency and this has led to a desta#ilization of the currency" 'hen the concerned central #ank failed to take care of its total lia#ility denominated in the form of total currency in circulation 'ith the #anks and the $u#lic! %his ty$e of situation had #een very common in the 1//<s 'hen several countries #ecame victims of the international currency $redators! Mo'ever" 'e 'ill discuss this as$ect in detail in +ha$ter 1;! 0%e Financial *rc%itecture %he $eriod 1//<s had #een marked #y a series of currency crises and the intervention of different overnments in res$onse to these crises first in the 6uro$ean Monetary System .6MS1 countries and then in Mexico! %he crisis then s$read to South 6ast 5sia and it soon s$read to other countries like *razil and Aussia! %hou h each country had its o'n uni(ue features in the currency crisis" there 'ere certain stylized facts in this $henomenon! %he 6MS crisis of 1//) 'as initiated #y >erman reunification and the reluctance of other mem#er states to $ursue $olicies" 'hich could have checked inflation! %he Mexican crisis had resulted as a com#ination of several factors after Mexico ex$erienced hu e ca$ital inflo' till 1//8 'hen the crisis occurred! %he forces
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'ere as follo's: First" interest rates increased in the Enited States makin investment in Mexico less attractive! Second" a re#ellion in the state of +hia$as increased dou#ts amon the investors a#out the $olitical sta#ility! 5lon 'ith that 'hen one $residential candidate of a $olitical $arty 'as assassinated" ca$ital inflo' to Mexico reduced drastically and Mexico had to use its de$leted reserve to save the currency! %he Aussian crisis in the aftermath of 1//: 'as a culmination of external shock like a decline in the $rices of ra' materials to an asymmetric ex$ectations of the creditors! %he decline of tax recei$ts of the overnment due to the fall in the $rice of oil led to an im#alance in the #ud et of the Aussian overnment! %he $arliament #locked the reform $ro$osal of the overnment and the currency #ecame 'eak due to ca$ital fli ht! In this situation Aussia sou ht hel$ from the IMF and after some controversy ot a loan of S11!8 #illion! %his created an u$'ard ex$ectation in the financial market and investors started #uyin short&term rou#le de#t to earn very hi h interest rates! Interestin ly no one understood that rou#le mi ht de$reciate further #ecause of hi h interest rates" and this $recisely did ha$$en! In 5u ust 1//: Aussia allo'ed the rou#le to float and %he de$reciation of rou#le sus$ended the redem$tion of rou#le denominated de#t!
initiated a PrunP on the #ank" as de$ositors 'anted to 'ithdra' rou#les to #uy dollars! %he #anks 'ere the holders of lar e de#ts 'hich 'ere PfrozenP and so they could not $ay their de$ositors! %he country had to suffer for the irrational decision of the investors first to $ut money 'ith 'ron ex$ectations and then 'ithdra' ca$ital leadin to the colla$se! ,ookin at the evolution of the international monetary system one finds several im$ortant conclusions! First" the maintenance of the fixed exchan e rate system in the #e innin and the flexi#le exchan e rate system since the early 1/=<s al'ays had to face the n&country $ro#lems as the num#er of inde$endent exchan e rates 'ould #e al'ays smaller than the num#er of currencies! %hus" it is im$ossi#le in theory for all the overnments to $ursue inde$endent exchan e rate $olicies! %he history of the evolution of the system since 1/;< has sho'n ho' the overnments had to solve the n&country $ro#lem at different times! IMF had not #een successful to control exchan e rate $olicies" thou h it had #een the source of #alance of $ayments credit! %he 'illin ness of the
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Enited States to allo' other countries adjust their exchan e rates vis&T&vis ES dollar solved the n&th country $ro#lem in the initial years till 1/0<! ,ater on the Enited States ex$erienced deficit in the #alance of $ayments and other countries accumulated dollar reserves and they su#stituted old reserves #y dollars! %he Enited States tried to solve this $ro#lem #y a reali nment of the exchan e rates #y Smithsonian 5 reement in 1/=1! *ut this arran ement fell a$art in 1/=@ 'hen the ES5 devalued the dollar unilaterally! %his induced other overnments to float their currencies! %he second lesson of the evolution of the international financial system is the market #ehaviour in the $e ed exchan e rate system! When the latter is firmly in order" investors are tem$ted to take advanta e of the interest rate differences 'ithout coverin their forei n exchan e ex$osure! *ut the moment market sus$ects the dura#ility of the $e ed rate system" the investors rush for cover! %he resultin conversion of currencies and the lar e amount of ca$ital flo's can $roduce the antici$ated exchan e rate chan e" 'hich the investors a$$rehended! %his has ha$$ened time and a ainG this ha$$ened in 6uro$e in 1//)&/@" Mexico in 1//;" 5sia in 1//=&/: and in Aussia in 1//: .>oldstein" 1//:G 5dams et al" 1//:1! %he re$eated crises has reo$ened the de#ate a#out 'hether restrictions should #e im$osed on the international ca$ital flo's" 'hat should #e the a$$ro$riate exchan e rate arran ement for the ne' market economies and 'hether IMF needs restructurin ! Some economists are in favour of introducin some sort of a tax on the international ca$ital flo's as su ested #y %o#in! %his 'ill make the transfer a #it costly #ut o$inion differs on this issue! Mo'ever" 'e 'ill have a close look at this issue later in this cha$ter! 5 ain the enormity of the crisis as seen in 5sia in 1//=&/: has induced thinkin alon the line 'hether the IMF in its $resent form can take care this sort of $ro#lem in future! 2c%ange 3ate *rrangements In recent times different countries have arran ed different ty$es of exchan e rate arran ements and #roadly these can #e $ut in the follo'in cate ories: &&&&+urrency $e &&&&+urrency $e ed to another stron currency or SBA ed to a currency com$osite
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&&&& flexi#le exchan e rates of a sin le currency &&&& flexi#le exchan e rate under coo$erative arran ement &&&& More flexi#le or mana ed floatin exchan e rate &&&& Inde$endent floatin exchan e rate +ountries like 5n ola" ,i#eria" Ira(" Oman" Canama" Syria and *eliz have $e in
arran ements 'ith ES dollar! 5 ain countries like *enin" +ameroon" +on o" Mali and Sene al have a fixed $e system 'ith French franc! %he countries like ,y#ia and Myanmar have $e ed their currency 'ith SBA" 'hile some countries have $e in arran ement 'ith s$ecific currency&&&e! !" %he countries 'ho have a $e Januatu! %he countries like *ahrain" Natar" Saudi 5ra#ia and E56 have currency 'hich are (uite flexi#le thou h not of the elite rou$! On the other hand the countries like 5ustria" *el ium" Benmark" Finland" France" >ermany" Ireland" Italy" ,uxem#our " Netherlands" Cortu al and S$ain have flexi#le and elite currencies 'hich are also sta#le throu h coo$erative arran ements! %hese countries #elon to the elite O6+B rou$! Some countries have currencies 'hose exchan e rates are descri#ed as mana ed floatin ! %heir list is (uite lon and the $rinci$al countries in this rou$ are&&& 5l eria" *razil" +hile" +hina" +osta Aica" 6 y$t" >eor ia" Mun ary" Indonesia" Israel" Iran" Malaysia" Cakistan" Aussia" Sin a$ore" Sri ,anka" %hailand" Jenezuela and Jietnam! %his $osition 'as as on Qune 1//=! Some countries have o$ted for an inde$endent floatin exchan e rate re ime and this list is very lon ! Some of these countries are: India" 5l#ania" 5ustralia" +anada" >hana" Qamaica" Oenya" ,e#anon" Mexico" Ceru" S'eden" S'itzerland" Enited States and Uam#ia! %he a#ove sho's that the exchan e rate arran ements of the different mem#ers of the IMF are of various nature and this has made the system much more com$lex! 6ach country follo's a course re ardin its currencyPs exchan e rate accordin to the stren th *hutan 'ith Indian ru$ee" *runei 'ith
Sin a$ore dollar" 6stonia 'ith >erman mark and San Marino 'ith Italian ,ira! in arran ement 'ith a currency com$osite are: *an ladesh" *urundi" +y$rus" Fiji" Iceland" Qordan" Malta" Slovak Ae$u#lic" %on a and
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of the economic fundamentals! In fact the Second 5mendment of IMF 5rticles in 1/=: has em$o'ered the mem#ers to choose their o'n exchan e rate re ime and su$$ly information to the Fund accordin ly! 0%e 0o,in 0a2 )ro&osal on $a&ital Mo(ement Crofessor Qames %o#in ar ues that in a 'orld of flexi#le exchan e rates the dynamics of the short term ca$ital flo's has a desta#ilizin effects on the sta#ility of the exchan e rates and in fact it can disru$t the 'hole $rocess . %o#in" 1/=:1: National economies and national overnments are not ca$a#le of adjustin to massive movements of funds across the forei n exchan es" 'ithout the real hardshi$ and 'ithout si nificant sacrifice of the o#jectives of national economic $olicy 'ith res$ect to em$loyment" out$ut" and inflation .$!1;8!1! %o#in ar ues that in the hi hly inte rated 'orld of today it is difficult for the national economies to $ursue inde$endent monetary $olicies! If domestic interest rate rises" this can induce a shar$ a$$reciation of the currency in real sense! 5 ain" a fall in the interest rate 'ill lead to a real de$reciation! %his sort of effect 'ill have adverse im$act on the economic $arameters of the economy and %o#in su ests that a tax can #e im$osed on all forei n exchan e transactions so that the desta#ilizin effects are reduced ! %he $ro$osed tax 'ill reduce the incentive for the s$eculators to insti ate hu e ca$ital flo' in and flo' out of the economy in res$onse to a small interest rate chan e! %o#in su ests that this ty$e of tax should #e im$osed on all ty$es of forei n exchan e transactions 'ithout exce$tion and then only it 'ill #e effective! %hou h it may have a ne ative effect on the international trade" %o#in thinks that the trade&off is 'orth'hile as it 'ill have a sta#ilizin effects on the exchan e rate and throu h that on em$loyment and income! Many economists #elieve that %o#inPs tax is a #it harsh measure as a flat tax on all forei n exchan e movements can reduce the de$th and #readth of the markets and the conse(uent reduction in li(uidity can increase the volatility of the market" and it is an o$$osite and un'elcome situation than 'hat is desired! 5lso 'ith todayPs innovative financial markets" it is hi hly $ro#a#le that the tax 'ill #e circumvented as financial
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innovation 'ill induce a re$lication of instruments that 'ould remain unaffected #y the tax! 0%e 4.< +tudy for World Monetary 3eform %he 5sian crisis in 1//= induced the >&= countries 7 the = countries are&&& the ES5" +anada" Enited Oin dom" France" >ermany" Italy and Qa$an 9 for a fresh study for revam$in the 'orld monetary system and the finance ministers of the seven countries #ou ht out a Ae$ort entitled " .trengthening the "nternational *inancial Architecture" 'hich 'as acce$ted in a summit in +olo ne in Qune 1///! %he Ae$ort identifies five main areas 'hich are to looked into for stren thenin the 'orld monetary system . >&=" 1///1!%he areas are: && trans$arency and #est $ractices && stron financial re ulation in industrial countries && stron macroeconomic $olicies and financial system in emer in countries && im$rovin crisis and mana ement 'ith $rivate sector involvement && $romotin social $olicies to $rotect the $oor Ae ardin the transparency the Ae$ort em$hasizes that trans$arency is needed to ensure that information a#out existin conditions" decisions and actions of the authority should #e made accessi#le" and easily understood #y the economic a ents! When the latter et sufficient market information" they can efficiently allocate the resources to minimize the risks! %rans$arency also $romotes healthy market ex$ectations of the a ents that hel$ maintain sta#ility in the system! Monetary authorities should $u#lish information a#out their reserve $osition" the levera e $osition and external inde#tedness! %he countries are to #e encoura ed to a$$ly uniform standards and sound $ractices to foster the develo$ment of sound financial system! International institutions should disclose their evaluations of the res$ective countriesP financial system!
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+tronger Financial 3egulation %he Ae$ort em$hasizes that inade(uate and inefficient evaluation of the credit $ro$osals are also res$onsi#le for the creation of #ad asset! 6xcessive risk takin alon 'ith hi h de ree of levera e can make the financial system fra ile and s$read ne ative ex$ectations! %he Ae$ort identifies three areas 'hich are to #e industrial countries and these are: &&im$rovin risk measurement and its mana ement &&assessin the im$lications of the activity of the highly leveraged institutions! and" &&evaluation of the im$lications of the activities of the Offshore Financial +entres %he three areas are inter&connected as it is the offshore re ions 'here the $ro#a#ility is very hi h that hi hly levera ed financial institutions are en a ed in hi h risk #usiness! %he resultant loss" 'hen it ha$$ens" erodes the #ottom line of the $arent institutions! +trong Macroeconomic )olicy %he Ae$ort devotes considera#le s$ace to discuss the s$ectrum of macroeconomic and financial $olicies the emer in countries should ado$t in the current lo#al scenario! One im$ortant area is the exchan e rate re ime 'hich should #e su$$orted #y consistent macroeconomic and fiscal $olicies #y the res$ective overnments! %he financial system should also 'ork in an efficient manner #y maintainin a $ro$er levera e $osition! %he Ae$ort also asks the >&= rou$ for its firm commitment to 'ork to ether 'ith the im$ortant financial institutions of the 'orld to im$rove the standard of su$ervision of #ankin and financial system! It also re(uests the overnments of the emer in countries to narro' do'n the zone of the overnment uarantee for $rivate sector loan so that the $ro#lem of moral ha1ards can #e minimized! %he >&= countries also caution the emer in countries 7 there are 11 in the rou$ and they are&&&& 5r entina" 5ustralia" *razil" +hina" India" Mexico" Aussia" Saudi 5ra#ia" Oorea" South 5frica and %urkey 9 to $roceed for ca$ital account li#eralization 'ith $ro$er se(uencin of $olicies and creation of necessary infrastructure! %he International addressed #y the
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Monetary Fund .IMF1 and other similar institutions are asked to monitor closely the trans&#order ca$ital flo's to minimize the $otential desta#ilizin effects of the latter! It is reco nized that the international ca$ital market has an im$ortant role for the im$rovement of $roductivity in the emer in countries!%he re$ort also asks the emer in countries to ado$t #est $ractices re ardin de#t mana ement 'ith reater reliance on lon term de#t" if $ossi#le" denominated in domestic currency and removal of #iases that encoura e short term ! $risis )re(ention and $risis Management Ae ardin crisis $revention the >&= re$ort envisa es a frame'ork for $reventin crisis 'ithout introducin moral hazards! %he main element in this frame'ork is the involvement of $rivate creditors in all the as$ects of de#t mana ement strate ies! %he Ae$ort reco nizes that the official financial assistance in certain situations can $lay an im$ortant role in the $revention of crisis" and even 'hen crisis occurs" in limitin the risk of conta ion! 5lso the Ae$ort ur es the emer in countries to develo$ a mechanism for a more consistent and systematic dialo ue 'ith the main creditors for the restructurin of loan and thus s$readin the lia#ility over a lar er time horizon so that the risk of conta ion remains limited! %he Ae$ort advises the de#tor countries to esta#lish sound and efficient #ankru$tcy $rocedures and stron judiciary to $romote trans$arency and e(uity in the insolvency re ime! %he Ae$ort $uts em$hasis on #oth the commitment of countries to meet their o#li ations and market disci$line! Formation of a -ew 4rou&! 4.20 On the initiative of >&= a ne' rou$ has #een created in the 'orld scene and it is called >&)<" 'hich com$rises = mem#ers of >&=" a Ae$resentative each of 6uro$ean Enion and jointly of the International Monetary Fund and the World *ank" and 11 major emer in countries! On this" the >&= is of the vie' that they $ro$ose to esta#lish a ne' mechanism for informal dialo ue in a frame'ork of *retton Woods institutional system " and to #roaden the dialo ue on key economic and financial issues amon major emer in
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economies for the $romotion of 'orld ro'th and sta#ility! Some sort of a collective management of the world financial system has #een the motivatin force #ehind the formation of >&)<" as this rou$ constitute the lar est mass of the 'orld economy on the #asis of market size! Whether countries outside this rou$in 'ill coo$erate 'ith this idea is a (uestion 'hich future 'ill ans'er!
-ew Initiati(e of IMF and t%e )oor %he financial crisis of 1//= had $roved that it 'as the $oor in the affected countries 'ho 'ere hit the hardest and a realization da'ned amon the academics that there should remain some safe uards for the $rotection of the $eo$le in the lo'er run of economic ladder in case financial crisis eru$ts! %he World *ank has taken the initiative in this field and it has develo$ed a set of 2rinciples and +ood 2ractices in .ocial 2olicy in 5$ril 1/// 'ith the o#jective of identifyin and mana in the social dimension of financial crisis! 5lso the IMF $ro ramme 2 6nhanced Structural 5djustment Facility2 has #een renamed as 2overty 3eduction and +rowth *acility. %his exercise si nals an im$ortant shift of em$hasis to'ard the achievement of social o#jective in the $ro rammes su$$orted #y the IMF! *oth the World *ank and the IMF are committed to achieve si nificant result and these t'in institutions su$$orted other measures 'hich are consistent 'ith the o#jective of $overty reduction! %hey also su$$orted the >&= initiative of de#t reduction of heavily inde#ted $oor countries! *ut the a$$roach relies on the $ositive as$ects of the market mechanism and they advise the $oor countries to do the necessary reforms so that the fruits of the $ro ress reaches the real $oor!
0%e -ew International Financial *rc%itecture In the last t'o decades the 'orld financial system has under one si nificant chan es and there is a ro'in concern amon the academic community a#out the
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sta#ility of this system . 6ichen reen" 1///G *linder"1///" >oldstein"1/// 1! %here has #een a #road consensus a#out 'hat the emer in countries should do re ardin external financial transactions and these are: ado$tion of a floatin exchan e rate re ime" less reliance on forei n currency #orro'in and extreme cautious a$$roach re ardin ca$ital account li#eralization! 5lon 'ith these elements there has #een an em$hasis on the role of market in the ne' scheme of thin s! %here are still certain ray areas 'hich are to #e looked into! %he sta#ility of the 'orld system de$ends on the interde$endence #et'een the macroeconomic $olicies of the lo#al financial $o'ers" $articularly the Enited States" 6uro$ean Enion and Qa$an! *ut the $resent arran ement may not #e considered as sufficient! 5s for exam$le" the lo' interest rate $olicy as 'ell as 'eak yen $olicy $ursued #y *ank of Qa$an since the middle of 1//; had #een necessary to fi ht the domestic recession! *ut this $olicy led to a hu e Qa$anese investment in the ES5 at a chea$ cost and also hu e Qa$anese loan to South 5sia! In early 1/// there had #een a shar$ reversal of the yen decline vis&T&vis ES dollar and the >&= $assively acce$ted that thou h it 'as not ood for the recovery of Qa$an! %he market took the si nal that yen 'as oin to a$$reciate further 'hich 'as consistent 'ith the 5merican attem$t to reduce the deficit in current account in its trade 'ith Qa$an! %here is $erha$s another issue 'hich should #e addressed $ro$erly and it is the li(uidity of IMF" 'hich o#tains its resources throu h (uota su#scri$tions from mem#ers! In return" IMF creates international li(uidity! %his is su$$lemented 'ith the creation of the S$ecial Bra'in Ai hts.SBA1! *ut in the $resent scenario of market&led 'orld financial system 'hat is feared is that IMF may create too much li(uidity in the system 'hich it may not endure! *ein the international lender of last resort IMF should not create any moral hazard $ro#lem so far as the mana ement of the current account of individual mem#er is concerned! *ut the market $erce$tion should #e clear that IMF has the means to $revent a crisis situation of a $articular mem#er from de eneratin into a systemic insta#ility! %his cha$ter ex$lains in detail the evolution of the 'orldPs financial system" and the descri$tion of the ne' financial architecture 'ill not #e com$lete 'ithout a
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discussion of the ne' ex$eriment of the t'entieth
century" i!e!" the formation of
6uro$ean Enion and the ne' currency 6uro! We 'ill discuss this in the next section!
uro&ean Anion and uro %he sin le currency of 6uro$ean Enion 6uro 'as launched on Qanuary 1" 1/// and it is a com$osite currency consistin of 1) currencies 'hose 'ei hts are $ro$ortionate to the im$ortance of the economy! %he currencies 'ith their res$ective 'ei hts are discussed in detail in +ha$ter 8! Mere 'e discuss the systemic im$act of the 6uro on the lo#al financial system! 5t the time of launch" 6uro 1 K Es S 1!1= and that 'as the theoretical value! *ut durin the last t'o years 6uro has lost heavily a ainst ES dollar and in Becem#er )<<<" 6uro 'ill #e in $hysical existence from Qanuary " )<<) as it 'ill come in circulation as a medium of exchan e" and the countries 'ho have taken u$ the currency 'ill have a dual currency system for the $eriod Qanuary to Qune" )<<)! Mean'hile" the le acy currencies 'ill #e 'ithdra'n and in Quly" )<<)" 6uro 'ill #e the only le al tender in the 6uro zone! 5t $resent t'elve countries have acce$ted 6uro as the currency and they are: 5ustria" *el ium" Finland" France" >ermany" Ireland" ,uxem#our " the Netherlands" Cortu al" S$ain and >reece. from Qanuary1" )<<11! %hree other countries are the mem#ers of the 6uro$ean Enion" #ut they have not ado$ted the 6uro yet and they are: Benmark" S'eden" and the Enited Oin dom!
uro&ean Anion as 5&timum $urrency *rea
6uro 'as (uoted around ES S <!:: " 'hich means a de$reciation of a#out )8 $er cent !
%he success of the 6uro #ecomin the sin le currency of the 6uro$ean Enion .6E1 de$ends on the 6E #ecomin an o$timum currency area! %o fulfil the latter criterion 6E should satisfy some conditions! First" the mem#ers of 6E should $ossess similar economies in the sense that they should have com$ati#le economic structures 'ith same level of economic diversification! In that case the countries 'ould et same ty$e of external shocks and same ty$e of exchan e rate they can follo'! In the a#sence of the
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similarity" same ty$e of external shocks 'ould create different ty$e of effects and the countries 'ould re(uire different exchan e rate $olicies! Second" the economies of the countries under 6E should #e $ro$erly inte rated such that they face the same $hase of #usiness cycles at the same time! %his 'ill facilitate ado$tin same interest rate $olicy and one monetary $olicy! %his condition is tou h #ut very im$ortant" #ecause if interest rates deviates from one another" diverse ca$ital movements 'ill create $ro#lems for the sin le monetary $olicy! %he latter is crucial for the credi#ility of 6uro #ein the sin le currency in 6E! It 'ill #e a difficult $ro$osition for the 6uro$ean +entral *ank .6+*1 to fi ht inflation in one country 'ith hi h interest rate and tackle recession in another country 'ith lo'er rate of interest! %hird" the mem#er states should have a common economy in the sense that the movement of ca$ital" la#our as 'ell as commodities should face no restrictions across the $olitical #orders! %his im$lies a sin le market condition and the industries in the concerned countries should #e ready to face this com$etition! %he three conditions as outlined a#ove are necessary for the esta#lishment of the o$timum currency areas! %he fact is that 6E mem#er states are yet to achieve this sta e! *ut the Maastricht %reaty tried to ensure that the eleven countries 'ere similar #y im$osin four convergence criteria related to the exchan e rate" inflation rate" interest rates and the $u#lic deficit . #ud et deficit1 in relation to the ross domestic $roduct! First" the exchan e rate of the country must remain 'ithin the normal fluctuation margin of the 6xchan e Aate Mechanism 7 6AM9 for ) years! Second" the rate of inflation should #e no more than 1!; $er cent a#ove the avera e rate of the three #est $erformin mem#er states! %hird" the lon term interest rate should #e in line 'ith the #est countries in term of $erformances! Fourth" the #ud et deficit should #e no more than @ $er cent of the ross domestic $roduct of the country! On the surface the success of the conver ence criteria in the case of 11 countries sho's the success of the common currency! *ut round reality may remain different! When all ca$ital market instruments are converted to common currency" the interest rates 'ill conver e" #ut that 'ill not ensure the similarity of the o#jective situations of the ca$ital markets of the mem#er states! Failure of this im$lies that ca$ital 'ill not move to
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the ca$ital $oor re ions as ex$ected initially! 5ll these sho' the difficulties in the 'ay of the mem#er states under 6E formin the o$timum currency areas! %he literature ex$lains the o$timum currency areas as an ideal state and it defines 'hether a rou$ of countries can enter into a monetary union 'ithout much ne ative externality! In a sense every country 'ith its o'n currency is a monetary union" #ut that does not uarantee that the country $resents an o$timum currency areas! *i countries like the Enited States" Aussia" +hina and India are not o$timum currency areas" as different states either in the Enited States or in India do not exhi#it the similarity of the economic structures as descri#ed under the o$timum currency areas! *ut the monetary unions do function and this they do 'ith relative success #ecause of the functionin of some adjustment mechanism like flexi#ility of factor $rices and mo#ility of la#our and ca$ital across the re ions! Flexi#le 'a es and interest rates 'ill clear the markets and that takes care of the unem$loyment and under em$loyment of factors of $roduction! Free and unrestricted mo#ility of ca$ital and la#our is very im$ortant in this adjustment mechanism 'ithout 'hich sectoral unem$loyment 'ill $revail! What is the real situation in 6uro$ean EnionV Bifferent studies su cultural and lin uistic differences amon est that the the countries in 6uro$e form a si nificant
#arrier to la#our mo#ility! It has to try hard to achieve the ty$e of la#our mo#ility as seen in the Enited States! *ut sociolo ists raise a more fundamental issue and that is 'hether the social friction that may result duo to la#our mo#ility in the face of cultural differences are desira#le from the sta#ility as$ect of the society! %his is an a$$rehension and for this economics has no ans'er! %he success of the 6uro 'ill de$end lar ely on the role of the 6uro$ean +entral *ank . 6+*1" 'hich is located in Frankfurt and 'hich is controlled #y a set of inde$endent central #ankers 'ho are not vulnera#le to the $olitical o$inion! %he 6+* 'ill see rou h days ahead as it tries to im$ose strict monetary and fiscal disci$line on the 'eaker countries for the sta#ility of 6uro and its success 'ill de$end to 'hat extent it can 'ithstand the $otential $olitical $ressure! %he formation of 6uro$ean Enion and its
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im$act is discussed in this cha$ter from the $ers$ective of the theory of o$timum currency areas! %he structure of the currency 6uro and its recent chan es are ex$lained in +ha$ter 8!
$%a&ter 3#
International Mo(ement of Money! 0%e Institutions
""n a world of banks and insurance companies! money markets and stock exchanges! money is $uite different thing from what it was before these institutions came into being". 7 Micks" 1/0=: $! 1;: 9
Money as a commodity is lo#al #y nature and its movement is facilitated #y 'ell&esta#lished institutions like money market" ca$ital market and the market for forei n currencies! %he latter is $art of money market #ut for the convenience of analysis 'e discuss it se$arately! In todayPs 'orld of inte rated treasury o$erations of #anks and other financial institutions the $ersons involved in the movement of money across the $olitical #oundaries are the same 'orkin us take the forei n exchan e market! Forei n exchan e is enerally referred to as the instruments " communications or orders that results in a chan e of o'nershi$ of demand #ank #alances a#road! %hus simultaneously in the three markets as mentioned! %he money market and the ca$ital market have #een descri#ed earlier" and let
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forei n exchan e is defined as any order" communication or any instrument that necessitates the recei$t or $ayment of funds in a currency other than the currency of the market 'here the settlement for the order or communication is made! %he instruments are enerally 'ire transfers" checks" airmail $ayment orders and #ills of exchan e! So any instrument that can #e sent to another country and effect a transfer in the o'nershi$ of demand #alances in #anks is a $iece of forei n exchan e! We can thus include 'ithin this definition forei n cash" forei n stocks and #onds" credit card vouchers" travelerPs checks etc!! 0%e Market for Foreign $urrencies %he market for forei n currencies or forei n exchan e market .F6M1 is the market for tradin in diverse currencies 'hich are all soverei n money uaranteed #y the res$ective overnments and issued #y the central #anks 'ith ade(uate reserves as the #ackin of the res$ective lia#ilities! 6ach transaction involves the exchan e of one currency" say ES dollar" #y the currency of another country" say Indian ru$ee" and in most of the cases it is #y chan in o'nershi$ of de$osit #alances in #ankin system! It is al'ays money a ainst money! 5t the smallest level it can #e as artless as the tout chan in ES dollar a ainst ru$ee in the market $lace at Mum#ai or the $orter chan in the dollar for ru$ee at the Calam air$ort! 5t the other extreme it may #e so$histicated electronic hook&u$ ta#les 'ith com$uter and tele$hones" fax machines and telex in the forei n exchan e dealin rooms of the #anks in major financial centres like Mum#ai" ,ondon" Ne' Work etc! transactin in millions of currencies of different denominations 'ithin a short time! %he essential $rocess is the same " only modern technolo y has facilitated the transfer of hu e volume 'ithin a very short time! %he 'orld has #ecome a very short $lace in the dealin room! It is not a market 'here t'o $arties meet each other face to face" #ut it is an electronically o$erated market and this sort of market functions )8&hours a day around the lo#e and handles over /; $er cent of total #usiness! %he $layers in the market are individuals" traders" financial institutions" commercial #anks" #rokers and central #anks! %he traders in the market o$eratin from
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the dealin rooms are dedicated to orderin the movement of money in and out of the account their #anks maintain in other #anks and corres$ondent institutions around the 'orld! %he F6M is closely linked 'ith #oth the ca$ital market and the money market since in the recent lo#alization of finance" many investors and other $artici$atin a ents are to o throu h financial intermediation across the $olitical #orders and from one currency to another to reach their counter&$arty! %he modern arran ement of inte rated treasury mana ement is the lo ical outcome of the close inte ration of the three markets! %he nature of the movement of the exchan e rates of different currencies are a su#ject matter hotly $ursued #y #oth the academicians and the traders 'ho man the terminals in the dealin rooms! %he theoretical ex$lanations are com$lex and sometimes tricky . Nandi"1//0 1 and one non&mathematical 'ay of understandin the market is $rovided in the %echnical 5nalysis literature! %he latter is not $ursued in this #ook as it is too s$ecialized a su#ject and the reader is advised to see any #ook on the su#ject for further discussion!
0%e F M and 0ime Bones %he lo#al F6M o$erations is a )8&hour cycle! On any 'eek day this market o$ens in 5uckland" Wellin ton and Sydney" then %okyo o$ens" follo'ed #y Mon Oon and Sin a$ore an hour later! When it is mid&day in the far east" *ahrain and other Middle east markets o$en and a fe' hours later the 6uro$ean markets o$en! It is then mid& afternoon in the Far 6ast as centre as Uurich" *asle" >eneva" Frankfurt" Munich and ,ondon o$en in the early trade hours! 5fter lunch in these markets" the eastern markets close" #ut Ne' Work o$ens! %he market then s$reads to'ards the 'estern side of the Enited States in $laces as +hica o" ,os 5n eles! When the evenin sets in 5merica" Ne' Uealand and 5ustralian #anks o$en the next day and thus the )8&hour cycle #ecomes com$lete! %he res$ective countryPs rules and re ulations #ein uni(ue that 'ay uide the o$eration in each market! In some exchan e rate is fixed" in others it is flexi#le and relatively free 'hile in some $laces it is a mana ed float ty$e! *ut the $layers are of a
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common mould any'here in the 'orld and the $roduct is the forei n exchan e! In s$ite of the fact that forei n exchan e re imes vary across the countries" the $layers in the market determine the exchan e rate and make the market! %his they do #y chan in the s$reads #et'een the #id -ask rates and sometimes throu h the hel$ of the #rokers and also #y creatin currencies! Foreign 2c%ange Market! Microstructural 6ynamics %he forei n exchan e market is characterized #y the AeutersP B)<<<&) electronic #rokin system 'hich dis$lay #id-ask of the inter& #ank dealers as 'ell as the firm deals 'hich occur thou h the AeutersP terminal! ,imit orders in$ut #y some dealers in the inter& #ank to B)<<<& ) are automatically matched 'ith the market orders of others" that results in yieldin data on the #est current #id and ask (uotations" the transaction $rices and volumes as 'ell as the inside s$reads of the (uotes! %hus enormous data are enerated throu h the tradin in the forex market and the AeutersP terminal exhi#it that data set on a continuous #asis&& )8 hours a day on a ;&day 'eek!! Some researchers have studied that data set and they have esta#lished one im$ortant feature of the data! %hey find that the firm (uotes have attenuated ne ative first order autocorrelation in returns" #ut the time series of deals sho' no autocorrelation in the returns . >oodhart et al" 1//01! %his $henomenon has #een ex$lained this 'ay! %his is mainly due to forces 'hich cause the limit order #ook in a com$etin market system to #e thin! %herefore" if the #est #id is exhausted #y a deal" the $rice 'ill ty$ically fall a com$aratively lon 'ay until it hits " or $rovokes a still lo'er entry! %he shar$ fall in the #id is most likely to take the #id #elo' the level 'here a deal can reasona#ly #e ex$ected! %his means that the s$reads 'ill #ecome excessively lar e! %his 'ill induce a com$etin market maker to increase the inventory to reverse the $rior fall . >oodhart and Cayne" 1//01! %his is a $icture of 2thin market2" first ex$lanation of 'hich 'as iven in Mo and Stoll .1/:@ 1! $ositions in the ex$ectations of influencin the future rates of the
Foreign 2c%ange 7rokers
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%he #rokers in the F6M o$erate in the inter&#ank markets and in some countries #et'een the customers and the #anks! %he #rokers do not set the rates in the markets" #ut their #ids and offers are $assed on to the commercial #anks and these reflect the demand& su$$ly factors in the markets! %hese facilitate the determination of final rates #y the #anks! %he existence of #rokers #roadens the markets and makes it more efficient! *rokers enerally do not take a $osition in the markets and they 'ork as liaison! When the trade occurs #et'een the customer and the #ank" #rokers do not a$$ear in #et'een" #anks often take their services 'hen market is volatile ! Of course the #rokers have their o'n customer #ase and they take commissions from #oth sides of transactions! *anks often use #rokers in forei n exchan e transactions to maintain anonymity until the closin of the deals and-or 'hen they 'ant to reduce the $a$er 'ork of their o'n! %he im$ortance of #rokers is related to the nature and or anization of the markets" and if there is a drastic chan e in the or anization of the markets . as are seen no'&a&days 'ith the arrival of ne' technolo y and ne' ty$es of money1" $osition of the #rokers 'ill chan e also! $ommercial 7anks %he commercial #anks are the lar est $layers in the forei n exchan e market and they conduct their o$erations throu h their dealin rooms! %he latter are connected 'ith the lo#al markets #y all modern ad ets of telecommunications! %he traders in these dealin rooms determine the a re ate demand and su$$ly of any currency and throu h arran ements these they determine the $rice! %he dealin rooms have electronic tradin
'ith the hel$ of on&line com$uters" the latter link $artici$atin #anks on a one&on&one #asis so that traders car reco nize on their monitor 'ho the counter&$arty is" the amount of #id or offer" the rates etc! %he deal "if a reed u$on" can #e closed 'ith the stroke of a sin le key of the com$uter! %he relia#ility of the deal is uaranteed as every transaction is electronically stored and thus documented! %he market information and the dealin facility are $rovided #y com$anies like Aeuter! 5lso other $roviders like *loom#er and Oni ht Aider are in the same cate ory of #usiness!
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5ll over the 'orld the dealin rooms are #usy 'ith the trade of five $rinci$al currencies & ES dollar" >erman mark" S'iss franc" *ritish $ound and Qa$anese yen! No' another currency has joined the lea ue and that is 6uro! 5 second layer of currency is com$osed of French franc" Italian lira" *el ian franc" +anadian traders do not create $ositions in third layer currencies ! +ommercial #anks maintain demand accounts at major #anks in all the countries 'hose currencies are traded! ,eadin #anks may maintain several corres$ondents at main financial centers of the same country to handle #usiness of the customers! In the major dealin room of the #ank several traders may #e involved in trade o$erations of one major currency" and the +hief Bealer remains res$onsi#le for the #ankPs lo#al $osition in the currency" as he must #e continuously monitorin the net $osition of that currency! %he chief dealer must #e alert a#out the likely movement of the currency in near future" 'hich may #e a day" one 'eek or one month! *anks en a ed in international o$erations do essentially international #ankin and it is taken u$ in +ha$ter ;! urocurrency Markets 6urocurrency markets are s$ecialized money and ca$ital markets" controlled and administered mainly #y commercial #anks in offshore financial centers . OF+ 1! %he assets and customers are enerally outside the countries of the centers! 6uro&currencies are currencies handled #y the #anks outside the countries of their ori in! %hese are mostly hard currencies like ES dollar" yen" >erman mark" S'iss francs and French francs! 6uro& #anks in offshore centers maintain accounts in different currencies in #anks in Ne' Work" ,ondon and such main financial centers and they transfer money accordin to the needs of the customers from these accounts! %he history of the eurocurrency markets is very interestin ! In the 1/;<s #anks in ,ondon and Caris #e an acce$tin ES dollar time de$osits from non&residents" mainly from east 6uro$ean countries and Ceo$lePs Ae$u#lic of +hina! %he latter #elieved that under the tension of cold 'ar the Enited States may #lock their #alances in 5merican dollar and Butch uilders! Other currencies are traded in lo' volumes " and one reason for this is that
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#anks! %he modern 6urocurrency markets develo$ed from these first roots and today the $otential of this market has attracted many financial centers in this #usiness like >eneva" ,uxem#our " 5msterdam" *russels" %oronto etc! 5t $resent more than ;< countries have #ankin re ulations that $ermit the o$enin of time de$osits accounts in forei n currencies on the #ooks of their financial institutions on #ehalf of their non&resident forei ners! %he currencies circulatin in this #usiness are currencies 'hich are ca$ital account converti#le" thou h major currencies are only a fe' in num#er! %he countries of ori in of these currencies have #ankin re ulations allo'in their #anks to incor$orate local su#sidiary financial institutions to #e treated as offshore institutions for the ac(uirin of the national currency as de$osits and doin financial intermediary! %he size of the eurocurrency market is hu e" thou h no $recise estimate availa#le! One rou h estimate $ut it in #et'een = and : trillion ES dollars .Aeed"1//: 1 e(uivalent and ES dollar constitutes a#out =< $er cent of it! %he rest are shared #y other currencies! %he major OF+s have accumulated hu e #usiness #ecause they allo' forei n individuals" cor$orations and overnments to $artici$ate in their markets as investors and also #orro'ers! %hese markets in 6n land" >ermany and S'itzerland also offer tax&free $latforms and in the $rocess they have attracted hu e intermediation #usinesses in 6uro& #onds" de#entures" 6uro&notes etc! 0%e +u&&ly and 6emand for urodollar %he su$$ly of 6urodollar de$osits re' from the advanta e for ES #anks in movin o$erations overseas! %his they do to avoid Federal Aeserve Ae ulation M! %he latter re(uires the kee$in of reserves a ainst de$osits! %his Ae ulation did not a$$ly to the forei n #ranches of ES #anks till 1/0/! %he non&kee$in of reserves a ainst the de$osits reduces the cost of funds for the o$erations outside the Enited States" and this induced the ES #anks to move some of their funds a#road for creatin interest earnin assets! %hus ES came and #ecame concentrated in ,ondon and other 6uro$ean financial centers! the im$ortant role of the
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Since 1/0<" the ro'th of the 6urodollar has #een induced #y factors other than the Federal Ae ulations! 6uro$eans and other non&5mericans have uneven cash flo's in ES dollars " havin a lar e time mis&match! %hey could sell the ES dollars for their home currency in times of hi her inflo's and re$urchase the same 'hen in need! *ut this involves transaction costs and exchan e risks! %hese can #e avoided if these dollars they kee$ as de$osits in 6uro$ean #anks so that they can avail these 'hen they need ! %his 'ay the 6urocurrency market has ex$anded ra$idly! %he 6uro$ean #anks includin the #ranches of the ES #anks 'ere seekin avenues for the de$loyments of the dollar funds! %hese funds they could not #rin to the ES5 as that 'ould attract the Federal Ae ulations! 5lso as a result of limitations in the 1/=<s on o#tainin loans 'ithin the Enited States that are not a$$lica#le to overseas" there had #een a si nificant demand for ES dollar overseas and the ES #anks could rede$loy the ES dollar de$osits in 6uro$e for this $ur$ose! %he interest e(ualization tax in the ES5 'as also res$onsi#le for the demand for ES dollar a#road! %his tax 'as functional durin the $eriod 1/0@ & 1/=8 and this 'as a tax on ES residentsP earnin s on forei n securities! %hus the forei n #orro'ers had to $ay hi her returns .interest1 to com$ensate the tax! *ut this could #e dod ed if funds 'ere sent first to 6uro$e and then used for the creation of asset $ortfolio! %his 'ay the ES #anks in 6uro$e could offer lo'er interest rates! %hus it 'as the set of Federal re ulations like Ae ulation N and Ae ulation M" the convenience of #ankin and $rofit considerations that influenced #oth the demand and su$$ly of 6urodollars! In fact takin a 6urodollar loan 'as much more convenient com$ared to takin a ES dollar loan in ES5 and a loan in other currency in 6uro$e! %he 6urodollar market could achieve its o'n momentum and in the 1/=<s 'hen most of the Ae ulations in the ES5 'ere removed" the adversely affected! ro'th of 6urodollar market 'as not
urocurrency Interest 3ates
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*oth the demand and su$$ly of 6urodollars 'ere affected #y ra' #usiness sense! %he de$ositors of 6urodollars 'ere interested in hi her returns" 'hich 'as $ossi#le as cost of funds 'as less" and the #orro'ers also could et funds at a relatively lo'er rate com$ared to credit created in the ES5 #ecause of the a#sence of Federal re ulations in case of #ankin outside the Enited States! %hus the 6urocurrency interest rates are enerally lo'er and these ive the #orro'ers an advanta e $rovided the exchan e rate risks are taken care of! 6eri(ati(e Markets Berivatives are financial instruments 'hich are used to hed e a ainst $otential risks in any financial transactions! %he value of derivatives are derived from the underlyin financial assets! %he common underlyin factors for #usiness on 'hich derivatives are #ased are the $rices of stocks" commodities" #onds" currencies" metals" real estate and the like! %he derivatives contracts from these elements are stock index" stock o$tions" commodity futures" currency s'a$s" o$tions" interest rate o$tions etc! %he cor$orate" individuals" #anks and other economic a ents #uy and sell different derivative $roducts! %he size of the market is hu e and one estimate reveals that the total outstandin derivative #usiness is a$$roachin a#out )< trillion ES dollars e(uivalent! %he market is ro'in steadily! %he derivative market de$ends on many other markets like commodity exchan es" stock exchan es" metal exchan es" forei n exchan e and eurocurrency de$artments of commercial #anks" s$ecialized o$tion and futures exchan es in ,ondon" +hica o etc! %he #usiness de$ends on fees at #anks" security houses and insurance com$anies and the determination of these fees are done 'ith the hel$ of so$histicated mathematical models 'hich are very com$lex and hard at times to understand! With the evolution of the derivative markets in the $rinci$al financial centres of the 'orld" the functional as$ects of the derivative instruments have influenced the macroeconomic $olicies of the countries! %his issue has #een taken in a later cha$ter! A35 I- 0' - W MILL -IAM
;<
In +ha$ter @ 'e have seen the system of the 6uro$ean Enion from the an le of the 'orld financial architecture! *ut the micro& level system of the currency 'as not discussed in detail! %his 'e can do no'! %he last year of the )< th +entury sa' the emer ence of a ne' currency in 6uro$e 'hich 'as a culmination of a lon dra'n $rocess of desire of the unification of the +ontinent 'hich is still on in the ne' millennium! It is 6uro" 'hich is the lo ical transformation of the 6uro$ean +urrency Enit .6+E1 as $er Maastricht %reaty! %he 6uro$ean +ouncil" on its meetin on Becem#er ;" 1/=: took the resolution in 'hich the follo'in lines 'ere stated: .i1 5 6uro$ean +urrency Enit 'ill #e at the center of the 6uro$ean Monetary System and 6+E 'ill #e used as the denominator of the exchan e rate mechanism and for o$erations for #oth the intervention and the credit mechanismG .ii1 .iii1 %he 6+E 'ill #e used as a means of settlement #et'een monetary authorities of the 6uro$ean communitiesG %he 'ei hts of the currency in the 6+E 'ill #e reexamined and if necessary revised 'ithin six months of the entry into force of the system" and thereafter every five years "or on re(uest if the 'ei ht of a $articular currency of the Enion has chan ed #y ); $er cent or more! Ender the Maastricht %reaty the o$tion for revisions every ; years has #een a#olished and 6+E has #een renamed as 6EAO 'ith the 'ei hts of 1) currencies as sho' #elo' in %a#le1:: 0a,le 1##
+urrency .11
A35 and its com&onents

Cortion of national currencies in #asket .)1 .@1 .81 Aelative 'ei hts 6xchan e rate 'ith 6EAO
&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&
&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&& Beutsche mark French franc *ritish Cound Italian lira Butch uilder *el ian franc !0)8) 1!@@) <!<:=:8 1;1!: <!)1/: @!@<1 @@!@8 )<!8/ 1<!88 =!1= 1<!8= :!;= 1!/0:); 0!;//;< <!0=:11@ 1/8)!1/ )!)1/@/ 8<!;::/
;1
S$anish $eseta Banish krone Irish $unt Cortu uese escudo >reek drachma ,uxem#our franc &
0!::; <!1/=0 <!<<:;; 1!@/@ 1!88 <!1@
8!)8 )!=) 1!<8 <!=1 <!8= <!@8
10=!1)/ =!;<188 <!=:@<01 )<1!88) @)=!;)) 8<!;::/
&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&& +ource!! 5nnex to the ) May 1//: +ommuni(ue %he fi ures in +ol!8 is derived #y usin the exchan e rate of ES dollar as on Quly @<" 1//: and also takin 6+EK 6uro 1K ESB 1!11;1;=1! 5ll these fi ures 'ill remain fixed for the time #ein and the exchan e rates of the currencies of the countries 'ho joined later 'ere determined #y the cross rates 'ith ESB as $revailin as on Quly @<" 1//:! %he formula 'ill remain the same for other countries also 'ho mi ht join later! It im$lies that the countries 'ho 'ill join later 'ill sim$ly acce$t 6uro as the currency and their ori inal currencies 'ill #e the thin s of the $ast! 6uro shall remain tied to the ori inal 1) currencies forever in the relations as stated earlier! )ost uro situation! 6uro came into #ein on Qanuary 1" 1/// ! Initially there had #een lot of s$eculation a#out the $otential of the ne' currency re ardin its $ossi#ility of #ecomin the vehicle currency and also to 'hat extent it can com$ete 'ith the su$remacy of ES dollar! %he dynamics of the situation has #een ex$lained in the literature . %em$erton"1//:G Nandi"1///!1! *ut the initial $romise could not #e sustained and 6uro started losin its litter very soon and durin its 1: months existence it has lost a#out 1; $er cent of its value vis&T&vis ES dollar! %oday the value of 6uro is : 6uro 1 K ESB <!/8@< .a$$rox!1!We are to remem#er that 6uro is a notional currency #ased on its relation 'ith 1) currencies as ex$lained in ta#le and it 'ill come into existence in $hysical form on Qanuary 1 )<<)" and 6uro 'ill #e the sole currency of 6uro$ean Enion on Quly 1" )<<)! %he Ceriod #et'een Qanuary 1 and Quly 1" )<<) 'ill #e a $eriod 'hen the countries in 6E
;)
'ill have a dual currency system and durin this $hase the national currencies like BM etc! 'ill #e 'ithdra'n and re$laced #y 6uro! %he reasons for the decline of 6uro a ainst ESB are many and 'e can document the $rinci$al ones as follo's: 1! 5t the end of 1//= the foundin 11 countries 7 Enited Oin dom did not join the 6uro system9 held a$$roximately ESB )=1 #n of forei n currency reserve " of 'hich an estimated ESB 8; #n 'as held in 6uro&zone currencies! If the 6uro$ean +entral #ank .6+*1 decided to re$lenish all of the ESB 8; #n reserve in 6uro&zone currencies #y sellin these for ESB" it should create an u$'ard $ressure on ESB! )! %he 6+* tried hard to maintain a sta#le interest rate for the steady state level for 6uro" #ut the central #anks of the mem#er states could not afford a hi h interest re ime #ecause of unem$loyment and recession! In fact some of the central #anks started follo'in a soft interest re ime to $romote ro'th! %his had a ne ative effect on the exchan e rates of the concerned currencies and since the latter constitute the 6uro in the a re ate " 6uro must #e 'eaker! @! Some of the mem#er countries "$articularly the 'eaker ones" ke$t their $romise of maintainin their fiscal deficit 'ithin @ $er cent of their >ross domestic Croduct .>BC1 #y default and even the alle ations of fud in >BC fi ures to lo'er the critical ratio 'ere not uncommon! 8! 6ven the $romise of 6uro #ecomin the vehicle currency 'as not achieved! 5 vehicle currency is one 'hich the ex$orters and im$orters choose for invoicin and settlement 'hich can #e #ou ht and sold at lo' transaction cost and has a hi h de ree of acce$ta#ility for other transactions! 5s a result " a thick externalities are created "or concentration in the use of currency&&&& the more a currency is used for invoicin and trade the more it 'ill continue to #e used re$lacin other currencies! %he advent of 6uro ironically reduced the use of BM" French franc and Italian lira. as 6uro is su$$osed to #e in their $lace1" and ESB #e an to #e used more as vehicle currency! %his has increased the demand for ESB! ;! %he increasin stren th of ESB is due to a reason (uite unrelated to the a#ove ar ument! In some former communist countries ESB has #ecome an im$ortant
;@
medium of exchan e alon side 'ith their national currencies! %his $henomenon has $ut an u$'ard $ressure on ESB vis&T&vis all the major 6uro$ean currencies! 0! Since the formation of 6ME in 1/;= till the si nin of the Maastricht %reaty the $o'er that #e in 6uro$e has maintained the #elief that the monetary union is a chan e in the unit of account only! *ut it is not $ro$erly a$$reciated that for an o#ject to #e acce$ted as money "it must serve #oth as a unit of account and a medium of exchan e! %o serve as a medium of exchan e the entity should have some value! In a 'orld of $a$er currency the value comes throu h the conferral of value on the medium of exchan e #y le islation on le al tender " central #ankin and the $rotection of de$osits! 5ll these are $olitical acts and these must have the $olitical $o'er of the state! %his is not there" thou h the $olitical elite of 6uro$e is conscious of this as leaders are ex$ressin their o$inion a#out the formation of united 6uro$e . Financial %imes" Qune ):" )<<< 1! 5t $resent there is 6uro$ean $arliament #ut 'ithout le islative $o'ers! %his is the inherent 'eakness of 6uro! What 'ill #e the im$act of 6uro on trade and commerceV So far as India is concerned em$irical studies have failed to identify s$ecific effects of the introduction of 6uro on IndiaPs trade 'ith 6E! *ut thin s in the international arena are chan in fast and the 6E is on a ex$ansion mode! %he formation of a #loc of the size of 6uro$ean Enion should have si nificant effects on lo#al trade and commerce! For the unfoldin of the full $otential 'e are to 'ait for some more time! %he main $ro#lem 'ill arise in the ca$ital markets 'here the instruments are denominated in different currencies and different interest structures are involved! Mean'hile the countries 'ithin the 6E are to achieve the conver ence of the interest rates and this is a difficult tasks for some soft countries! %he latter are findin it difficult to have a hi h interest re ime #ecause that 'ill com$licate further the unem$loyment $ro#lem there! 5lso #y Qanuary )<<)" all ca$ital market instruments are to #e converted into 6uro denomination! %his itself is not a $ro#lem" #ut the interest rate structure #y that time should #e similar! %o 'hat extent that can #e achieved is an o$en (uestion!
;8
Money and t%e +tate! 0%e )rocess of Moneti1ation What is the role of money in the societyV %his (uestion has surfaced a ain as the 'orld has #een 'itnessin the $rocess of transition in a lar e num#er of countries #oth in 6uro$e and 5sia&&& the countries #ein the former communist countries! %here is a consensus in the literature that the monetization of an economy is a $u#lic ood as the efficiency ains that accrue to the economy from the transition from #arter to the money economy are shared #y everyone in the society! %he role of the state in the $rocess of monetization can #e #etter ex$lained if 'e analyze the transition of the command economies of east 6uro$e and Aussia! %he essence of the $ro#lem these countries faced are difficulties for the movin from a socialist command economy to a market economy " and at another level it 'as a movement from a non&monetary to a monetary economy! %hou h money had #een there in the socialism ex$erience" its $rimary function 'as a claim ticket to a discretionary $ortion of the social dividend .%aylor" )<<<1! %here had #een savin s in the economy " and this savin s 'ere invested also as the $ools of fluid ca$ital existed" #ut these ca$ital 'ere directed to the end uses #y the command of the state" and not throu h a $rocess of monetization and market $rice system! When the soviet em$ire colla$sed" the command system 'as no more" #ut there 'as no institution and ex$erience in $lace to monetize the stocks of fluid ca$ital and use that investment and $roduction throu h a market oriented $rice system! %he monetization started from the scratch" and there had #een a fall in $roductivity com$ared to 'hat had #een in the command economy! %his ha$$ened in Aussian in 1//1&/)! Money had #een there in the economy" #ut it 'as not there at the ri ht $laces at ri ht time! %his re(uires a #ankin system 'hich 'ill facilitate the monetization of fluid ca$ital existin in the economy on an efficient #asis! %he $rocess of ne' monetization as mentioned in the earlier $ara ra$h im$lies the emer ence of a set of financial institutions for channelin the $ool of fluid ca$ital! It also im$lies the #irth of a system of relative $rices for uidin $roduction " investment and consum$tion decisions! In a command economy $rices are set #y the authority and these are not formed on the #asis of relative scarcities and the 'illin ness to $ay of the consumers! In the a#sence of all these" ho' $rices 'ill emer e in the transition economies #ecomes an im$ortant area of study! %he ex$erience of Aussia in the early
;;
1//<s sho's that the economy a$$arently lacked a via#le
fiduciary structure! %he
#ankin system 'as lar ely a#sent and as a result the #anks could not facilitate the fundin of current $roduction #y the creation of money throu h the self& li(uidatin short term loans . Woodruff" 1/// 1! Much of the Aussian economy at that time 'as #arter driven and money had little role! In such a situation the $eo$lePs confidence on the domestic currency should #e restored first! %his can #e done #y $e in the exchan e rate of the domestic currency 'ith a 'orld level currency like ES dollar! %he economy can then fix the $rices of the traded oods 'ith the hel$ of international $rices and then relate these $rices 'ith $rices of other oods! %he a#ove ex$osition of the transition $rocess of the command economies and the $ro#lems they face in the attem$t of monetization sho's the institutional im$ortance of money in a society! %his a ain sho's money as an institution is an im$ortant innovation in human civilization!
$%a&ter ; Money and $a&ital Markets . Interrelations 0%e Money Market %he money market $rovides a channel for the sale and $urchase of financial assets for money! It esta#lishes 2a mechanism throu h 'hich holders of tem$orary cash sur$luses meet the holders of tem$orary cash deficits2! 5lso the money market $rovides the o$$ortunities to meet the short term cash re(uirements of financial institutions" firms and overnments throu h the mechanism of rantin loans as short as over&ni ht and as lon as one year to maturity! On the other hand" money market $rovides an investment outlet for the economic units like cor$orations etc! that hold sur$lus cash for short $eriod of time!
;0
In most countries the money market is #road and dee$ as it can a#sor# a very lar e volume of transactions 'ithout any si nificant effects on security $rices or interest rates! %he market consists of a vast net'ork of securities dealer" #anks and #rokers 'ho remain alert to any #ar ain #ein constant in touch 'ith one another! %his is a very efficient market! S$eed is the essence of the market as volumes of cash remainin out of investment even for a day means hu e loss for the holder! Money is a hi hly $erisha#le commodity! Aecent research has o#served that national money markets are #roadly of t'o ty$es & those that are security market dominated and those that are #ank dominated! In the former most #orro'in and lendin are throu h o$en&market tradin of financial instruments! %he money market in the develo$ed countries are enerally of this nature! *ut in the develo$in countries 'e find that #ank #orro'in and lendin are at the centre of most transactions! %he $rinci$al financial instruments traded in the money market are %reasury #ills" overnment securities" dealer loans" re$urchase a reements" commercial $a$er" financial futures" #ankersP acce$tance etc! %he im$ortance of these instruments varies from country to country de$endin on the structure of the market and the level of develo$ment! %he rate of return on money market securities is anchored on the overnment securities 'hich have zero default risk and thus lo'est $ossi#le return! %hus the return on other securities are scaled u$'ards de$endin on $erce$tion of risks and also maturity! %he relationshi$ #et'een the rates of return on the instruments of different maturity is #ased on the risks associated 'ith time and this ives the term structure of the interest rates" 'hich sho's the relationshi$ #et'een the lon term interest rate and various short term interest rates! %his is yield curve and the sha$e and level of this yield curve are used to $redict the movement of other macro varia#les in the real sector of the economy! 5s for exam$le" the chan in slo$e of the yield curve is used to $redict the future course of inflation!
;=
%he Wield +urve %he relationshi$ #et'een the rates of return on the financial instruments and their maturity is called the term structure of interest rates! %he latter is $resented visually #y a curve 'hich is kno'n as Wield curve! %he Wield curve sho's the relationshi$ #et'een the maturity of a security and its rate of return .yield1 at one $oint of time all other factors held constant! %he slo$e of the yield curve is ex$lained #y a theory kno'n as un#iased ex$ectation hy$othesis! %his ar ues that investor ex$ectations re ardin future chan es in the short term interest rates influence the sha$e of the curve! When the investors ex$ect that short term interest rates may increase a#ove the current level" the yield curve 'ill have a $ositive slo$e and it 'ill #e a risin curve! When the investors in the market ex$ect the current short term interest rate to $revail at the same level in the future" the yield curve 'ill #e horizontal! If un#iased ex$ectation is true" the yield curve can #e used for forecastin the $ossi#le future movement of short term interest rates! *ased on this theory the $osition of yield curve is used em$irically to $redict the future inflation in a country! 0%e 2&ectation 0%eory and t%e 0erm +tructure of Interest 3ates ,et us examine the securities 'ith maturity of one and t'o $eriods & and these are $ure discount securities! ,et C1.t1 and C).t1 #e the $rices at time t of securities that 'ill $ay Ae 1 at times .tL11 and .tL)1 res$ectively! %he securities are assumed to have zero risk of default! ,et i1.t1 and i).t1 #e the continuously com$ounded $er $eriod yields to maturity of the t'o securities! %hen #y definition i1t C 1t!e )!i)t K C )t!e K 1
From this i1t K &ln C1t and i)t K & .ln C)t1 - )
;:
,et us no' consider an a ent 'ho has no net #orro'in needs at time t" #ut he needs to #orro' money at time .tL11 to #e re$aid at .tL)1! ,et us also assume that the #orro'in need can #e ex$ressed as the re(uirement to re$ay Ae 1! at .tL)1! %he a ent can 'ait until .tL11" and #orro' CtL1 dollars at an interest rate of itL1!
5n alternative transaction 'ould lock in an interest rate at time t! %he a ent can issue a )&year #ond" and invest the fund $)t in $)t-$1t one year #onds! Mere the a ent 'ill carry a zero #alance from t to .tL11! 5t .tL11 the one year #ond matures and the a ent 'ould receive $)t-$1t ru$ees 'ith the re(uirement to re$ay Ae 1!<< at time .tL)1!
Mere the im$lied interest rate from .tL11 to .tL)1 on this transaction is : ft K &ln .$)t-$1t1 K )! i)t & it
and this is called the one&year&ahead" one year for'ard rate! It is the one year rate of interest that can #e locked in one year ahead of time! It thus im$lies that the )&year rate is the avera e of one year rate and the for'ard rate! When the a ent is faced 'ith a choice #et'een lockin funds in the for'ard rate at time t and 'aitin to #orro' at time .tL11" he is likely to com$are the for'ard rate to the one& year rate 'hich is ex$ected to $revail at .tL11! %he ex$ectations hy$othesis assumes that the market forces 'ill drive the for'ard rate to #e e(ual to the ex$ected one year s$ot rate $lus a 2term $remium2! %he latter is su$$osed to #e constant over time! %he ex$ectation hy$othesis can #e stated as ft K 6t .itL11 L N
;/
'here
N as term $remium is commonly understood to reflect the differin risk of
alternative t'o strate ies and in $rinci$le it can #e $ositive" ne ative or zero! If N K <" in risk neutral case" the ex$ectation hy$othesis in fact cannot hold for all maturities simultaneously! When N is non&zero" there are no com$ellin reasons 'hy they should remain constant all the time! %he ex$ectation theory of term structure im$licitly assumes $rofit maximization hy$othesis! In stead of that the market $artici$ants may #e uided #y risk minimization! %his chan e of stance ives an alternative ex$lanation of the chan es in the slo$e of the yield curve and this is kno'n as market se mentation theory! We 'ill have more discussion on the term structure of interest rates in a later cha$ter! Market +egmentation 0%eory >M+0? %he MS% assumes that all securities are not $erfect su#stitutes in the mind of the investors! %he latter may have $references over maturity and they 'ill not chan e their desired maturity ran e unless some additional yields or other favoura#le terms come as an inducement to chan e their $referred maturity structure! It is assumed that the investors in the market minimize the risk in their $ortfolio and they $refer to hed e a ainst the risks of fluctuations in the $rices and yields of securities throu h the #alancin of the maturity structure of their asset 'ith the same of the lia#ilities! %he existence of maturity $references amon investor rou$s im$lies that so far as fixin of maturity $references of investors are concerned" the financial markets are not one lar e $ool of loana#le funds #ut these are se mented into a series of su#&markets! %his ty$e of se mented markets do not rule out the $ossi#le influence of ex$ectations in sha$in the term structure of interest rates! It only ar ues that the factors related to the maturity s$ecific demand and su$$ly of #onds are also im$ortant to influence the sha$e of the yield curve!
0<
It is enerally seen that interest rate moves #ack to its historic mean value over a very lon $eriod of time" 'hich is kno'n as mean reversion! %his as$ect ena#les researchers to make lon run forecast of interest rates #ased on yield curve! %hou h investors in eneral do not re ard all maturities of securities as $erfect su#stitutes" there are a lar e num#er of traders in the market 'ho do not have s$ecific maturity $references! %hey are uided #y the relative ex$ected return on different securities! %he com#ined result of their #ehaviour $attern can lead to a $osition 'hich more or less conform to the $rediction of the ex$ectation theory! %hus the latter ives a #enchmark ex$ected fi ure! Li=uidity in t%e Market ,i(uidity in the financial market is an im$ortant as$ect 'hich influences the sha$e of the yield curve! Some researches have revealed that there exist li(uidity $remium or term $remium attached to the yields on lon er term securities" 'hich com$ensate the investors for additional risks related to time! $ro$osition! $a&ital Market %he money market consists of institutions throu h 'hich market $artici$ants i!e!" individuals and institutions 'ith tem$orary sur$luses of funds meet the needs of the #orro'ers 'ho feel the tem$orary fund shorta es! %hus money market is desi ned to make short term loans! *ut the ca$ital market is desi ned to fund lon term investments #y #usinesses" overnments and households! While time dimensions are used to distin uish the different nature of these t'o markets" in todayPs financial 'orld of a lar e num#er of so$histicated financial instruments this distinction if often #lurred! *ut for initial understandin 'e can $roceed from this $remise! %he text #ook vie' of ca$ital market is as follo's: %he #uyin and sellin of existin stock is im$ortant in ensurin that (uoted firms remain efficient and seek to maximize their $rofits! 33%he stock market encoura es efficiency and $rofita#ility of firms and there#y #enefits the economy in eneral 3335 'ell develo$ed stock market %he term $remium is de$endent on #usiness conditions and to some extent random in nature! %his makes the forecast a difficult
01
'ith a hi h de ree of li(uidity therefore hel$s to #oth increase the volume of ne' issues and their costs3! %he $erformance of stock market also has #oth a direct 'ealth effect on ex$enditure decisions and also an im$ortant confidence influence on economic a ents! 7 Cil#eam" 1/:/" $$!1=0&==! 9
%he construction of factories" hi h'ays" homes and other ty$e of ca$ital oods is $ossi#le throu h the channelin of funds throu h the ca$ital market #y the financial instruments havin maturity of more than one year! %he estation $eriod of ca$ital stock of this nature is enerally lon and that ex$lain the lon duration of financial intermediation in the ca$ital market! +om$ared to the money market" the $rinci$al su$$liers and demands of funds in the ca$ital markets are more varied! >overnment ta$ the ca$ital market for funds for the construction of social ca$ital like schools" hi h'ays etc! *usiness houses are the most im$ortant #orro'ers as they issue lon term #onds to finance the $urchase of ne' e(ui$ments for their factories! 5 ain" the main su$$liers of funds in the ca$ital market are insurance com$anies" $ension funds" develo$ment #anks a$art from millions of individuals 'ho $artici$ate directly in the market of shares! +a$ital market is su#divided into smaller markets each havin its o'n characteristics! %he most or anized section of ca$ital market is the same for cor$orate stock re$resented #y the major exchan es in the country like *S6" NS6" etc! 5nother #i section of the ca$ital market is the market devoted to residential and commercial mort a e loans to finance the construction of homes and #usiness $remises! Many s$ecialised institutions and su#sidiaries of commercial #anks are $rinci$al $artners in this market! urocurrency Markets %oday more than ;< countries have #ankin re ulations that allo' the o$enin of time de&osits accounts in forei n currencies on the #ooks of the domestic commercial #anks
0)
and other financial institutions on #ehalf of non&resident forei ners! It all started in a #i 'ay in the early 1/;<s 'hen #anks in ,ondon and Caris #e an acce$tin ES dollar time de$osits from non&residents! %hese de$osits came mainly from east 6uro$ean countries and mainland +hina! %hese countries #elieved that under the tension of cold 'ar the Enited States mi ht #lock the dollar #alances of these countries in 5merican #anks! From this first #e innin the modern 6uro&currency market flourished and a lo#al customer #ase has #een created! No' the financial centers around the 'orld like >eneva" Uurich" *russels" Frankfurt" %oronto" Canama Sin a$ore" Mon Oon and other $laces carry out hu e amount of 6uro&currency #usiness! 6uro&currency has nothin to do 'ith 6uro$e" and technically" 6uro&currency #usiness are financial transactions in currencies" #oth de$osits acce$tances and credit creation" other than the currency of the country 'here the #ank is o$eratin ! %hus the markets of %okyo and Mon Oon talk of 5sian dollars! It is #asically a market in offshore time de$osits and loans in hard currencies like ES dollars" >erman mark" French franc" *ritish $ound and Qa$anese yen! %he rules of the ame" the nomenclature and the ex$ressions vary across re ions #ut the essence of the ame is the same and today it is a multi&trillion dollar #usiness! %he $rinci$al $layers are commercial #anks" IMF" World *ank" *ank for International Settlements " central #anks and overnment a encies! %he euro&currency market has ro'n as a lar e lo#al inter&#ank market and this tradin is done for a num#er of reasons like the re(uirement of maintainin de$osit&to&loan and other o$eratin ratios or the matchin #et'een the de$osits and loans! %hese eurocurrency loans from one #ank to another is called in financial 'orld as P$lacementP" and this amounts to a transfer of the underlyin hard currency fund throu h the res$ective offshore accounts of the t'o #anks!
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$%a&ter C Linkages 7etween +ectors, Monetary )olicy and 0ransmission Mec%anism
"All theori1ing is simplifying! cutting out the unimportant and leaving what is thought to be important! in the hope that by simplifying we may increase understanding" 7 Micks" 1/0=G $! 1;0 9
%he central #anks of the develo$ed countries are keen to exercise their inde$endence #y formulatin suita#le monetary $olicy 'ith the t'in o#jectives of sta#ility of $rice level and the sta#ility of the exchan e rate of the domestic currency! %hese t'o o#jectives are com$lementary to each other and the central #anks study the channels of transmission of their different $olicies to have a fair idea a#out 'hat is kno'n as leads and lags of monetary $olicy! In fact the entity 'hat is kno'n as the X6conomyP of a country is hardly com$artmentalized and its stylized different sectors are linked throu h the dynamic functionin of different economic $arameters some of 'hich are heavily de$endent on social conditions! We assume that the social conditions remain fixed or some sort of social sta#ility #ecomes the round reality of their assum$tion! When a $erson #uys a house throu h the MBF+ loans at a s$ecific interest rate" he seldom realizes that the intrinsic value of his $ro$erty may chan e #y the chan es in the market interest rate" thou h his $ro$erty is tied to the contract rate of MBF+! Neither does he realize that his decision may have some im$act in the linka es #et'een the money market and the asset market!
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%he linka es #et'een the sectors are im$ortant in the sense that the im$act of the monetary $olicy s$reads throu h the sectors 'ith the hel$ of those linka es! %he effects of monetary $olicy throu h the linka es in different sectors" 'hat is kno'n as the transmission mechanism" are also different in the develo$in countries com$ared to the develo$ed ones! In the latter" monetary ex$ansion is su$$osed to affect out$ut in the short run" even if the effects sim$ly lead to the chan es in the $rice level over a lon $eriod of time! *ut in the develo$in countries" an ex$ansion in money su$$ly may inflate the $rices immediately and still have little transitional effects on other real varia#les! %his situation occurs 'hen the credi#ility of the central #ank is lo' and inflationary ex$ectations are dominant! %he situation may #e a ravated if the financial markets are shallo' and volatile" and in this case the effects of the monetary ex$ansion on the real sector #ecomes difficult to $redict! Crice sta#ility should #e the o#jective of the monetary $olicy in this case! In recent literature there has emer ed a near&consensus amon the economists that monetary $olicy cannot influence the lon run ro'th of the economy" thou h it can affect the real sector in the short run! 6ven the effectiveness of influencin the short run situations has #een under dou#t as the la s in reco nizin turns in the #usiness cycle" and the su#se(uent la effects in the res$onse of the economy to the chan es in the $olicy make it difficult for the $olicy maker to choose the correct time for the announcement of the $olicy for fine tunin the #usiness cycle! Crice sta#ility has #een the $rinci$al o#jective of the monetary $olicy! >enerally it is a reed that an a$$roximate @ $er cent inflation should #e tolerated 'hich can take care of the difficulties of the measurement and the adjustment of the relative $rices that reflect differential $roductivity trends in different sectors of the economy! In the develo$in countries the tolera#le limit of inflation should #e hi her" say ; to 0 $er cent as the relative $rice adjustment 'ill #e more si nificant and $ronounced in such economies #ecause $roductivity ains in the trada#le sector is hi h and the differences of $roductivity ains in different sectors are hi h also!
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%he develo$in countries have another dimension 'hich make it im$erative that monetary $olicy should have o#jectives other than $rice sta#ility! It is enerally seen that the concentration of out$ut occurs in a smaller num#er of $roducts! 5lso" the financial markets are not develo$ed 'ith relevant ex$ertise lackin ! 5ll these may make the develo$in country more vulnera#le to the desta#ilizin shocks! %his necessitates the usefulness of counter cyclical monetary $olicy! %here is another as$ect! Since the financial system is 'eak" the a$ex #ank can use monetary $olicy to direct credit to the sectors considered to #e vital for the ro'th of the economy! 6ven 'hen $rice sta#ility is the sole o#jective of monetary $olicy" the effects of the latter on the out$ut and em$loyment cannot #e ne lected 'hen inflation&control #ecomes the $riority of the monetary $olicy" the $ace of deflation 'ill have a contraction effects on out$ut and em$loyment! It is enerally seen that various features of hi h inflation develo$in economies" includin lack of credi#ility" the 'a e&ri idities in the markets" etc! may create an inflation inertia and this increases the out$ut cost of anti& inflation monetary $olicy! +onsiderin all these many develo$in countries follo' monetary $olicy 'ith multi$le o#jectives consistent to their local conditions! 0%e 0ransmission $%annels of Monetary )olicy ! In a modern monetary system four channels of transmission mechanism of monetary $olicy have #een identified! %he first is throu h the direct interest rate effects" and this affects #oth the cost of credit and the cash flo' of de#tors and creditors! %he second channel is throu h the im$act of monetary $olicy on domestic asset $rices i!e! $rices of #ond" stocks and real estates! %he third channel is throu h the exchan e rates and the fourth channel is the credit availa#ility! functionin In an economy the nature of the of these four channels de$ends on the structure and macroeconomic
environment! One recent $henomenon is the lo#alization and the li#eralization! %his has chan ed the structure of the domestic financial system and thus the dynamics of the functionin of these channels has chan ed too! 0%e Interest 3ate $%annel !
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In the traditional Oeynesian model of monetary transmission" a $olicy induced chan e in the money su$$ly" for a iven money demand" 'ill lead to a chan e in the interest rate! +han e in the interest rates induces chan e in the mar inal cost of #orro'in " 'hich leads to chan e in investment and savin s and so a characterized as the follo'in schematic form: re ate demand! In Oeynesian frame'ork an ex$ansionary monetary $olicy 'ill have effects that can #e
M KY i KY I KY W 'here the sym#ol . 1 indicates an increase! %hus M indicates an ex$ansionary monetary $olicy that 'ill lead to a fall in the interest rate" a rise in investment and a re ates out$ut!
Oeynes em$hasized that the interest rate channel o$erates mainly throu h #usiness decision a#out investment s$endin ! oods and housin ! +%ort.term and Long.term Interest 3ates : %he #ehaviour of the short term and lon term interest rates in the face of the chan es in the monetary $olicy can #e $ut in a stylized fashion in the sim$le frame'ork! Su$$ose that a monetary $olicy chan e takes $lace that chan es the short term interest rate! %he latter should have effects #oth on the exchan e rate and on the lon term interest rates! *ut short term interest rate is not the sole determinant of the chan es in lon term rate and exchan e rate" and the effects of the short term interest rate is uncertain! %he chan es in the nominal exchan e rate and interest rate 'ill chan e the real exchan e rate and real interest rate! %he chan e in the latter 'ill have effects on ex$orts" im$orts" consum$tion" investment and ross domestic $roduct .>BC1! In the lon run" real interest rate and real exchan e rate return to their fundamental level and >BC comes to normal level! So the linka es are from the short term interest rate" to the exchan e rates and lon term interest rates and then to the level of inflation and real >BC! *ut recent research reveals that interest rate channels 'ork e(ually 'ell throu h the consumer ex$enditure on dura#le consumer
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Mo' is the short term interest rate determinedV In a model 'ith a sta#le demand for money" a re ate money demand de$ends on short term interest rate and income! %he a$ex #ank can affect the interest rate #y controllin the su$$ly of money! 5s money su$$ly increases" a decline in the interest rate 'ill clear the market! *ut this traditional analysis suffers from t'o inade(uacies! First" the money demand functions are not sta#le enou h to ive relia#le estimated value of the $arameters essential for $olicy makin ! Second" the #ehaviour of the a$ex #ank is not accurately descri#ed #y one&time chan es in the money su$$ly! %oday" many central #anks take multi$le actions in the money market to uide the short term interest rate in a $articular 'ay! %hus a descri$tion of the central #ankPs reaction function can sho' ho' it adjusts the short term interest rate in res$onse to various factors in the economy like inflation" exchan e rate and real >BC! 0%e Long 0erm 3ate of Interest ! Follo'in the financial market $rices vie' of the monetary transmission
mechanism" lon term interest rate is iven #y the ex$ected 'ei hted avera e of future short rates a$$ro$riate for the maturity of the lon #ond! If the central #ank initiates action to increase short term rates and the a ents in the market ex$ect the short term rate to decline radually #ack to the startin value in the future" then the rate of increase of the lon rate 'ill #e lo'er than the short rate! 5 ain" if the central #ank initiates action to increase the short term rates" #ut the a ents in the market think that this is just the first $hase of a lon er se(uence of events" then the increase in the lon rate 'ill #e hi her than the short rates! %hus market ex$ectations can $lay an im$ortant role in makin the chan es in the short and lon rates asymmetrical! %he ex$ectation model of the term structure of interest rate enerally 'ork 'ell 'hen the risks of interest rate chan es is covered" #ut 'hen the risks are not covered" it lacks $recision! %hat 'ay it has similarity 'ith the covered interest $arity condition in the exchan e rate movement! While one should kee$ this in mind" it is true that chan es in the short term rate is em$irically si nificant factors in determinin the chan es in the lon rate! >iven the ri idities in the $rice structure in the market" lo'er short term rate
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'ill reduce the real lon term rate" may #e for a s$ecific $eriod of time! In the lon run real lon term rate 'ill return to the $ath determined #y the fundamental economic factors and the chan e in money su$$ly 'ill have no im$act on the real ross domestic $roduct! Interest 3ate $%ange and *sset )rices ! *sset )rice $%annel ! %he chan e in the interest rate #ein the result of the chan e in the monetary $olicy can also influence the level and structure of the asset $rices in the economy! %he $rices of #ond" e(uity and real estate de$end on interest rate! In the case of lon term fixed interest #ond market" hi her short term rate may result in a decline in the #ond $rices! %his link #ecomes stron er as market develo$s thou h com$lications are there! %he ex$ectations theory of the term structure im$lies that lon term interest rate re$resents the avera e of future ex$ected short rates $lus a risk $remium" and the $rices of the e(uity can #e inter$reted as reflectin the discounted $resent value of ex$ected future earnin s of the enter$rises! 5lso the $rinci$le of uncovered interest $arity im$lies that exchan e rate chan es are determined #y the chan es in interest rate differentials! %hus" the chan es in the short&term interest rates 'ill influence lon rates and asset $rices and to 'hat extent this may ha$$en de$ends u$on ho' monetary $olicy affects the $ath of ex$ected future short&term rates enter$rise earnin s and rents! *ut even in mature economies the res$onse of lon rates and asset $rices to the chan es in the short term interest rates has #een difficult to $redict and this is for the follo'in reasonsG First" this de$ends on ho' the ex$ected future $ath of short term interest rates is affected #y the $olicy decision of the central #ank" es$ecially ho' market ex$ectations are chan ed! Second" asset $rices are also de$endent on the ex$ectations of future macroeconomic $erformance and this a ain affects #oth future short term interest rates and future asset $rices! Since future macroeconomic varia#les are difficult to $redict" the res$onse of the lon term interest rate and asset $rices to a chan e in the short term rates #ecomes uncertain! %he $ro#lem #ecomes more com$lex as the causality #et'een asset $rices and macroeconomic varia#les runs #oth 'ays!
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%hird" many a time asset $rices are seen to deviate si nificantly from the results of the ex$ectations model as these reflect chan in risk $remiums" s$eculative #u##les and other random factors not directly related to ex$ected future returns! 5lso asset markets are seen to #e shallo' and less com$etitive in the develo$in countries and this makes the asset market res$onse to the monetary $olicy chan es less certain! Jolatility in the asset market $rices is reinforced #y the reater availa#ility of credit in the 'ake of financial reforms! %he $artici$ants in the market are less ex$erienced and information a#out many near firms are not com$lete! 5ll these make $rice determination less efficient! 5ll these consideration contri#ute to uncertainties a#out the a$$ro$riate level of asset $rices and the res$onse of the latter to the chan es in monetary $olicy! *sset Market in an Im&erfect +ituation : In an uncertain and volatile 'orld a small chan e in monetary $olicy mi ht have lar e effects on asset market and a re ate demand! 5 small dose of ex$ansionary monetary $olicy may lead to a shar$ increases in all #ut very short run interest rates" if it #rin s concerns a#out a ne' sur e of an inflation! %his induces a shar$ fall in e(uity $rices and exchan e rate and the net effects of all these movements 'ill #e contractionary and not ex$ansionary as ori inally $lanned! %he movement of asset market $rices may #e such that it may offset the direct effects of a monetary $olicy action in mature economy also" thou h em$irical evidence su more $ronounced in develo$in countries! D . 0%eory and Eames 0o,in ! Monetary $olicy induced chan e in the asset $rices can affect the a re ate ests that the offset ex$erience is much
demand and this is N&%heory of investment of Crofessor %o#in! When the monetary $olicy is easy and ex$ansionary" e(uity $rices 'ill rise on the 'ave of inflationary $rocess" and this increases the market $rice of firms relative to the re$lacement cost of their ca$ital! 5lso ne'ly issued e(uity in the $rimary market can command a hi her $rice relative to the cost of real $lant and e(ui$ment and this reduces the effective cost of
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ca$ital! %hus" even in #ank loan rates react little to the $olicy easin " monetary $olicy can influence the cost of ca$ital and investment ex$enditure! %he chan es in asset $rices induced #y monetary $olicy can also affect demand #y alterin the net 'orth of households and enter$rises! %his ty$e of chan es may tri er a revision in income ex$ectations and induce the households to adjust their consum$tion ex$enditure! 5 ain" the chan e in the value of assets held #y firms 'ill chan e the (uantum of resources availa#le for investment! When the asset $rices decline" it 'ill have ne ative effects on s$endin as the resultant chan e in de#t&to&asset ratios make it difficult for the firms and households to meet their de#t o#li ations! 5 lar e fall in stock and #ond $rices may reduce the value of li(uid assets availa#le to the firms and households to re$ay loans! 5ll these ex$lain the effects of monetary $olicy chan es on a mechanism 'orkin re ate demand and their transmission throu h the asset $rices may #ecome am$lified as the $ace of
economic activity #e ins to res$ond in a more dynamic fashion! 5 decrease in the interest rate increases the asset $rices and im$rove the #alance sheets of firms! %his leads to an initial increase in out$ut and income and thus im$roved economic activity increases the cash flo' of firms and households! 5ll these induces a second round" ex$ansion of ex$enditure and $rolon ed u$'ard s'in in economic activity may continue for sometime even 'hen monetary $olicy may #e reversed!
2c%ange 3ate $%annel ! +onsistent 'ith its overall o#jectives the central #ank of a country tries to affect the exchan e rate throu h the o$eration of its monetary $olicy! In many develo$in countries the markets for e(uities" #onds and real estate are not mature and dee$ and exchan e rate is $ro#a#ly the most im$ortant asset $rice 'hich is affected #y the monetary $olicy! In a flexi#le exchan e rate re ime" a ti ht money $olicy increases the interest rate leadin to an increase in the demand for domestic asset! %his induces an
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a$$reciation of the nominal and real exchan e rate in the #e innin ! %his a$$reciation is transmitted to the increase in the ex$enditure in t'o 'ays! First" the a$$reciation of the exchan e rate makes the forei n oods chea$er" and thus the latter su#stitute the domestic oods to some extent! %hus this relative $rice effects reduces the domestic a demand! Second" the result of the chan e in the exchan e rate may have a #alance&sheet effects" as the firms and households in many countries may have hu e forei n de#t! If the latter is not offset #y the holdin of forei n exchan e reserve and forei n currency asset" chan es in the exchan e rate should have effects on the net 'orth of the firms and households! In many develo$in countries domestic households and firms are net de#tors in forei n currency throu h the #ankin system! When the domestic currency a$$reciates" this leads to an im$rovement in the #alance&sheet situation of the firms and thus this induces an ex$ansion of domestic a re ate demand! Sometimes" this sort of #alance& sheet effects dominates the relative $rice effects! %he a#ove ex$lains ho' the exchan e rate channels can affect the a demand 'hen monetary $olicy chan es! *ut it can affect the a re ate re ate
re ate su$$ly also
domestically! 5n ex$ansionary monetary $olicy 'ill reduce the interest rate" increase domestic $rice level and leads to a de$reciation of the exchan e rate! %he latter increases the im$ort costs and this induces the firms to increase their domestic $roducer $rices even 'hen there has #een no ex$ansion in the a re ate demand! In many countries 'ith 'eak financial structure and not&so&develo$ed market mechanism exchan e rate chan es are seen as a si nal of future $rice movements" and thus 'a es and $rice may chan e even #efore the adjustment time 'orks it out throu h the chan e in the im$ort costs havin effects on the cost structure! Fi2ed 2c%ange 3ate 3egime and Monetary )olicy
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When a country is havin a fixed exchan e rate" the effect of monetary $olicy on the latter is constrained! For a lon time" fixed exchan e rate has $rovided a hel$ful environment for faster economic ro'th to many develo$in countries! 6ven 'hen flexi#le exchan e rate has #ecome the dominant $aradi m" many countries 'ith 'eak financial system $refer exchan e rate as the nominal anchor and they $ay their currency 'ith one stron currency in the 'orld i!e! ES dollar" French franc or >erman mark! One major defect of the fixed exchan e rate $olicy is that the central #ank cannot $ursue inde$endent monetary $olicy" as it is forced to acce$t the international level of interest rate! %his means that the central #ank is una#le to use the domestic interest rate to influence a re ate demand! 5 sin le o#jective $olicy .fixed exchan e rate1 may lead to the $ersistence of dise(uili#rium in the domestic economy! When domestic currency #ecomes over&valued" the #alance of $ayments crises may come in the form of deficit in current account! %he adjustment mechanism 'hile maintainin the fixed exchan e re ime is $ainful for the economy as do'n'ard ri idities in the domestic $rices mean that current account deficits should #e adjusted #y monetary outflo's and demand com$ression! %his causes disru$tion in the economy in the form of unem$loyment and decline in out$ut! *ut it has #een o#served that in the develo$in countries domestic and forei n assets are not $erfect su#stitutes! In such situation" 'ith ca$ital flo' re ulated #y the authority" there is some sco$e for inde$endent monetary $olicy even under fixed exchan e rate re ime! 5s the rates of return on domestic and forei n asset diver e" the effects of monetary $olicy throu h the asset market cannot fully offset #y the reverse ca$ital flo' as the latter is re ulated! So in the short run" the chan es in the monetary $olicy may have some effects! Institutional factors also have some influence in the diver ence of rates of return of domestic and forei n assets! When the financial markets are se mented and #ecome clear throu h the non&$rice rationin mechanism" the $artici$ants in the market cannot
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successfully ar#itra e deviations of domestic rates of return from international norms! Su$$ose domestic money market is 'ell inte rated 'ith international ca$ital markets" even then the chan es in the money market rates may not lead to immediate corres$ondin movements in de$osit or loan rates! %his sort of situation $revailed in some east&5sian countries as they used to enjoy some inde$endence in monetary $olicy throu h market se mentation! One fall out of the ty$e of monetary $olicy follo'ed in the 5sian countries is the existence of financial fra ility and the dilemma of the central #ank to maintain the $e ed exchan e rate! When the country is havin a hu e forei n currency de#t" the central #ank cannot afford the do'n'ard revision of the exchan e rate as that 'ould im$ose hu e #urden on the domestic front! 5 ain" if the #anks are in $oor financial $osition" the central #ank is constrained to raise the interest rate to defend the $e ed exchan e rate! %he dilemma continues and the economy remains in a hi hly levera ed state! %his sort of constraint $osed #y financial fra ility on the monetary $olicy does not vanish even 'hen the currency is floated as the de$reciation of the domestic currency im$oses heavy #urden on the firms and households and lead to a crises of confidence in the economy! We come #ack a ain to the im$ortance of institutional factors as the country 'ith 'eak financial system should ado$t structural reforms first so that it can #enefits of inde$endent monetary $olicy! *efore sterilized intervention in the money market! )olicy Inter(ention and Foreign 2c%ange market When the central #ank resorts to sterilized intervention in the money market" 'hat is its effects in the forei n exchan e marketV %he literature is confused in this as$ect as the (uestion 'hether sterilized intervention can #e used inde$endent of the monetary $olicies so that the monetary authorities can $ursue t'in o#jectives of exchan e rate and domestic sta#ilization! %heoretical discussion su ests that there may exist one or more 'e ras$ the take u$ that issue" another
im$ortant $olicy $ers$ective should #e discussed #riefly! %his is the situation of
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channels throu h 'hich the intervention can affects the exchan e rate of the domestic currency! In a system of inde$endently floatin exchan e rate re ime 'ithout ca$ital control the inflo' of forei n money 'ill increase the money su$$ly! If the authority follo's a money su$$ly tar et $olicy or a $olicy of inflation rate tar etin " it is to control the money su$$ly! Faced 'ith an automatic increase in money su$$ly" the central #ank can $erform o$en market o$erations to suck money out of the system so that the stock of money availa#le in the market does not chan e si nificantly! In short" the effect of the inflo' of forei n money into the economy is sterilized so that it can not desta#ilize the domestic e(uili#rium! %his is sterilized intervention .SI 1 'hich is 'idely $racticed #y the central #anks all over the 'orld! In theoretical analysis sterilized interventions can influence the exchan e rate of the domestic currency in four channels: &&&& the $ortfolio #alance channel:: SI induces dise(uili#rium in the $rivate $ortfolios and the adjustment takes $lace 'ithin the $ortfolio throu h the chan e in the exchan e rate" &&&&the market efficiency channel:: SI focuses the attention of the $u#lic on the ne lected information 'hich are im$ortant for exchan e rate adjustments" &&&&&&&su$erior information channel:: SI transmits other'ise unavaila#le information that induces the economic a ents to make necessary adjustments in the forei n exchan e market" &&&&&&&future antici$ation channel:: the SI creates future antici$ation a#out the $otential chan es of other $olicy related to money su$$ly and exchan e rate and the resultant adjustment of the economic a ents in their res$ective market $ositions can chan e the exchan e rate! If SI o$erates throu h the first t'o channels" the influence of SI is inde$endent of the other $resent and $otential domestic $olicies! *ut if SI o$erates throu h the third and fourth channels" that may si nal the chan es of other $olicies in the future! Whether the SI 'ill have im$act on the exchan e rate throu h the chan es in the $ortfolio de$ends on the de ree of su#stitutions amon the assets! If the investors think that the identical assets denominated in different currencies are $erfect su#stitutes " then the SI 'hich increase the su$$ly of securities denominated in $ound sterlin and reduce
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the su$$ly of the securities denominated in French franc 'ill have little effects on the exchan e rate of >*C- F franc" as the investors 'ill continue to hold the chan ed stock of securities 'ithout any ex$ectation of exchan e rate chan es! *ut if the investors think the assets denominated in different currencies as im$erfect su#stitutes" the SI 'ill cause the relocation in the $ortfolio as the chan ed inci$ient demand and su$$ly situation 'ill come to an e(uili#rium throu h a chan e in the exchan e rate of >*C in terms o French franc! If the investors kno' #efore hand the im$endin SI" they 'ill use this information in their forecasts of the future s$ot exchan e rates" and this altered #ehaviour 'ill ultimately chan e the exchan e rate! %he influence of the $rior kno'led e of the SI can induce the investors to ne lect the structural varia#les affectin the exchan e rates and rely only on the information on future SI! %he $ortfolio #alance model of exchan e rate determination de$ends on the uncovered interest $arity condition" and the latter is found to ex$erience deviations in real life as the interest rate movements may not ensure the constancy of the real interest rate ! %he deviations from the uncovered interest $arity 'ill induce the chan es in the exchan e rates and these are (uite consistent 'ith the o$erations of the first t'o channels! $redit *(aila,ility $%annel ! %he credit availa#ility channel is ex$lained on the assum$tion that #anks $lay a s$ecial role in the financial system as they are 'ell suited to deal 'ith certain ty$e of #orro'ers 'ho are im$ortant from the stand$oint of the economy! %here exists a lar e num#er of small firms in any economy 'ho confront asymmetric information re ardin the financial system and these firms re(uire funds for their o$erations! %hey a$$roach the #anks 'ho are to meet their li(uidity $ro#lem! %he #i firms can a$$roach the ca$ital market directly! In many develo$in countries $rivate markets for credit are $oorly develo$ed #ecause of structural reasons! 5 ain such $rivate markets may #e $revented #y
=0
overnment re ulations from o$eratin freely on efficiency consideration alone! In such situation monetary $olicy is likely to affect a of credit! re ate demand more #y chan in the availa#ility of credit than throu h the direct or indirect effect of the chan es in the $rice %his is true 'hen the #anks are directed to channel a certain (uantum .$ercenta e1 of credit to some $riority sectors! 5 ain" sometimes there exists #indin " ceilin s on the interest rates to #e char ed #y the #anks! In such cases #anks use non& $rice means of rationin loans and this increases the im$ortance of credit availa#ility effects! Sometimes overnment of some countries et involved directly in the market for loans either throu h $u#lic sector or overnment controlled develo$ment #anks or throu h fiscal su#sidies on the loans of commercial #anks! %his sort of situation also 'ill have the credit availa#ility effects as ex$lained a#ove! Aecently" the financial sector in many develo$in countries has #een li#eralized! %his li#eralization does not eliminate the credit availa#ility effects! Aecently economists have esta#lished that im$erfect information and contract enforcement $ro#lems are im$ortant in the sense that they chan e the means #y 'hich credit market clear! In res$onse to ti ht money $olicy" #anks may not rely exclusively on increasin the interest rate on the loans to ratio credit" as this may encoura e riskier investment #ehaviour on the $art of #orro'ers! %o $revent the risk&lover #orro'ers comin as customers" #anks do ti hten credit 'orthiness standards a$art from increasin the loan interest rates! %his leads to a decline in the su$$ly of credit alon 'ith the increase in the $rice of credit! We see that credit can $lay a s$ecial role even in the li#eralized financial sector! For this central #anks in many countries includin India closely monitor credit ro'th in the evaluation of their o'n monetary $olicy! 5 ain" monetary $olicy has its effects on the credit availa#ility throu h its effects on the value of assets of #oth the #orro'ers and the #anks! 5s monetary $olicy alters the monetary conditions" asset $rices chan e 'hich chan es the value of the collateral for
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#ank loans! %he latter chan es the $o'er of access of the #orro'ers! %he chan es in the credit 'orthiness of the #ank customers and the financial conditions of the #anks to ether 'ould induce the chan es in the credit rationin 'hen the #anks $erceive the constraints in the economy! 0ransmission Mec%anism, Inter(ention and 3ecent $%anges ! ,eavin out the extreme situations like hi h inflation and recession in the
economy" 'hen normal conditions $revail" the monetary authorities in many countries have a#andoned monetary tar etin ! *ecause it has #een o#served that chan es in the demand for money have caused the relationshi$ #et'een the monetary a a re ates" re ate demand and $rices to shift over time! Some central #anks ive im$ortance to
the real rate of interest" thou h the definition of inflation for the determination of the real interest rate is still de#ated! In many develo$in countries" uncertainties a#out the channels of transmission of monetary $olicy have #een made more com$lex #y the structural chan es in these channels themselves! 5ll these have made the inter$retation of the indicators of monetary situation difficult! Sometimes" the volatility of the financial markets and macroeconomic insta#ility may loosen the linka e #et'een indicators of monetary conditions and future economic situation of the country even 'hen the channels of monetary transmission mechanism are sta#le!
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$%a&ter 6 Monetary )olicy, Interest 3ates and $a&ital Mo,ility
""t is impossible that an organi1ation should be entirely handed down as a blueprint from above. "t has to grow! being based at every moment on what has gone before". 7 Micks" 1/0/G $!11 9
Monetary $olicy o$erational throu h the actions of the central #ank affects #oth short term and lon term interest rate! 5lso the latter is linked 'ith inflation and real out$ut! %he a$ex #ank determines the interest rate in res$onse to the deviations of inflation and real sector economic varia#les from some desired levels as $rescri#ed #y the $olicy o#jectives! When the economy is o$en" the chan e in the monetary $olicy may #ecome #oth the flo's #oth 'ays! %he standard models of ca$ital mo#ility in the literature ex$lain the channels of transmission of the effects of monetary $olicy in the o$en economy set u$! 5t $resent situation has #ecome much more $ronounced as the lo#alization of the ca$ital markets of the countries of the 'orld is much more advanced than 'hat is enerally #elieved! %he chan e in the nature of international #ankin " the volume of #usiness in the cause and the effects of the ca$ital mo#ility across the $olitical #oundaries! %he de ree of o$enness of the economy of course affects the level of ca$ital
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international ca$ital market" the volatility in the international currency market and the $henomenal develo$ment of information technolo y have revolutionized the inte ration of the 'orld financial system! %he stylized versions of the 'orld financial system hel$ us understand it #etter! Cerha$s it 'ould not #e im$ro$er to remem#er that in s$ite of the limitations associated 'ith the model #uildin exercises" the analysis throu h the model facilitate #etter understandin of the various nuances of the linka es existin amon the sectors! %he models associated 'ith the names of Mundell" Flemon and others have tried to ex$lain the 'orkin of the macro&economy throu h the different linka es! We take these models in the follo'in $ara ra$hs!
Mundell . Fleming Model %he Mundell&Flemin .MF1 model can #e $resented #y the follo'in e(uations :
m & $ K >y & 5 r y K &*r L,yZ L .e L $Z& C1 L $ K $Z r K rZ !!!
!!! .:!11
!!! .:!)1 .:!@1 !!! .:!81
Where all the varia#les exce$t r and rZ are in lo arithm .natural lo 1 and
m y r e $
K K K K K
money stock real out$ut interest rate exchan e rate .$rice of forei n exchan e1 domestic $rice level
:<
K rZ WZ K K
overnment s$endin forei n interest rate forei n real out$ut
5ssumin that domestic $rices are held constant at $ and #ecause of $erfect international ca$ital mo#ility e(uation .:!81 holds and in that case the level of real out$ut y de$ends only on m! 5n increase in money su$$ly m $roduces si nificant chan e in real out$ut y" even 'hen r remains unchan ed as these are accom$anied #y a de$reciation in e! 5n ex$ansionary monetary $olicy induces do'n'ard $ressure on rate of interest r" 'hich induces inci$ient ca$ital outflo' from the domestic economy! %he latter ha$$ens as the international investment demand in res$onse to the differences #et'een domestic and international rate of interest .r and rZ 1 is infinitely elastic! *ut ca$ital outflo' causes the de$reciation of the currency and so e chan es" 'hich shall have effects on #oth ex$orts and im$orts! In the fixed exchan e rate re ime" 'hen the domestic interest rate starts to fall in the face of ex$ansionary monetary $olicy" ca$ital outflo' starts and the central #ank in that situation is to sell its forei n exchan e from the reserve to defend the currency! %his intervention in the financial market #y the central #ank 'ould have to #e non&sterilized in order to #e effective" the money stock 'ould have to return to the ori inal level! %hus 'hen $erfect ca$ital mo#ility is associated 'ith a fixed exchan e rate re ime" monetary $olicy #ecomes ineffective to have its im$act on the macroeconomics varia#les! %he MF model de$ends on some assum$tions 'hich are extreme and do not conform to modern day conditions! %he model i nores 'ealth effects and $ortfolio considerations! 5lso inflation and ex$ected chan e in the exchan e rate are set e(ual to zero! %he domestic $rice level $ is insensitive to the chan es in the exchan e rate! %he modal also i nores a re ate su$$ly effects and ca$acity constraints are i nored! 5ll these restrictions make the model a real Oeynesian one! In the MF model the domestic interest rate r move only in res$onse to chan e in forei n interest rate and thus it has no inde$endent role in the transmission of monetary $olicy! %his sort of situation is unlikely to hold in real 'orld situation! What is more common to see is that the chan e in the monetary $olicy 'ill induce a com#ination of real exchan e rate effects and interest rate
:1
effects! In fact inde$endent movement of domestic interest rate vis&a&vis the forei n interest rate is related to the nature of ca$ital mo#ility!
International Mo,ility of $a&ital %here are four alternative definitions of international ca$ital mo#ility de$endin on the narro'ness or s$ecificity and these are: i1 ii1 iii1 iv1 +overed interest $arity and ca$ital mo#ility Encovered interest $arity and $erfect asset su#stitution 6x ante and ex $ost real rates of interest at home and a#road! Uero investment savin correlation!
We discuss these four issues in turn!
$o(ered Interest )arity and $a&ital Mo,ility If domestic and international assets are $erfect su#stitutes" then returns on com$ara#le assets in different markets of the 'orld 'ould #e e(ual $rovided there are no transaction costs" exchan e control" tax distortions" investment restrictions and $olitical risks! %he e(uality 'ould #e esta#lished throu h ar#itra e o$erations #y market $artici$ants! %his is kno'n as the condition of covered interest $arity and it can #e sho'n as : .i & iZ1 & .f & e1 K z 'here i K domestic nominal interest rate iZ K forei n nominal interest rate .f & e1 K for'ard $remium" z K +overed interest differential !!!.:!;1
:)
When it is seen that the value of z is si nificantly different from zero" it means that +a$ital mo#ility is lackin ! %hus even 'hen the domestic and forei n nominal interest differ #y the amount of for'ard $remium .meanin interest rates should #e e(ual! Anco(ered Interest )arity and )erfect *sset +u,stitution Sometimes investors may #e 'illin to shift funds #et'een uncovered assets denomination in t'o different currencies" on the assum$tion that covered interest $arity condition is satisfied! %his #ehaviour in the limitin case leads to $erfect asset su#stitution as investors treat t'o assets of t'o different countries e(uivalent and ex$ect the same ex$ected rate of return! %hus no exchan e rate risk $remium is re(uired to induce investors to shift funds #et'een forei n and domestic currency assets! %he condition can #e 'ritten as : .i & iZ 1 & .[ & e1 K ' K o 'here [ K ex$ected exchan e rate of the domestic currency ' K exchan e risk $remium" and others same! %he e(uation .:!01 is called uncovered interest $arity and the ca$ital mo#ility im$lied #y it is some'hat #roader in sco$e com$ared to the case of covered interest $arity! 5 com$arison of the t'o cases im$ly that if #oth $erfect ca$ital mo#ility and $erfect asset su#stitution are satisfied" the for'ard $remium on covered transaction .f& e 1 in e(uation .:!;1 'ill #e e(ual to the ex$ected rate of de$reciation of domestic currency in e(uation .:!01 or 'e can 'rite : .i & iZ 1 K .f&e1 K .[ & e1 !!!.:!= 1 !!!.:!01 that z is zero1" $erfect ca$ital mo#ility is ensured! 5lso" this model does not $resume that domestic and forei n real
We find from .:!= 1 that it is not necessary for the domestic interest rate to move in lock& ste$ fashion in #oth the covered interest $arity and the uncovered interest $arity cases! *ut #oth the cases im$ly a close relationshi$ #et'een the t'o interest rates 'hich reveal the inte ration of the t'o ca$ital markets!
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Ex ante and Ex post 3eal Interest 3ates Some researchers ar ue that in the context of inte ration of 'orld ca$ital markets" the real interest rates of different countries 'ill #e e(ual! %he im$licit assum$tion is that the real interest rate differentials on domestic and forei n currency assets 'ill #e smaller and smaller as the de ree of inte ration of the 'orld ca$ital markets #ecomes more $erfect! If the uncovered interest $arity holds" one can ensure that ex ante .e(uili#rium1 real rate of interest 'ill #e e(ual on domestic and forei n currency assets if one additional condition is im$osed on e(uation .:!= 1! %his condition is kno'n as 2ex ante $urchasin $o'er $arity2 and it im$lies that ex$ected chan e in the real exchan e rate is zero! %his can #e satisfied in the follo'in 'ay : %he nominal exchan e rate can #e assumed to chan e in $erfect com$ensation for the chan e in relative inflation rate! %his is sometimes called relative $urchasin $o'er $arity .CCC1! %hus ex ante CCC to ether 'ith $erfect mo#ility of ca$ital and asset su#stitution uarantee that the lon term difference #et'een the t'o real interest rates .domestic and forei n1 'ill #e zero! So far the discussion of the transmission of the monetary $olicy is carried out 'ithout the im$lication of fiscal $olicy" thou h fiscal im$lications 'ill #e there! In the a#ove case it #ecomes interestin if taxes are introduced into the $icture! IN the latter case" even 'hen forei n and domestic taxes #ein tZ and t res$ectively" ex ante CCC re(uires that .[ & e1 K 6 . & Z 1 K < !!!!.:!: 1
In order to e(uate net real rates of return across the countries and ensure that the nominal interest rates adjust to ex$ected chan es in inflation rate" the follo'in condition should hold :
:8
i K 6 .r L 1 -.I & t1 K iZ K 6 .rZLZ1 - .I& tZ 1 5ssumin that forei n and domestic tax rates are same" t K tZ" e(uation .:!/1 can #e 'ritten as 6 .r & rZ1 K .i&iZ1 .i & t1 & 6 . & Z1 K .i & iZ1 .i&t1 & .[ & e1
!!!.:!/1
!!!.:!1<1
From .:!1<1 it is clear that unless 6.r &r Z1 is non&zero" .:!1<1 is not consistent 'ith uncovered interest $arity! %his 'ay taxation com$licates the $ro#lem in e(ualizin the real interest rates in the context of $erfect ca$ital mo#ility!
Bero In(estment.+a(ing $orrelation : Feldstein and Morioka .F&M1 in their model .1/:<1 have su ested that if ca$ital
markets are $erfectly inte rated internationally" then the correlation #et'een national servin s and investment should #e zero! When demand for ne' investment increases" ca$ital inflo' takes $lace and thus there 'ill #e no si nificant chan e in the sharin and real interest rate of the country! %he relation in mathematical form is .I-W1 K a L # .S-W1 'ith null hypothesis .MO1 : # K <! !!!.:!111
%he idea is that 'hen 'e estimate the a#ove relation econometrically" that is the least s(uare re ression is a$$lied on . I - W1 K a L # . S -W 1 L e 3 . :!1) 1 'e see 'hether the estimate of the coefficient # . that is # &hat 1 is statistically si nificant! If 'e fail to reject the null hy$othesis . that is" #K <1" it im$lies that invest&
:;
income ratio in a country is inde$endent of the savin &income ratio! %his creates the case for international mo#ility of ca$ital! For the satisfaction of .:!111" it is essential that the real rates of return on all classes of domestic real and financial assets should #e e(ual to the real rate of return of com$ara#le forei n assets! It is clear that the a#ove condition holds only if t'o other conditions are satisfied and these are $erfect ca$ital mo#ility and $erfect asset su#stitution! *ut 'hat has #een o#served in the #ehaviour $attern of the overnments is that the latter chan e the fiscal varia#les drastically 'henever they face lar e deviation in the #alance of $ayments and this reduces the sco$e of lar e scale ca$ital inflo's so essential in the .F&M1 model! %he su ested unit correlation #et'een the current account and ross domestic $roduct is unlikely to #e overnments as descri#ed! Cerha$s no domestic investment ex$ressed as ratio of satisfied #y the #ehaviour $attern of the
overnment 'ants to ex$ose the domestic ca$ital market to the fluctuations of the international ca$ital market and that ex$lains 'hy the authority reacts in the fiscal side to sta#ilize the situation! One can a$$reciate the a#ove situation #etter if he com$ares the Indian ca$ital market situation at this first year of the millenium! %hanks to lo#alization the *om#ay stock exchan e closely follo's the stock market of Ne' Work and the volatility exhi#ited in the forei n markets are transmitted easily in the domestic markets! %he situation 'ill #e more com$lex once Indian ru$ee #ecomes ca$ital account converti#le! %his 'ill make ca$ital mo#ility 'ithout any hindrance and the $ortfolio investment may #ecome volatile 'ith a very small chan e in the $arameters like $rices and interest rates! %he sta#ility in such a situation demands an efficient com#ination of fiscal and monetary $olicies and selective intervention of the overnment 'ith fiscal instruments! %his cha$ter has examined the issue of ca$ital mo#ility from a theoretical $ers$ective! 5n understandin of the different economic $arameters 'ill facilitate the understandin of the com$lexities of the international ca$ital flo's descri#ed in detail in +ha$ter 1;! In todayPs context of lo#al inte ration the M&F frame'ork and also the F&M frame'ork assume im$ortance since the domestic economic $arameters like interest rates" inflation rates have #ecome de$endent on the lo#al economic situations!
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$%a&ter < Monetary &olicy and $%annels of 0ransmission
"4ike all serious schools of thought! monetarism has differing emphases and degrees". 7 C! 5! Samuelson" 1/:;G $!@)0 9 2 The delicate! invisible web you wove%.. " 7 %! S! 6liot 9
%he $rinci$al o#jective of the monetary $olicy is to influence the real and the nominal macro varia#les throu h the chan es in the money su$$ly 'ith the hel$ of some transmission channels often $resumed to #e 'orkin in the economy! %he stren th of these channels and their linka es de$end on the a re ate structure of the economy includin the level of inte ration of different sectors! %he literature discuss a#out t'o $rinci$al channels of transmission and these are&&& the money vie' channel and the interest rate channel! %he former is also called the credit vie' channel! %he de#ate sometimes centres on the relative stren th of the t'o channel! Sometime the (uestion is asked 'hether the Xmoney vie'P channel is all $o'erful or not! %he name comes from the $hiloso$hy that money matters and money is
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exo enous and that the central #ank can control it!
In this vie' the financial
intermediaries offer no s$ecial services on the asset side of the #alance sheets! On the lia#ility side of the #alance sheet" the financial intermediaries $erform a s$ecial role" i!e!" the #ankin system creates money #y issuin demand de$osits! %he $resum$tion is that the ca$ital structures do not influence real decisions of the #orro'ers and the lenders" 'hich is the result of Modi liani and Miller .1/;:1! 5$$lyin the MM thesis it 'as ar ued later in the literature that $ortfolio $references of the $u#lic re ardin #ank de$osits" #onds or stocks should have no effect on real outcomes" i!e!" the financial system is merely a veil! %he ex$lanation of the a#ove o#servation is iven as follo's : Su$$ose that there are t'o assets & money and #onds! In the $hase of monetary contractions the central #ank reduces reserves" 'hich limit the #anksP a#ility to sell de$osits! No' the de$ositors must hold more #onds and less money in the $ortfolios! If the $rices do not adjust simultaneously the chan es in money su$$ly" the decline in the money holdin s of the households re$resents a decline in the real money #alances! %o restore e(uili#rium there should #e an increase in the real interest rates of #onds" and this increases the user cost of ca$ital and thus the ex$enditure 'hich is sensitive to interest rate declines! %hus interest rate $rovides the linka e #et'een the money market and the ca$ital market! %he a#ove descri#es the money vie' of the transmission mechanism or the interest rate channel! It de$ends on four assum$tions : First" the central #ank must control the su$$ly of Xoutside moneyP for 'hich there are im$erfect su#stitutes! Second" the central #ank can influence #oth the real and the nominal short term interest rates! %hird" the chan es in the real short term interest rates affects lon er term interest rates! Fourth" the $lausi#le chan es in the interest sensitive ex$enditure in res$onse to monetary $olicy intervention match 'ell 'ith the o#served chan es in the real sector! Some economists have characterized that the money vie' focuses on the a re ate side as o$$osed to the distri#ution& related conse(uences of $olicy actions! a monetary contraction does %he latter im$lies that a hi her interest rate follo'in
::
de$ress desired investment #y firms and households! When the investments falls" there is a reduction in #usiness and $roduction! *ecause of this consideration there has #een a search for a #roader transmission mechanism addressin #oth the macro concern as ex$lained a#ove and the micro concern! %he micro concern relates to the im$act of im$erfections in information system in the case of insurance and credit markets! Mere the $ro#lems of asymmetric information #et'een the #orro'ers lead to a a$ #et'een the cost of external finance and internal finance! %he conventional interest rate channel de$ends on com$lete market a$$roach" #ut the notion of costly external finance is shar$ly different and it does not consider the links #et'een the real and the financial decisions! In contrast to the money vie' the a#ove descri$tion is the 2credit vie'2 of the transmission channel! %his considers the financial constraints on the #orro'ers" as some #orro'ers face hi h cost of external finance! Further" this vie' accommodates the idea that the s$read #et'een the cost of external and internal funds varies inversely 'ith the #orro'erPs net 'orth! %he latter de$ends on the interest rate movement" as an increase in the interest rate increases the de#t service #urden of the #orro'ers" and also it reduces the $resent value of the net 'orth! %he latter consideration influences the decision of the lender re ardin the ne' loan! Cerha$s in this context 'e may discuss in de$th the role of #anks in the conduct of monetary $olicy!
7ank Lending and Monetary )olicy
%hou h the im$ortance of interest rate channel is 'ell acce$ted" there are several situations 'here the lendin from the #anks has some im$ortance! First" credit market im$erfections have certain im$lications for the firms 'ho a$$roach the #anks for finance! *anks do $lay a role throu h the evaluation and monitorin of small firms 'ith little $u#licly disclosed financial information! Second" the financial conditions of the firms 'ill chan e over time throu h the $hases of the #usiness cycles and so the res$onses of these firms to the chan es in the monetary $olicy 'ill vary accordin to the o#jective conditions! So the effects of the chan es in the monetary $olicy 'ill #e sensitive to the health of the #ankin institutions and the financial health of the firms!
:/
%hird" future financial innovations and chan es in the re ulations may chan e the future effectiveness of the monetary $olicy! %his may re(uire the $olicy makers to adjust their $olicy actions so as to incor$orate the im$act of these structural chan es on the transmission of monetary $olicy! 5$art from the a#ove three as$ects the nature and the size of the effects of monetary $olicy transmitted to the economy throu h the #ankin sector 'ill de$end on the financial conditions of the #anks and the $olicy of re ulations! For exam$le" the size of the effects o$eratin throu h the credit channel 'ill #e sensitive 'ith differin results from one to other as more num#er of #anks come under statutory ca$ital re(uirements .i!e!" the amount of ca$ital the #anks are to maintain as a $ercenta e of their risk& 'ei hted asset $ortfolio1! %he central #anks should take into account the financial $osition of the #anks and also the re ulatory frame'ork in time of formulatin the monetary $olicy! In recent times there have #een su#stantial chan es in the financial markets and financial re ulations im$lyin 'hat is kno'n as change of regime in the econometrics! %his means that historical data on the transmission of monetary $olicy 'ill not #e a relia#le uide to the central #anks for the conduct of monetary $olicy in future! %hou h 'e discuss the role of #ank lendin in the transmission of monetary $olicy in the a#ove $ara ra$hs" 'e are to ex$lain the interest rate channel a ain! %he interest rate channel of monetary $olicy #ecomes #roader 'hen 'e consider the credit vie' alon 'ith the traditional money vie'! %his also sho's the link #et'een the money market and the ca$ital market! %hou h it is a fact that sometimes it #ecomes difficult to make distinction #et'een these t'o vie's" as the contractionary monetary $olicy may have t'o conse(uences! *ecause in #oth the cases the current real 'ealth and the $ortfolio overheads #ecomes lo'er in ma nitude! %he chan e in $ortfolio overheads can emer e either from any com#ination of a chan e in the return on an outside asset" or a chan e in the covariance structure of the returns" or a shift in the consum$tion $rocess! +onsiderin the differences arisin out of the relative im$ortance of the shifts in loan demand and loan su$$ly" a credit vie' also
/<
$redicts cross sectional differences arisin from #alance sheet considerations! Of course this is an em$irical (uestion! %he linka es #et'een the money market and the ca$ital market remains functional throu h the effectiveness of the different channels of transmission o$eratin in the economy! %his also de$ends on the financial structure alon 'ith the conventions rulin in the money market! %he em$irical (uestions $ointin out the relative stren th of different channels and the sizes of different $arameters is an interestin one" #ut this has not #een attem$ted in the $resent study! Cerha$s a eneral e(uili#rium macro model can address this interestin (uestion! We may kee$ this ex$ectation for the future! One interestin as$ect 'hich has #een the center of #rainstormin in the academic 'orld is 'hether the chan e in the exchan e rate causes the chan e in the $rice level of the domestic economy! %his amounts to an ex$ort of inflation to other countries throu h the exchan e rate channel! %he fact is that the chan e in the interest rate of a currency may ha$$en for a num#er of reasons and the movements in the ca$ital market #elon to that set! %hus the chan es in the ca$ital market can s$read its influence in the money market throu h the chan es in #oth the interest rate and the exchan e rate! 5 #etter a$$reciation of the channel of transmission facilitates the ado$tion of correct $olicy! %his is $erha$s one im$ortant issue 'hich re(uires $ro$er examination for the effectiveness of $olicy! $entral 7ank 0argets and +trategic Issues In eneral" central #anks no'&a&days try to achieve $rice sta#ility and this is taken as a sin le intermediate tar et! 5 ain some 6uro$ean central #anks are usin monetary a re ates as intermediate tar ets in the #elief that monetary a re ates are linked 'ith the medium term chan es of nominal varia#les in a $redicta#le fashion! %hus these varia#les can #e controlled #y the central #anks and $u#lic o$inion can #e educated throu h the chan es in the medium term monetary $olicies! +entral #anks are enerally not in favour of makin a direct inflation tar et! %he $ro#lem emer es from the com#ination of lon la s in the effects of monetary $olicy" and also uncertainty a#out the future shocks and the res$onse of the structure of the economic systems! *ecause of uncertainty and the la s in the $olicy"" the (uantum of
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chan e re(uired in the monetary varia#les to kee$ inflation rate 'ithin a s$ecific #and is difficult to identify! *ecause of these $ro#lems some central #anks in some O6+B countries desire to et inflation do'n to or #elo' the tar et level instead of advancin the rate to the tar et zone! Of course" the literature documents the inflationary #ias of monetary authorities for the sim$le reasons that the o$$osite" i!e!" the deflationary #ias may hurt the rate of ro'th of the real sector of the economy! %his has emer ed throu h the cost #enefit analysis of the t'o a$$roaches as the fear of recession alon 'ith $otential unem$loyment are associated 'ith the $olicy of deflation! 2c%ange 3ate 0argets %he central #anks face $ro#lems to maintain the exchan e rate tar ets " #ecause it is related to the nominal interest rate! *ut the latter re(uired to maintain the exchan e rate link may re$resent a real interest rate 'hich may not #e suita#le for the $artner country! If the real interest rate lyin under the nominal interest rate is considered as not sustaina#le" the nominal interest rate may not #e effective to $erform t'in functions&& maintainin the exchan e rate and ensurin the inflo' of ca$ital! In other 'ords" one instrument" interest rate" fails to achieve t'o tar ets&&&& exchan e rate sta#ility and ca$ital inflo'! One $ro$osal in such a situation is im$osition of exchan e control so as to ena#le the interest rate to kee$ ca$ital inflo' steady! *ut the shortcomin s of the exchan e control are 'ell kno'n" and also attem$ts to influence the interest rates throu h the fiscal $olicy are also trou#lesome! *ecause of these $ro#lems many economists find it difficult to reconcile to the idea that a $e ca$ital movement! While the central #anks are serious a#out the im$lementation of the monetary tar ets" the im$ortant o$erational issues in this context are: &&choice of monetary a re ates &&the relevant reference $eriod over 'hich the instruments are set && the s$eed 'ith 'hich the deviations from the tar ets are corrected && 'hether the drift in the #ase 'ill #e allo'ed! ed #ut adjusta#le exchan e rate re ime may ensure a sta#le e(uili#rium in a situation of free
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%o have decisions re ardin the a#ove issues the central #anks use information 'hich are availa#le throu h their kno'led e of other monetary and financial varia#les! %hrou h this $rocedure the central #anks may chan e the $lannin horizon and ski$ some steps su ested in the literature! So lon the central #anks enjoy re$utation and credi#ility" they re ates to their #enefits and may can utilize even mild deviations from the monetary a conduct $olicy 'ith fe' informational inefficiencies! When a country is havin a fixed exchan e rate re ime" money su$$ly #ecomes endo enous under the follo'in conditions: the country is not in a $osition to influence the international interest rate international ca$ital mo#ility is $erfect and no country is im$osin restriction" and there exists $erfect su#stitution #et'een domestic and forei n #onds! In these circumstances the monetary authority loses control on the ro'th of total money su$$ly" it can only influence the #reakdo'n of the ro'th of money su$$ly #et'een the domestic and external sources! %he tar et rate of money ro'th can #e fixed ex ante so as to make it com$ati#le 'ith the sta#ility of the exchan e rate" #ut in the event of any external shocks " the actual 7 ex post 9 ro'th of money may differ from the ex ante one if the central #anks 'ish to maintain exchan e rate sta#ility! Which one the central #anks 'ill choose is a hard $olicy decision and it de$ends on other monetary a also macroeconomic information! re ates and any
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$%a&ter F Money, Markets and Institution
""f everybody minded their own business!" the 5uchess said in a hoarse growl! "the world would go round a deal faster than it does." &&&& ,e'is +arroll Alice's Adventure in #onderland
In the circulation of commodities and services" trade and exchan e 'ith any form of money and other financial instruments take $lace 'ith some form of market structure" the latter varies from country to country de$endin on socioeconomic conditions! We can define the market structure in a theoretical frame'ork! In reality most markets are far from the Pmodel&formP $ortrayed in the eneral e(uili#rium theory&&& that is" idealized" timeless" non&institutional and a $rice eneratin mechanism! 5n attem$t can #e made to characterize some of the #road features a market mechanism should exhi#it for the ideal functionin of the economy! %he literature has defined the market mechanism in $recise manner . Bu#ey and Sahi" 1//)G Shu#ik" 1/// 1! %he market as a relation can involve any su#set of traders on either side tradin a set of commodities a ainst another! It follo's then that the num#er of market structures can increase astronomically for even a modest num#er of traders
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and commodities" and this may leave out the multi$licity of exchan e mechanism that mi ht #e used for the clearin of the market 'hen a set of commodities are #ein traded for another set! When a sin le commodity is exchan ed for another commodity" there is a natural 'ay to a re ate bids and offer and to form a final market $rice! %he (uantities of re ated" and the (uantities of commodity j re ated! %he exchan e rate #et'een the commodity i offered #y all sellers can #e a
su$$lied #y all #uyers of commodity i can #e a the t'o (uantities!
t'o commodities or the price of commodity i in terms of j can #e defined as the ratio of
Markets in Microeconomic 0%eory In mainstream analysis of microeconomic theory 'e assume that there exists a anonymous market mechanism that satisfies the follo'in conditions:
1!
5&enness! 5 market is o$en in the sense that that entry and exit are com$letely free and any#ody can enter and o out of the market any time! %he market is not exclusive in the sense an auction #y invitation is!
)!
*ggregation! *y a his messa e and the a commutative!
re ation it is meant that an individualPs trade de$ends only on re ation of the messa es of all other a ents $artici$atin in these are #oth associative and
the markets! %he messa es are $rocessed and

@!
Feasi,ility! 5 $rocessed messa e 'ill facilitate trade so that individual R 'ill deliver a s$ecific #undle of oods in the market! %his condition re(uires that no matter ho' the messa e of individual R is $rocessed" the $erson R 'ill al'ays #e a#le to su$$ly the commodities in the market!
8!
*nonymity! 5 market is anonymous in the sense that no sin le individualPs entry or exit has any #earin on the outcome of the market! In fact" this rules out mono$oly situation!
;!
5rt%ogonality! Messa es sent to the markets #y the a ents are su#ject to a restriction in the sense that these are s$ecific to the markets sent for and these can refer to trades
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that take $lace in these markets! It im$lies that the varia#les contained in the messa es are used in the trades s$ecific to these!
0!
+im&licity! %he messa es sent #y the a ents are sim$le and these are understood #y all e(ually 'ell! %he information sent throu h all these messa es are symmetric re ardin the moves of all traders! %his 'ay the market can avoid com$lex strate y #ased on the availa#ility of all information!
=!
$onnectedness! 5 market structure satisfies connectedness if any commodity i can #e exchan ed for any other commodity j throu h a series of exchan es in a set of markets! %he exchan es take $lace in an ordered se(uence!
:!
Moneyness! 5 market structure contains a medium of exchan e .money1 if there exists one commodity that can #e exchan ed directly for every other commodity and it has acce$ta#ility amon the a ents!
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$om&leteness! 5 market structure is com$lete if every commodity can #e exchan ed for every other commodity" and in this sense every commodity is as ood as money! %he a#ove conditions descri#e a market structure in a stylized situation! In an exchan e economy 'ith a finite num#er of traders " it is o#served that as the num#er of traders increases" the nature of market e(uili#rium a$$roaches a situation 'hat is called the com$etitive e(uili#rium in microeconomic theory! 5s lon as the num#er is finite and there are no transaction costs" the individual can maintain some influence in the demand or su$$ly situation in the market! For this the infinite num#er of individuals are taken as the theoretical re(uirement for model #uildin in market structure!
)rimiti(e and $eremonial Monies! Crofessor 6inzi .1/8: 1 has defined primitive money as 2 a unit or o#ject conformin to a reasona#le de ree to some standard of uniformity" 'hich is em$loyed for reckonin or for makin a lar e $ro$ortion of the $ayments customary in the community concerned" and 'hich is acce$ted in $ayment lar ely 'ith the intention of em$loyin it for makin $ayments2!
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6inzi also offers a check list for the classification of $rimitive money! Follo'in Shu#ik .1/// 1 'e can $ut the criteria as follo's: a! Boes it have an existenceV #! Boes it assume the form of credit or currencyV c! What form does it assume" or 'hat material it consists ofV d! Is it fiduciary issue " or it has some intrinsic valueV e! Is it a luxury or necessityV f! Is it used exclusively for monetary $ur$osesV ! Whether its use is confined to commercial $aymentsV h! Is it used for internal $ayments onlyV i! Is it $roduced locally or #ein im$ortedV j! Is it converti#le into other o#jectsV k! Which of the monetary function does it $erformV
5 close look at the criteria confirms that these lead to a definition of money 'hich is close to its modern form! 6vidences from history and anthro$olo y sho' that $rimitive societies had used some commodities as ceremonial monies 'hich 'ere meant not for the use as medium of exchan e! 6xam$les are the famous stone money of the Wa$ Islanders " or the tokens of value the $eo$le of Calau Islands had used in marria e" divorce" #irths and other social rites and similar occasions . Merskovits" 1/8< 1! %his is ex$lained in detail in earlier cha$ter! +eremonial monies de$end for their sco$e of use u$on the la's and customs of the society and also the a#ility of the society to enforce the rule of la'! In all societies 'e find relationshi$s amon money" $resti e and $o'er and this $henomenon is common for all time! %he anthro$olo ical evidences su of exchan e reveals the extent of domain of economic measurement! est that the use of ceremonial monies in s$ecial occasions 'ithout its use as a eneral medium
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%he etymolo y of the 'ord money and some names of famous monetary units su ests that there has al'ays #een a close and stron relationshi$ amon the use of money" the develo$ment of the le al system and the use of 'ei hts and measures! For exam$le" the 'ord Pmark' in the >erman monetary unit deutsche mark is ex$lained as a coin or 'ei ht unit that has #een marked #y the overnment! On the other hand it has #een su ested in the literature that the 'ord dollar of the currency of the Enited States .and some other countries 1 is derived from the 'ord Thaler! %he latter in turn is derived from Qoachimsthal in *ohemia" in the latter $lace the counts of Schlick coined silver coins kno'n in history as ,oachimsthalers 6 Shu#ik" 1/// 1! Money itself is an institution and it is a net'ork $henomenon! %he economic use of money #rin s efficiency in the system 'hen the society is a#le to create some institutions 'hich can enerate services re(uired #y the society for the circulation of commodities includin money! Burin the course of historical evolution the character of the institutions have chan ed" same has ha$$ened to the nature and form of money One exam$le is the use of old " 'hich is near& money and 'hich has close relation 'ith money! %he ancient literature defines old as 2 Crecious non&rustin metal sometimes used in the Middle 5 es in thin leaves for 'ra$$in some $aste and certain roast #irds! >old is still used for this $ur$ose in the Far 6ast 7 4arousse +astronomi$ue! 6n lish edition" 1/01 9! %he use of the yello' metal as near& money is relevant even today as countries una#le to cover their #alance of $ayments a$ even #y #orro'in s are to ex$ort old a#road " and old here $lays the role of money due to its 'ide acce$ta#ility! In India $eo$le #uy old and accumulate the yello' metal either in the form of je'elry or $lain old #ars ! %his they do #oth as a hed e a ainst the declinin value of ru$ee and also as a source of savin s thinkin this as ood as money! %he demand for old in the develo$in countries has more to it than sim$ly as a su#stitute of money! %he demand for the yello' metal in India is more than =<< ton $er year " this much old must #e used for $ur$oses other than ornaments! %his is yet to #e $ro$erly ex$lained!
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Money, Markets and 4lo,al Finance %he creation of markets for money and other near&money assets is enerally associated 'ith the role of the state mechanism" thou h it is often difficult to sho' this 'ith o#jectivity! %his is #ecause of the follo'in factors: First" the last t'o decades of the )<th century had seen ra$id develo$ment of transnationali1ation re ardin the develo$ment of financial markets! %his is caused mainly #y the ca$ital mo#ility across the $olitical #oundaries! +a$ital movement takes $lace as short time and volatile ca$ital can move (uickly in res$onse to un$leasant re ulatory and $olitical interventions! 5ll these are done to dod e the rules and may #e tem$orary in nature! Second" the anarchic nature of com$etitive dynamics amon the develo$in countries for ettin a fair share of forei n ca$ital has led to fre(uent chan es in the rules and re ulations of the country in the name of li#eralization! 5ll these are done to facilitate the inflo' of forei n ca$ital! In the financial markets these are referred to as regulatory competition. %he economic a ents 'ith the necessary ca$ital seek the most soft areas to et the maximum return of the investment" and thus 'regulatory arbitrage' continues! %his makes the $osition of the market a ents much stron er and it #ecomes difficult for the state to exercise effective control on the market $rocess! %his as$ect is often lost si ht of and the authority makes the situation com$lex #y the attem$t to control the market! %hird" the existence of a hu e lo#al market s$ace outside the effective control of the state authority has reatly affected the conduct of macroeconomic $olicies" $articularly monetary $olicies and $olicies re ardin exchan e rates! In a #id to attract more forei n ca$ital states are seen to o for more li#eralization" and then try to sta#ilize the fluctuations of economic $arameters 'hich are the conse(uence of ca$ital flo's! In extreme situations states are seen to #e at the mercy of the market makers and a ents 'ith the money $o'er! 5lso there exist $arallel $ressure on the state to $ursue orthodox macroeconomic $olicies to $reserve the sta#ility of the exchan e rate of the national currency and the #alance of $ayments! Since 1/:< the 'orld has #een seein the volatility of the flexi#le exchan e rate re ime and the countries have #een facin the $ro#lems of #alance&of&$ayments
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financin $ro#lems! %o solve the latter $ro#lem" central #anks and national treasuries had searched for ne' sources of finance #eyond the domestic markets as internal savin s 'ere not sufficient! 5lternatively" faced 'ith easy availa#ility of forei n ca$ital" national fiscal deficits #e an to mushroom" 'hich someone can inter$ret as a moral hazard $ro#lem! 5lso existin $olicies consistent 'ith 'elfare state and related $aradi m are often com$romised for more li#eralization 'ith a vie' to attract more ca$ital! In either case states #e an to de$end on the lo#al market $lace for their financial re(uirements! One im$lication of this $henomenon is that state has emer ed as an im$ortant $layer in the lo#al financial markets! %he attitude of the different countries to'ards the lo#al financial markets have #ecome am#i uous ! Faced 'ith chronic do'nslide of im$ortant economic $arameters" countries are increasin ly relyin increased market7friendly $olicies inducin on the lo#al market $lace 'ith ro'th in the overnment more innovation and
financial system! *ut in the $rocess the countries are losin control on their economic systems to the $rivate market $layers! %he central #anks and the treasuries are less neutral o#servers and regulatory referees today in the lo#alization of financial markets" and #ein a $art of the system they are more and more interested in the success of the $rocess of lo#al financial inte ration .Melleiner" 1//8G +erny" 1//@ 1! While the state has #een do'nsizin markets for monitorin efficient o$eration" the evolvin 'ith im$roved rules and re ulations! itself leavin system more s$ace to the calls for more orderly
%he a#ove evidence sho's that the state has $layed a si nificant role in the develo$ment of modern financial markets! %his has induced contradictory macroeconomic $olicies #ein $ursued simultaneously in a country as are often seen! 5s for exam$le" 'hile the central #ank follo's ti ht monetary re ime to kee$ the exchan e rate sta#le" the state treasury ives sufficient inducements for increased inflo' of forei n ca$ital" and the latter increases money su$$ly to make the task of the central #ank difficult! 4lo,ali1ation and Institutions
1<<
%he term lo#alization descri#es the $rocess of intensification of international economic relations under a s$ecific circumstances 'hen the international economic relations have t'in roles! On the one hand these cause economic ro'th and an im$rovement in the livin dise(uili#ratin standards" on the other these are res$onsi#le for the the form of $ro#lems that cause serious im#alances in
unem$loyment and intra and inter&sector loss of $roduction! %he develo$ment of the international economic relations in the real and nominal s$here induces chan es in the or anizational forms and also in the institutional frame'ork of the society! %hus international la's are develo$in to'ards the su$ranational la's forcin the nations to #rid e the a$s in the le al frame'orks! %he MN+s are esta#lishin their o'n hierarchies irres$ective of country affiliations and they are takin ne' measures to u$ rade their efficiencies! Whether it is the location of ne' esta#lishments" or the recruitment of $ersonnel the MN+s do not consider the country $ers$ectives! %he $rocess of internationalization $rocess descri#e a#ove has t'o as$ects&&& intensification of international economic transactions and the chan es in their or anizational forms! %hese t'o as$ects are closely interconnected and often they reinforce each other! While the ne' trade re ime under W%O leads to li#eralization of the financial sectors and more trans&#order inte ration" the latter induces the concerned countries to formulate ne' rules and re ulations to safe uard the sta#ility of the domestic system ! %his as$ect comes a ain and a ain as country after country faces insta#ility in their financial system as the latter can not a#sor# the shocks comin from the external sector! 5r entina" +hile in ,atin 5merica" Indonesia and %hailand in 5sia " and Aussia and some east 6uro$ean countries have ex$erienced convulsions in their financial system 'hen the latter failed to 'ithstand the external shocks! One remedy to this ty$e of $ro#lem " as su the next section! $urrency 7oard +ystem 5 currency #oard system .+*S1 is a $art of the monetary system in any country that has commercial #anks and other financial institutions! %he system is also ested in the literature for the sta#ility of the re ional currencies" is the +urrency *oard System 'hich 'e discuss in
1<1
characterized #y a certain ty$e of #ehaviour of the financial institutions re ardin converti#ility" exchan e rates" overnment finances and other related matters 'hich are ex$lained #elo'! A currency board system is defined as a monetary institution that issues base money which is fully backed by a foreign "anchor" or reserve currency ! and the money thus issued is fully convertible into the reserve currency at a fixed rate on demand. %he currency under +*S is fully converti#le and the #oard exchan es its currency for the reserve currency at a fixed rate 'ithout limit! *ut a currency #oard does not uarantee that de$osits at commercial #anks are converti#le into currency #oard currency" and it is the res$onsi#ility of the concerned commercial #ank! Ender +*S the monetary $olicy is rule #ound and the #oard has little discretion in this re ard! %he currency #oard is not allo'ed to alter the exchan e rate " nor its reserve ratio or the re ulations affectin the commercial #anks! %he #oard remains $assive re ardin the chan e in the demand for money! Market forces the monetary $olicy and this is done in res$onse to determine the money su$$ly! *ut under the usual central #ankin system" the central #ank has a discretion in $ursuin s$ecific situations 'hether it refers to exchan e rate" or inflation "or normal #usiness cycles! %hou h the de ree of inde$endence enjoyed #y the central #anks of various countries differ " a central #ank usually can alter the exchan e rate" the reserve ratio " or re ulations affectin macroeconomic varia#les! 5 central #ank is a lender of the last resort" #ut a currency #oard is not! %he currency #oard does not lend to commercial #ank or other financial institutions in case of need! Neither the #oard can finance a fiscal deficit of the overnment! %he latter 'ill have to #alance its #ud et if it is una#le to #orro'! Ender the +*S disci$line is enforced on the $rice fronts as the domestic currency is $e ed to the anchor reserve currency at a fixed rate and the #oard is committed to unlimited conversion #et'een the t'o currencies! %his #rin s credi#ility to the domestic currency!
%a#le:: * $entral 7ank (ersus a $urrency 7oard &&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&& +entral *ank +urrency *oard &&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&& 1! Jaria#le forei n currency reserves 1! Forei n reserve 1<< $er cent )! Ce ed or floatin exchan e rate and )! Fixed exchan e rate and full converti#ility converti#ility
the commercial #anks and also a #road s$ectrum of
limited
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World Financial Infrastructure and Money : Sukumar Nandi @! Biscretionary monetary $olicy @! Aule&#ound monetary $olicy 8! ,ender of last resort 8! Not a lender of last resort ;! Ae ulates the commercial #anks ;! No $o'er to re ulate #anks 0! +an finance fiscal deficits 0! +an not finance fiscal deficits =! Ae(uires $reconditions for monetary =!Ae(uires no $reconditions for reforms monetary reforms! &&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&& .ource&& .chuler! '889. &&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&
%he a#ove ta#le com$ares the t'o system in a
#rief 'ay as the $rinci$al
characteristics of the system are contrasted! 5 currency #oard holds reserve currency #onds" #ank de$osits and also a small amount of currency&&& all these a ainst its lia#ilities of currency issued to the $u#lic! Many #oards have held more than 1<< $er cent reserves . sometimes 11< $er cent or more1 to have a mar in of $rotection in case the value of the asset declines! *ut a ty$ical central #ank 'ill have a varia#le reserves in forei n currency and assets " and it can hold also domestic assets! 5 currency #oard has ood credi#ility! Its more than 1<< $er cent reserves" rule& #ound monetary $olicy" trans$arency in functionin " $rotection from $olitical $ressure and fixed exchan e rate 'ith full converti#ility &&& all these make the currency a ood choice in the forei n currency markets! 5 ain" inflation is also ke$t under control! In contrast to that most central #anks" exce$t a fe' in O6+B countries" have a $oor record of controllin 'istorical )ers&ecti(e More than =< countries have had currency #oards and the first currency #oard 'as esta#lished in 1:8/ in Mauritius" then a *ritish colony! %ill 1/<< currency #oard s$read slo'ly" thou h 5r entina esta#lished it! 5fter 1/<< *ritish colonies made the +*S as the system of monetary mana ement! In the 1/;<s currency #oards reached their reatest extent 'ith most of the countries in 5frica" the +ari##ean" and South 5sia +*S! %he +*S of the orthodox ty$e as ex$lained in the earlier $ara ra$hs exists today in Mon Oon " >i#ralter" the +ayman Islands" the Falkland Islands" *ermuda had the currency #oards system! In 5sia" #esides Mon Oon " Sin a$ore" Malaysia" Chili$$ines" *urma and *runei 'ere the countries havin the inflation!
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and the Faroe Islands! Since 1/:: the overnment of Mon Oon has chan ed the system 'hich ives a diluted version of the currency #oard! In some countries 'e see currency board7 like system that does not have all the features and these countries are &&& 5r entina" *osnia" *ul aria" *runei" Bji#outi and 6stonia! %he record of the currency #oards are very ood as all of them have successfully maintained fixed exchan e rates and full converti#ility into their anchor currencies" and this they could do even durin the >reat Be$ression years! %he currency #oard in Falkland has #een maintainin the fixed exchan e rate of >*C 1 K Falkland $ound 1 ever since the creation of it in 1://! Bes$ite success stories many countries converted currency #oards into a central #ankin system in 1/;<s and 1/0<s after attainin inde$endence as the +*S 'as #ecomin synonymous 'ith the colonial system! 5lso creation of the central #anks ives the $olitical masters the sort of levera e 'hich is not availa#le 'ith the currency #oard system! It is no 'onder that many central #anks in small and ne' countries have lost their credi#ility due to excess $olitical influence! Money +u&&ly %he currency #oard does not have any active role in the determination of the monetary #ase! %he reserve of 1<< $er cent and a fixed exchan e rate 'ith the anchor currency 'ith unlimited converti#ility make it im$ossi#le for the #oard to use any discretion! %he #oard also does not chan e the relation #et'een the money su$$ly and money #ase as it maintain the 1<< $er cent or more reserve and it does not chan e the ratio! %he su$$ly of money in this system is determined #y the market forces! In eneral" under +*S" the startin $oint in the se(uence of events for an increase in the su$$ly of monetary #ase and hence money is an increase in the forei n demand for ood of the home country! +han es in the demand for oods ori inate in the markets" and that reflect the desire of the $u#lic! *ut this induces a $ositive element in the current account of the #alance&of& $ayments! %his is neutralized #y the inflo' of forei n money and this increases the money #ase! %he currency #oard is una#le to create reserve for the commercial #anks at its o'n discretion" and money su$$ly res$onds to the chan es in the market demand and
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it is (uite elastic! 5s the system ac(uires fresh forei n reserves . in anchor currency1" money su$$ly increases" and for this it is not necessary that the country should have a current account sur$lus! %he missin link is the ca$ital inflo' 'hich can increase the money #ase in this system even 'hen the current account #alance is ne ative! %hus it is not necessary for a +*S to have a sur$lus in the current account of the country so that it can ex$and the money su$$ly! Forei n ca$ital inflo' can offset or exceed the deficits in the current account and that means an increase in reserves and also money su$$ly! *nc%or $urrency Mistorically" *ritish $ound had #een the anchor currency of the reserves of the currency #oards of many countries #efore 1/;< and $articularly in the former *ritish colonies! ,ater on" ES dollar has taken a $redominant $osition" thou h Qa$anese yen and >erman Mark have #een selected #y some currency #oards as the currencies of reserves! One feature of the anchor currency is that it must #e a sta#le one and 'ith a ood credi#ility! 5fter 1/80 ES dollar has #ecome the international currency and that has facilitated its $osition in the 'orld! "s the )(. a desirable institution: %he ans'er is $ositive #ut in an a#normal situation! %ake the case of Indonesia" 'hich introduced the system in Fe#ruary 1//:! 5t the time" more $recisely in 1//=" the *ank Indonesia devalued the currency ru$iah and it lost the credi#ility! %ake some fi ures&&& the current ru$iah re$laced the old 1/0; ru$iah at a rate of 1 current ru$iah K 1<<< old ru$iah of 1/0; vinta e!
5lso @!:< of old ru$iah of 1/8/ vinta e K <!<<@:< current ru$iah" and this sort of insta#ility continued in the history of Indonesia! Surely" for the sta#ility of the financial system a stron ado$ted! medicine 'as re(uired and +*S 'as $rescri#ed and it 'as
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%he +*S is a disci$lined and ri id system and it is not amena#le to sudden chan es if these are 'arranted to fi ht the #usiness cycles . Schuler" 1//0: Williamson" 1//;1! Sometimes it is also ar ued that +*S is an extreme solution for a very unsta#le situation and it can not #e an ideal one for the normal situation of a country! 5ctually" no country 'ants to sacrifice the freedom of $ursuin inde$endent monetary and fiscal $olicy and this #ecomes the case under +*S! %here are certain other disadvanta es in +*S! 5$art from the initial mo#ilization of the 1<< $er cent reserves in the anchor currency" the reserves $osition ideally should #e more to earn credi#ility of the system! Moreover" +*S is totally $assive to the chan es in the monetary conditions! %here is a tendency that the domestic li(uidity tends to #e $ro&cyclical&&& in the u$s'in $hase" money flo's in and the lon term rate of interest tends to fall and the economy moves to'ards #oom conditions" and it #ecomes reverse in the do'ns'in $hase! %his causes fluctuations! %hou h currency #oard can ive ne' currencies a (uick start" it hardly $rovide a lastin foundation! 5s the economy develo$s" the chan e in its industrial structure re(uires its $rices and the values of the assets to shift relative to those of the trade $artners! In this $ers$ective" a currency #oard may a $rices and the returns on the assets in the develo$in countries! ravate the volatility of an
%o conclude" the introduction of +*S in an economy facin
extreme
macroeconomic insta#ility may #e not 'ithout risk as the economy may #e su#ject to lar e amount of stress in the initial $eriod! *ut once the economy #ecomes a#le to 'ithstand the $ressure" the system ains credi#ility" rates of interests sta#ilize" ro'th $rocess starts and the economy catches u$ the ro'th trajectory! %hus it is more im$ortant that the economy is a#le to a#sor# the initial shocks and the social tensions are contained 'ithin reasona#le limits! It is the a$$rehension of the latter 'hich $ro$els many economists not to recommend the +*S for a country even thou h it #ecomes the $erfect solution! Colitics stands in the 'ay of 6conomics!
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$%a&ter :
Financial 6eri(ati(es and Macroeconomic )olicy
%he develo$ment of derivatives is an im$ortant innovation in the financial 'orld in the last t'o decades of the t'entieth century! Berivatives are financial instruments" 'hich" 'hile shado'in the underlyin asset" ive the o'ner a uarantee re ardin the intrinsic value of the asset! %he ro'th of this market is $henomenal! %he notional amount outstandin of the exchan es in derivatives in O%+ markets 'as ES S=) trillion in Qune 1//:" accordin to *ank for International Settlements .*IS" 1/// 1" 'hile the ross market value in O%+ markets 'as ES S )!0 trillion! 5t the same time the ross domestic $roduct .>BC1 of the 'orld in 1//: 'as ES S )/!) trillion .IMF" 1/// 1! %he avera e daily turnover on O%+ markets 'as ES S 1!)0 trillion $er day in 5$ril" 1//:! %hese fi ures sho' the reat levera e allo'ed #y the derivative contract in the markets! )rinci&al Markets %he $rinci$al markets of derivatives in the 'orld sho' the different levels of technolo y functional in these markets! %he +hica o *oard of %rade .+*O%1 and +hica o Mercantile 6xchan e .+M61 are the lar est derivative markets in the 'orld! %he 6uro$ean 6xchan e .6urex1 and the ,ondon International Financial Future 6xchan e
1<=
.,IFF61 are im$ortant markets in 6uro$e 'hich sa' most of the innovation in derivatives! %hese markets sho' different tradin systems! ,IFF6 is famous for its o$en outcry system for most of its $roducts" #ut 6urex is an electronic tradin $latform" and it allo's the traders to function throu h the com$uter terminals! Aecently ,IFF6 launched a ne' electronic tradin system called ,IFF6 +ONN6+%! %his system 'ill re$lace the o$en outcry radually! %here are certain other im$ortant markets like Ne' Work Mercantile 6xchan e .NWM6R 1" Mercato Italiano Future .MIF1" Marche a %erm Future .M5%IF1" Sin a$ore International 6xchan e .SIM6R1 alon 'ith other centres s$read all over the 'orld! *ut there is ske'ed distri#ution of the derivative #usiness re ardin eo ra$hical distri#ution" as @) $er cent of the total transactions take $lace in ,IFF6" and 1: $er cent take $lace in the Enited States! %he future develo$ment of the derivative exchan es 'ill #e lar ely sha$ed #y the evolution of tradin technolo y! %he size of the derivative markets reveal their im$ortance in the functionin of the economies" 'here the close link #et'een financial innovation and investment" #ankin and the activities in the industrial sectors are documented! %he functionin of the derivative markets are crucial as these influence the economic $olicies $articularly in the monetary field! In the follo'in sections 'e 'ill first take a #rief overvie' of the different cate ories of derivative instruments availa#le in the market and then analyze the relationshi$ #et'een derivatives and underlyin assets and the im$lications of this in monetary $olicies! 6eri(ati(e Instruments! *n 5(er(iew Berivatives can #e #roadly classified into Over&the &counter .O%+1 ty$e and 6xchan e traded! Most de#t instruments are traded over&the&counter 'ith lar e #rokera e firms makin markets in s$ecific issues! Berivatives like for'ards" S'a$s and customized o$tions are traded over&the &counter .O%+1! %hese are tailored accordin to the needs of the customers and these are non&transfera#le a reements #et'een t'o $arties!
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5 financial instrument is exchan e traded if it is traded in a formal exchan e! +urrency futures" standardized exchan e itself! *orward contracts are sim$le derivatives for 'hich t'o $arties enter into an a reement to #uy or sell an asset at a fixed $rice at a certain future time! It is not traded in an exchan e and it is enerally #et'een t'o financial institutions or #et'een one financial institution and a client! One of the $arties in a for'ard contract a rees to #uy the underlyin asset on a certain future date for a s$ecified $rice and thus takes a long position. %he other $arty a rees to sell the asset and assumes a short $osition! 5 for'ard contract is settled at maturity as the holder of the short $osition delivers the asset to the holder of the lon $osition in return for the delivery $rice s$ecified in the contract! +wa&s S'a$s are O%+ instruments in 'hich t'o $arties a ree to exchan e streams of $ayments or cash flo's over time! %here are t'o main cate ories&&& interest rate s'a$ and currency s'a$s " #ut more esoteric ty$e of s'a$s are $ossi#le de$endin on the needs of the counter $arties! 5n interest rate s'a$ is amount! 5 currency s'a$ is an a reement to #uy and sell forei n exchan e at $re& s$ecified exchan e rates 'here the #uyin the and sellin are se$arated in time" i!e!" #orro'in one currency and simultaneously lendin another! %he contract also involves exchan e of interest $ayment in one currency for those denominated in other 5 s'a$ is sometimes a com#ination of t'o simultaneous trades: an outri ht for'ard contract and an o$$osite s$ot deal! For exam$le" a #ank may swap in three month dollar #y simultaneously #uyin s$ot dollar and sellin three&month for'ard dollar! Futures and 5&tions currency! an a reement #et'een t'o $arties to exchan e stated interest o#li ations for a certain $eriod in res$ect of a notional $rinci$al o$tions and hi hly ca$italized stocks are exchan e traded! %hese contracts are transfera#le as the counter&$arty to the exchan e is the
1</
5 futures contract is a le ally #indin a reement #et'een t'o $arties! It is a standardized contract 'ith a standard underlyin commodities" stocks" %reasury #onds etc! 5n o$tion contract is defined as an a reement #et'een t'o $arties in 'hich one $arty rants to the other the ri ht to #uy or sell an asset under s$ecified conditions and assumes the o#li ations to sell or #uy it! %he $arty 'ho #uys the ri ht to #uy " #ut no o#li ation to it" is called the #uyer of the o$tion and as a #uyer he-she $ays a $rice to the seller .'riter1 of the o$tion! %he underlyin asset can #e currency" #onds" stocks or commodities! O$tions may #e esoteric and in recent times a set of derivative instruments have #een develo$ed to meet the com$lex nature of market demands! %aken as 'hole the markets of derivatives " #ein a $roduct of the com$lex financial system" have chan ed the dynamics of the lo#al financial structure! We are to see the im$lications of this t'o& 'ay relationshi$s! 0%e 4rowt% of 6eri(ati(es 5t the international level the ro'th of derivatives is one im$ortant $henomenon in the international financial system! %here has #een discussion in the literature a#out the $rinci$al causes of this $henomenal ro'th! Sometimes it has #een ar ued that the derivative instruments have come in an evolutionary 'ay to hed e the systemic risks of the financial system 'hich had #een increasin since the #e innin of the flexi#le exchan e rate re ime! *ut Oaufman .)<<<1 ar ues that 'ith the slo' do'n of inflation at the 'orld level investors started investments in financial assets like stocks and #onds in a #i 'ay! 5s the size and sco$e of the $rofessionally mana ed $ortfolio increased and it assumed international dimension" the mana ers #e an to limit the ex$osure of the $ortfolio 'ith the hel$ of derivative instruments! %hus the size of the derivatives markets and the dimension #ecame $ro$ortional to the size of the investment $ortfolio and also the market uncertainty! 5lso that has #een a steady source of #usiness of the financial institutions 'ho s$ecialize in the are of dealin 'ith the derivatives! asset and the s$ecifications relate to the standard (uantity and (uality of the underlyin asset! Futures are traded for assets like
11<
With the slo' do'n of lo#al inflation $articularly in the O6+B countries" the term structure of interest rates #ecame sta#ilized and the yield curve attained the normal sha$e 'ith a $ositive slo$e! %he normal sha$e of the curve has had the indirect #ut si nificant effect that ena#led a 'ide ran e of market $artici$ants to im$rove their $rofita#ility 'ithout takin too much ex$osure in credit risk! %his has induced the financial institutions to $artici$ate more effectively in the derivatives markets for #usiness reasons! %he result has #een an ex$losive derivatives. Oaufman" )<<<1! %he 'orld has also seen the emer ence of a lar e $ool of risk capital under the control of the fund mana ers 'ho 'ant an a ressive de$loyment of these funds for a hi h returns! In the market "for every cautious $ortfolio mana er 'illin to take cover #ehind the 'all of derivatives" there must #e a 'illin risk taker 'ho can $rovide the desired $roduct! %he existence of the s$eculators of the latter ty$e $revents the markets from #ecomin reasona#le limits! 5 relatively sta#le lo#al $rice level" a sta#le and risin yield curve" too much li(uidity in the 'orld financial markets under the control of a intent on investin intermediation $rocess in international #ankin ressive fund mana ers 'ith a dis& these funds in the search of hi her returns alon lo$&sided and the result is that $rice of derivative remain 'ithin ro'th of the market for the
have created an ideal situation for the
ex$losive ro'th of derivative markets! *ut 'hether the hi h ro'th of derivatives has created a situation of insta#ility throu h excess s$eculation is a $oint 'hich is #ein de#ated in the literature!
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6eri(ati(es and Anderlying *sset %he financial health of the derivatives markets are #etter kno'n #y three characteristics: &&the li(uidity of the market &&the #id -ask s$read and its movement &&the volatility of the asset $rices or that of returns Aesearch has #een conducted to test the effects of derivatives on these three features of the financial markets! It is sho'n that the introduction of futures has reduced the volatility of the underlyin asset and it has also reduced the asymmetry of information! %he $roof that derivatives hel$ in the reduction of volatility in the markets is im$ortant as the level of volatility is an index of the efficiency of market o$eration 'hile it sho's the amount of risk . +onrad" 1///G *hanot"1//: 1! %he introduction of derivatives such as o$tions and futures increases the li(uidity in the market and this a ain reduces the noise component in the stock $rices! 5s a result of this volatility in $rices reduces! %he noise com$onent 'hich is the additional $art a$art from the random one is the outcome of a com$lex $rocess 'hose chemistry consists of uess 'ork" $anic reaction" additional mark&u$ and certain other factors! %he introduction of derivatives has also reduced the #id-ask s$read in the $rice (uotations and markets are much more sta#le 'ith hi her $ercolation of information to the $artici$ants! With investors #etter informed in a symmetric fashion" there has #een more sco$e that the allocation of resources has #ecome efficient! In an im$ortant study %se" ,ee and *ooth .1//01 have analyzed the functionin of three markets&&& ,IFF6 for 6uro$e" IMM for the Enited States and SIM6R for 5sia&&& 'ith different tradin hours so that these three can #e considered as a sin le market " and the $a$er $roves that the transmission of information amon the three markets a#out the underlyin asset has im$roved 'ith the introduction of futures! %he volatility is lo'er in the tradin hours than in the non&tradin hours! %he consensus in the financial economics literature on the introduction of derivatives is that the market sho's the follo'in tendencies:
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&&%he volatility and the variance of the $rices decreases &&%he li(uidity of the market im$roves &&%he #id-ask s$read reduces! One im$ortant as$ect of the introduction of derivatives in the market is that it
increases the li(uidity" 'hich in effect means an increase in money su$$ly and also an increase in insta#ility in the system! %his has an effect on the interest rates! %he function of the derivatives is also to minimize the $rice distortion in the market 'hich is sometimes called as $rice discovery effect! It is seen that the a#ility of the future $rice to antici$ate the future interest rates is related to the li(uidity of the market! Some econometric studies have confirmed the effects of derivatives on the short term interest rates throu h the chan e in the li(uidity!
6eri(ati(es, Money and Monetary )olicy %here are several definitions of money in the economics literature! %he instrumental definition associated 'ith Crofessor Milton Friedman identifies the monetary #ase throu h the instruments #y 'hich it is made . Friedman and Sch'artz" 1/0@1! 5lternatively" the functional definition s$ecifies that the monetary #ase is com$osed of those instruments 'hose function is of com$ulsory reserve at the central #ank or free reserve held #y the commercial #anks! From these t'o definitions it is difficult to distin uish #et'een monetary #ase and money 'hen a ne' instrument is introduced in the market! 5lso at the international level there is no com$ulsory reserve on #ank de$osits in forei n currencies as a$$lica#le for domestic money! In this $ers$ective any classification conce$tual $ro#lems! #et'een the t'o cate ories of definitions 'ill enerate many
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%he analytical distinction #et'een monetary #ase and monetary assets is esta#lished in the literature throu h the li(uidity effects! %he monetary #ase is com$osed of all those instruments that reveal an inverse relationshi$ 'ith interest rates" #ut the relationshi$ 'ith money and interest rates is direct! %his needs some ex$lanation! %he ne ative correlation #et'een the interest rate and monetary #ase holds 'hen the economic a ents have unchan ed inflation ex$ectations! %herefore" it is an unantici$ated chan e in the monetary #ase that affects #oth the nominal and the real interest rates! In the a#sence of this (ualification the relationshi$ 'ill chan e! If the existin ex$ectations in the market are rational" the market 'ill react to an increase in the creation of monetary #ase #y a rise in the interest rate to incor$orate hi her inflation ex$ectations! %hus the market 'ill #e uided #y the Fisher 6(uation as the nominal interest rate 'ill exactly com$ensate the real interest rate as 'ell as the antici$ated rate of inflation! 5$art from the interest rate as$ect of derivatives" the com#ination of a set of derivative $roducts can create a synthetic assets that are su#stitutes for existin financial and monetary instruments! 5s for exam$le" a $ortfolio consistin of a lon #ond $osition and of a short three&month future on the same #ond is financially e(uivalent to a three month fixed de$osit! *ut the latter is a com$onent of broad money or ; and attracts the com$ulsory reserve ration $rovision" #ut the synthetic $ortfolio is not considered that 'ay! *ut the minimum rate of return of the investment and the cost of transaction can influence the choice #et'een a three&month fixed de$osit and a synthetic $ortfolio as descri#ed! *ut one $oint is clear! %he monetary effects of t'o situations are different! One im$lication of this conclusion is that $ortfolio reallocation can modify the im$act of monetary actions! If the economic a ents 'ho are more sensitive to interest rate chan es take cover a ainst the risk 'ith the hel$ of derivatives" the final effects of interest rate chan e on the macro economy 'ill #e much less than 'hat is antici$ated! In many instances central #anks try to influence the short term money market 'hen their lon term o#jective is to control inflation! For this they al'ays monitor and control the su$$ly of money #y fre(uent chan e in the com$ulsory reserve and free reserves of the commercial #anks! Sometimes central #anks also try to chan e the interest
118
rate structure" like an increase in the interest rate if they think that market is sufferin from too much li(uidity! In this case the existence of a lar e and effective derivative market can reduce the im$act of interest rate chan es on the macro $arameters " #ecause the economic a ents 'ill take hed e #ehind the 'all of derivative instruments! %his is a ne' $henomenon! It is not entirely ne' as the kno'led e 'as there in the literature" #ut the enormous size of the market of derivatives and the 'ay these influence the $otential im$act of interest rate chan es on the yield curve is somethin monetary theory! With the develo$ment of financial markets and more a'areness a#out risk mana ement derivatives have #ecome the $otential instruments of the monetary $olicy of the central #anks and the latter can utilize the hu e li(uidity to invest in the derivative markets for hed e $ur$oses! One im$lication is that derivatives have introduced a ne' mechanism of money creation" and for this the existin monetary a monetary a re ates are to #e re& examined for a #etter monetary $olicy! For exam$le" the less li(uid com$onents of re ates like fixed de$osits and certificates of de$osits .+C1 can #e used as underlyin assets for the creation of derivative instruments 'hich #ecome more li(uid in the markets and these are ood su#stitutes for s$eculative money! %his $henomenon im$lies that the im$ortant underlyin assets should #e included 'hen 'e talk a#out li(uidity! %his 'ill facilitate #etter mana ement of the monetary $olicy 'ith the hel$ of a sta#le ro'th of money! In the #anks derivatives are not accounted se$arately from the other financial instruments and enerally these are not classified in relation to the ty$e of risk these instruments hed e! Berivatives are the off7balance7sheet items in the #ankin system and so these are not considered as $art of a #ankPs resources! %herefore" it does not attract the com$ulsory reserve $rovision! %hou h commercial #anks invest in derivative market" the 'hole amount of resources invested is not enerally calculated in the traditional #ankin a re ates" thou h the latter is included in the monetary tar ets of the central #ank . IMF" 1//:G *IS" 1/// 1! *anks also invest a $art of their free reserves in derivatives for a short $eriod ! 5ll these #ehaviour re ardin the commercial #anksP investment in derivative markets affects the size of the money multiplier" as its size ne' in the recent
11;
increases com$ared to the situation 'hen #anks do not invest in derivatives! *ecause the latter affects the #ehavioural coefficients like #anksP $ro$ensity to li(uidity" $u#licPs $ro$ensity to li(uidity and the com$ulsory reserve ratio! 5ll these three ratios determine the size of the money multi$lier! %o the extent the size of the multi$lier chan es as a result of the derivatives" #ank can lend a reater amount of money to the cor$orate sector 'ith the hel$ of the synthetic reserves they create 'ith their investment in the derivative markets! When the central #anks 'orks 'ith a credit tar et " monetary $olicy may #e off the tar et if the potential credit creation #y the #anks 'ith the hel$ of derivatives is not taken into consideration! %he existence of derivatives influences the size of money su$$ly as ex$lained in the $revious $ara ra$h" and so the monetary $olicy is to address that issue! 5lso the central #ank is to monitor the movement of the lon term interest rates 'hich are determined #y the markets! When the yield curve of the money market is sta#le and steady" the lon term interest rates are functions of the short term rates! 5lso the short term rates are influenced #y the rates of the re$os . re$urchase a reements1 central #anks conduct on a re ular #asis to monitor the li(uidity in the system! %he lon term interest rates esta#lish the link #et'een the domestic money market and the lo#al one! %he central #ank should check that $ro$erly as the interest rates differential affects the movement of the external value of the domestic currency" i!e!" the exchan e rate! 5ny lar e scale deviations of the interest rate can cause insta#ility in the system and the central #anks can face financial loss either throu h the chan es in the exchan e rates or throu h short term ca$ital flo's!
Ase of 6eri(ati(es in Monetary )olicy In recent times some central #anks are seen to use derivative instruments as a su$$lements to their monetary $olicy and many a time derivative instruments have stren thened the $o'er of s$ecific $olicy of the central #ank!
110
First" in some countries the secondary markets for overnment #onds are not develo$ed and in such situations the central #anks use derivatives as a su#stitutes for the secondary short term markets for securities! %he exam$les are the central #anks of Molland and S'itzerland! When the tradin desks of the central #anks issue derivative securities" it can #etter inte rate the connections #et'een $olicy intentions for the short term rates and current lon term interest rates! Since the central #anks are to have t'o sets of $olicies simultaneously" and since inter&tem$oral $lannin on the $art of the #anks involves $ortfolio mana ement over time" a #etter coordination #et'een short term and lon term $olicies is an im$erative for the central #anks! When the market #ecomes narro' and the short term rates a$$roach a near &zero level" the channel of information #ecomes meanin less as the s$ot rate fails to ive the necessary si nal! In such a situation central #anks can o$erate directly on the lon #ond rates throu h the $urchase or sale of #onds! Second" central #anks sometimes use the derivative instruments to defend their monetary tar ets! 5s an instrument of monetary $olicy derivatives can #e $urchased either throu h the #ankin system or throu h the central #anks of other countries! In the case of the former" the (uantity of the domestic monetary #ase chan es" 'hile in case of the latter" no ne' money creation is involved! %hird" sometimes central #anks try to influence the money market either #y a chan e in the interest rate or throu h inducin a chan e in the su$$ly of credit! %he first is kno'n as money view " 'hile the second is kno'n as credit view. %hese t'o alternatives ive the am#ience in the literature a#out the instruments of monetary $olicy the central #anks 'ill use to influence the course of events of the #road macroeconomic $arameters! 5ccordin to the money vie' it is the money su$$ly 'hich affects the ro'th of ross domestic $roduct .>BC1 in the lon run and hence the central #anks should control money su$$ly to sta#ilize the ro'th rates of >BC! In the credit vie' it is said that #ank credit availa#ility has a $ositive effect on the macroeconomic activity and hence the central #anks should control the #ank credit ex$ansion! %he findin s in the em$irical literature #roadly a ree that 'hile money su$$ly has the lar est effects on the >BC" #ank
11=
credit has a fairly stron effect that is lar er than the $rice effects in the short run! In case of a lon er run" #ank credit remains a salient factor #ut it is the $rice effects 'hich dominate! In the money vie'" the central #ank can em$loy the convenience of havin money in lieu of financial assets and 'hen the su#stitution #et'een the t'o is not $erfect" then the central #ank can alter the com$osition of $ortfolio! When derivatives are introduced" the $artici$ants et more information and they have more s$ace for o$erations! 5s a result the market efficiency increases" #ut the a#ility of the central #ank to influence the choice of the investors et reduced! *ecause" the investors can take a hed e a ainst the $otential moves of the central #anks! *ut in the $ers$ective of the credit vie'" the central #anks control the feasi#ility of su#stitution #et'een credit and financial assets! Cerfect su#stitution may not #e achieved #ecause of the asymmetry in the information flo' and- or #ecause of #arriers in the financial markets! %he latter are enerally due to domestic rules and re ulations" #ut the former" i!e!" asymmetry can #e lar ely reduced 'ith the introduction of derivatives in the markets! When the central #anks chan e the interest rates" the investors can take a hed e a ainst this throu h the $urchase of an interest rate s'a$! %hus the $o'er of the central #anks ets reduced to influence the market at least in the short run! Fourth" central #anks also use derivatives for the defense of the external value of the currency at crisis times! %his they do #y takin an o$en $osition in the O%+ market 'ith a small initial $ayment and thus try to influence the rate! *ut the #anks do secretly and do not let the market kno' that they are usin derivatives to defend the currency! %he reason is sim$le! If the credi#ility of the central #ank is not ood and the currency is not stron " the market $artici$ants #elieve that the #ehaviour of the central #ank is far from consistent 'ith the stated intention! %he market closely 'atches the central #ank and the strate y of the #ank may not 'ork!
0%e 0%ailand 2am&le
11:
Burin
1//; and 1//0 %hailand faced acute $ro#lems in her #alance of trade and
the currency *aht started sho'in the si ns of 'eakness! %he central #ank of %hailand 'as not ready to devalue the currency as that 'ould ive 'ron si nal to the inflo' of forei n ca$ital! So the central #ank tried to defend *aht throu h the $urchase of futures of t'o& 'eek maturity in the summer of 1//0! %his could not #e ke$t a secret! Once the futures contracts reached maturity" the o$erators in the markets realized that *aht had to #e devalued and they accordin ly took $osition! %he central #ank did not have enou h forei n exchan e reserve to frustrate the desi n of the market s$eculators! %he result 'as that the central #ank had to devalue the currency in 1//= and 'ith this reali nment of *aht the 5sian crisis started! %he rest is history!
One im$lication of %hailand case is that the country had #een follo'in
a $e
ed
exchan e rate system to facilitate a steady inflo' of forei n direct investment! *ut throu h this adherence of fixed exchan e rate $olicy" the central #ank lost a lar e $art of its freedom in $ursuin the domestic monetary $olicy! When the exchan e rate came under $ressure" the central #ank had to take certain measures 'hich should #e consistent 'ith other economic $arameters! %his 'as difficult to achieve and slidin do'n of *aht continued!
%he evolution of the financial markets 'ith the develo$ment of derivatives 'as an im$ortant event in the last t'o decades of the )<th century! Berivatives not only #rou ht de$th in the markets" these also hel$ed the o$erators in the markets to hed e a ainst the ne' ty$e of risks 'hich #ecame very common in the last t'o decades of )< th century! It 'as also natural for other market $artici$ants to use the hed e tools for #rin in finer s$reads in the financial intermediation" for #etter $ortfolio mana ement " for the minimization of risks and also for su$$lementin of derivatives to achieve #etter results! %he 'ide use of the derivatives in the international financial system has chan ed the com$lexion of the international money as the set of derivatives are #ein used as macroeconomic $olicies 'ith the use
11/
ood su#stitutes for other cate ory of financial assets! In reco nition of this the IMF has introduced certain norms 'hich the commercial #anks are to com$ly if they are involved in derivative #usiness 5lso IMF +ommittee on *alance&of&Cayments Statistics has introduced ne' rules to make the *OC statistics more consistent! Financial derivatives are removed from the eneral items contained in the current account and the +ommittee has introduced a ne' cate ory of financial account and a ne' item is inserted in the annex of the #alance of $ayments" 'hich is called .upplementary "nformation . IMF" 1//:1! %his covers the detailed #reak do'n of different ty$e of derivative instruments" classes of risks and the counter $arty! Berivatives are still ne' instruments and a si nificant ray areas exists in the $ro$er understandin of the dynamic of these! %he exam$le of ,%+M failure in the Enited States $oint to the fact that the fra ility of the financial system is somethin 'hich the international community should take care of! In this a e of unhindered ca$ital mo#ility across the national #oundaries the financial chaos can easily #e transmitted to other countries! %his is somethin for 'hich the emer in economies should #e $ro$erly cautioned!
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World Financial Infrastructure and Money : Sukumar Nandi 5r y" J!" %he Mundell& Flemin Model : Its Stren th and ,imitations" in acroeconomics& Theory and 2olicy! -E.! 3outledge! '88?. J! 5r y" "nternational
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1)1
World Financial Infrastructure and Money : Sukumar Nandi +aves" A! 6!" ultinational <nterprises and <conomic Analysis" Second 6dition" 1//0!
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+orsetti" >!" and C Cesenti" Welfare and Macroeconomic Interde$endence" Guarterly ,ournal of <conomics" 5u ust" )<<1!
Bevereux" M! *!" 6xchan e Aate Cass&%hrou h" 6xchan e Aate Jolatility" and 6xchan e Aate Bisconnect" -(<3 working 2aper -o. FF@F" N*6A" 5$ril" )<<)! &&&&&&&&&&&&&&&&&&&& " Aeal 6xchan e Aates and Macroeconomics : 6vidence and %heory" )anadian ,ournal of <conomics" @<" 1//=" ==@& :<:! Bollar" B!" Out'ard Oriented Bevelo$in +ountries Aeally Bo >ro' More Aa$idly: 6vidence from /; ,B+s" 1/=0 ? :;" <conomic 5evelopment and )ultural )hange! 5$ril" 1//)! Booley" M!C! and C! Isard" %he Cortfolio *alance Model of 6xchan e Aates and Some Structural 6stimates of the Aisk Cremium" " * .taff 2apers! ;>! '8F;! 9F;78=. Booley" M! C!" 5 Survey of ,iterature on +ontrols over International +a$ital %ransactions! " * .taff papers" 8@ .8 1" Becem#er" 1//0" 0@/\0:=! Born#usch" A!" 6x$ectations and 6xchan e Aate Bynamics" ,ournal of 2olitical <conomy" :8" 1/=0" 1101 \=0! Born#usch" A!" S$ecial 6xchan e Aates for +a$ital 5ccount %ransactions" -(<3 #orking paper! -o. '9@8! N*6A" 1/:;! Born#usch" A! and S! Fischer" 6xchan e Aates and +urrent 5ccount" American <conomic 3eview! A>! 1/:<" /0<\=1! Born#usch" A! and Q!5! Frankel" %he Flexi#le 6xchan e Aate System: 6x$erience and 5lternatives" -(<3 #orking 2aper! -o! )808! Born#usch" A!" W!+! $ark and S! +laessens" +onta ion: Mo' it S$reads and Mo' it can #e sto$$ed" Croceedin s of the World *ank +onference on International financial +onta ion" Washin ton B!+!" Fe# @ \8" )<<1! Buarte" Mar arida" International Cricin in Ne' O$en& 6conomy Models" *ederal 3eserve (ank of 3ichmond <conomic Guarterly! :=" Fall" )<<1" ;@\=<! Bun#ar" Nicholas" Meri'etherDs Meltdo'n" 3isk" Octo#er" 1//:! 6dison" M! and Q % Olovland" 5 Nuantitative Aeassessment of the Curchasin Co'er My$othesis: 6vidence from Nor'ay and the Enited Oin dom" ,ournal of Applied 6conometrics" )" 1/:=" )</\@@! 6d'ards" F! A!" Med e Funds and the +olla$se of ,on &%erm +a$ital Mana ement" ,ournal of <conomic 2erspectives! 1@.)1" s$rin " 1///" 1/:\)1<!
1))
World Financial Infrastructure and Money : Sukumar Nandi 6ichen reen" *arry" Towards a -ew "nternational *inancial Architecture" Institute for International 6conomics" Washin ton B!+! 1///! 6ichen reen" *!" 5! rose" and +! Wy$losz" +onta ious +urrency +risis" .candinavian ,ournal of <conomics! Becem#er 1//0" /:.81! 6n el" +harles" real exchan e Aates and Aelative Crices: 5n 6m$irical Investi ation" ,ournal of <conomics! @)" 5u ust" 1//@" @;\;<! onetary
6vans" M! and A! ,yons" Order Flo' and 6xchan e Aate Bynamics" ,ournal of 2olitical <conomy" 11<" )<<)" 1=<& 1:<! Financial 5ction %ask Force .F5%F1" '88F C '888 3eport on Secretariat" Caris" 1///! oney 4aundering Typologies" F5%F
Fiorentini" >! and S! Celtman" The <conomics of Hrgani1ed )rime" +am#rid e" +am#rid e Eniversity Cress" 1//=! Fischer " S! and W! 6asterly" %he 6conomics of the >overnment *ud et +onstraint" #orld (ank 3esearch Hbserver " ; .)1" Quly" 1//<! Fischer" S!" Sei nora e and the +ase for a National Money" The ,ournal of 2olitical <conomy" /< .)1" 1/:)" )/;\@1@! Flemin " Q!M!" Bomestic Financial Colicies under Fixed and under Floatin 6xchan e Aates" " * .taff 2apers" / .@ 1" Novem#er" 1/0)" @0/\@=/! Flood" Ao#ert and C! >ar#er" +olla$sin 6xchan e Aate Ae imes: Some ,inear 6xam$les" ,ournal of "nternational <conomics! 1=.1&)1" 1/:8" 1\1@! Frankel" Q! 5!" International Nominal %ar etin .IN%1: 5 Cro$osal for Monetary Colicy +oordination in the 1//<s" The #orld <conomy" 1@.)<" 1//<" )0@\=@! Frankel" Q!" S! Schmukler and ,! Serven" Jerifia#ility and the vanishin Intermediate 6xchan e Aate Ae ime" ,ournal of 5evelopment <conomics" 00 .)1" )<<1" @;1& @:0! Frenkel" Q! 5!" Flexi#le 6xchan e Aates" Crices and the Aole of ne's: ,essons from the 1/=<s ! ,ournal of 2olitical <conomy" :/" 1/:1" 00;\=<;! &&&&&&&&&&&&&&&&&" >lo#al %ransmission of Interest Aates: Monetary Inde$endence and +urrency Ae ime ! -(<3 #orking 2aper series! Ca$er No! ::):" march" )<<)! Frenkel" Q and M! Qohnson .eds!1" The <conomics of <xchange 3ates & .elected .tudies! Aeadin " Mass!" 5ddison Wesley Cu#lishin +o! 1/=:! Fry" M! Q!" Money" "nterest and (anking in <conomic 5evelopment" *altimore" Qohn Mo$kins Eniversity Cress" 1/::! >andolfo" >iancarlo" "nternational *inance and Hpen <conomy Jerla " )<<1! acroeconomics" Meidel#er " S$rin er ?
>anesh" S!" Who is 5fraid of Forei n Firms V +urrent %rends in FBI ! <conomic and 2olitical #eekly" March" 1//=! >i#son" Aajna" Hption Ialuation& Analy1ing and 2ricing .tandardi1ed Hption )ontracts" Mc>ra'& Mill" Ne' Work" 1///!
1)@
>iovannetti" >!" 5 Survey of recent 6m$irical %est of the Curchasin Co'er Carity My$othesis" *anca -a1ion1le del 4avaro Guarterly 3eview! 1:<" march" 1//)" :1\1<1! >old#er " Cinelo$i" and Michael Onetter" >oods Crices and 6xchan e Aates : What have 'e ,earnedV ,ournal of <conomic 4iterature! @;" Se$tem#er" 1//=" 1)8@\=)! >oldstein" M and Chilli$ %urner" (anking )rises in <merging <conomies& Hrigin and 2olicy Hptions" *!I!S! 6conomic Ca$ers" No! 80" Octo#er" 1//0! Mamada" O!" The 2olitical <conomy of "nternational MI% Cress" 1/:;! onetary "ndependence! +am#rid e" Mass" ES5!"
Manke" S! M! and O! Schuler" )urrency (oards for 5eveloping )ountries" San Francisco" I+> $ress" No! / in I+> Sector Study Series" 1//8! Martmann" Chilli$" )urrency )ompetition and *oreign <uro" +am#rid e Eniversity Cress" +am#rid e" 1//:! <xchange arketsJ the 5ollar! the Een and the
Mau" Marald" 6xchan e rate Betermination: %he Aole of Factor Crice Ai idities and Nontrada#les" ,ournal of "nternational <conomics" 5$ril" )<<<" ;< .)<" 8)1& 8=! Mausmann" A!" E o Canniza" and 6rnesto Stein" Why Bo +ountries Float the 'ay %hey Float V" ,ournal of 5evelopment <conomics! 00 .)1" )<<1" @:=& 818! Mayek" F! 5! von" 5enationalisation of oney& An Analysis of the Theory and 2ractice of )oncurrent )urrencies" ,ondon" Institute of 6conomic 5ffairs" 1/=0! &&&&&&&&&&&&&&&&&&&&&&" %he Ese of Ono'led e in Society" American <conomic 3eview! Se$tem#er" 1/8;! Meller" M!A! and A! A! Ahom#er . eds!1" The International Monetary Fund" 1/==! Moover" Oevin B!" )ausality in onetary Approach to (alance of 2ayments" Washin ton"
acroeconomics! +am#rid e" +am#rid e Eniversity Cress" )<<1!
Mume" Bavid" .1=@/1" A Treatise of Human -ature! Oxford" +larendon Cress" 1:::! &&&&&&&&&&&&&&&&&&&&" . 1=;81" <ssays& oral! 2olitical! and 4iterary! Indiana$olis" ,i#erty +lassics" 1/:;!
Isard" C.! <xchange 3ate <conomics" Ne' Work" +am#rid e Eniversity Cress" 1//;! Qohnson" M!" %ariffs and 6conomic Bevelo$ment: Some %heoretical Issues" ,ournal of 5evelopment .tudies! Jol! 1" 1/08! Oaldor" N!" %he 6ffects of Bevaluation on %rade in Manufactures" in *urther <ssays on Applied <conomics! ,ondon" Buck'orth" 1/=:! Oenen" C! *!" .ed1" /nderstanding "nterdependence& The Crinceton Eniversity Cress" 1//;! acroeconomics of the Hpen <conomy" Crinceton"
Oeynes" Q! M!" Social +onse(uences of +han es in the Jalue of Money" in Q! M! Oeynes" <ssays in 2ersuasion" Ne' Work" W! W! Norton" 1/0@! Oindle#er er" +!" International Cu#lic >oods 'ithout International >overnment" American <conomic 3eview" =0 .11" 1/:0" 1\1@!
1)8
World Financial Infrastructure and Money : Sukumar Nandi Ookko" 5!" %echnolo y" market +haracteristics and s$illovers" ,ournal of 5evelopment <conomics" 8@" 1//8! Oumar" N!" ultinational enterprises and "ndustrial Hrganisation! The case of "ndia! Sa e Cu#lications" Belhi" 1//8! Oollmann" Ao#ert" Incom$lete 5sset Markets and the +ross& +ountry +onsum$tion +orrelation Cuzzle" ,ournal of <conomic 5ynamics and )ontrol" May" 1//0" )< .;1" /8;&01! Oru man" Caul" a Model of *alance of Cayments crisis" ,ournal of oney )redit and (anking! 5u ust" 1/=/" 11.@1" @11 ? );! Oru man" C!" *alance Sheets" the %ransfer $ro#lem" and Financial +risis" "nternational tax and 2ublic *inance! Novem#er" 1///" 0.81" 8;/ ?=)! ,aidler" Bavid" %he Nuantity %heory is 5l'ays and 6very'here +ontroversial ? WhyV" <conomic 3ecord! 0=" Becem#er" 1//1" ):/ ? @<0! ,illey" Ceter" 5irty 5ealing & The /ntold Truth of +lobal )<<<! oney 4aundering" ,ondon" Oo an Ca e ,td"
,incoln" 5!" any *ree countries Have 4ost Their 4iberty! a .peech on the .ub treasury! S$rin field" Illinois" Becem#er )0" 1:@/! ,ucas" Ao#ert 6!" Interest Aates and +urrency Crices in a %'o ?+ountry World" ,ournal of <conomics" Novem#er" 1/:)" 1< .@1" @@;\;/! onetary
,yons" A! O! " Forei n 6xchan e: Macro Cuzzles" Micro %ools" <conomic 3eview ! .Federal Aeserve #ank of San Francisco1" )<<)! MacBonald" A!" *loating <xchange 3ates& Theories and <vidence" ,ondon" En'in Myman" 1/::! Marshal" 5!" oney! )redit and )ommerce! ,ondon" Macmillan" 1/)8!
Mc+om#ie" Q! and 5! C! %hirl'all" 6ast 5sian Financial +risis: Aetros$ect and Cros$ect" Asia and Australasia& 3egional Hverview! ;rd. Guarter! 1///" 6conomist Intelli ence Enit! McOinnon" A!I! " Mundell" the 6uro" and the World Bollar Standard" American <conomic 3eview" May" )<<<! 777777777777777777777777! oney in "nternational <xchange" Ne' Work" Oxford Eniversity Cress" 1/=/!
&&&&&&&&&&&&&&&&&&&&&&&& " %he 6xchan e Aate and Macroeconomic Colicy: +han in Cost 'ar $erce$tions" ,ournal of <conomic 4iterature" 1/" Qune" 1/:1" ;@1\;;=! Meese" A 5! and O! Ao off" 6m$irical 6xchan e Aate Models of the Seventies: Bo they fit out of sam$leV ,ournal of "nternational <conomics" 18" 1/:@" @\)/! Misselden" 6!" The )entre of the )ircle of )ommerce! ,ondon" Q! Ba'son for N! *o'ne" 10)@! Mundell" A!5!" "nternational <conomics" Macmillan" 1/0=! &&&&&&&&&&&&&&&&&&& " +a$ital Mo#ility and Sta#ilization Colicy under Fixed and Flexi#le exchan e Aates" The )anadian ,ournal of <conomics and 2olitical .cience! =8 6 ?B! 1/0@" 8:=\//! &&&&&&&&&&&&&&&&&&&" %he Future of the 6xchan e Aate System" 2aper prepared for the 3occa de .alimbeni )onference" Siena" Italy" Novem#er" 1//8!
1);
&&&&&&&&&&&&&&&&&&&" What the 6uro Means for the Bollar and the International Monetary SystemV" Atlantic <conomic ,ournal! )0.@1" Se$tem#er" 1//:! Mur$hy" Qohn Q!" Technical Analysis of *uture Nandi" Sukumar" "nternational &&&&&&&&&&&&&&&&&&&&" "nternational arket& Theory and 2ractice" Sokol" 1//0!
oney and *inance" Samskriti" Ne' Belhi" )<<1! oney and )apital" *usiness Cu#lications Inc!" Mum#ai" 1///! oney arket"
Nandi" Sukumar" +rowth ! *inancial )ycles and (ank <fficiency& An Analysis of "ndian *usiness Cu#lications Inc!" Mum#ai" 1//:!
77777777777777777777! <ssays on "nternational *inance& The "ndian 2erspective" National Institute of *ank Mana ement" Cune" 1//0! Nandi" Sukumar" 6xchan e Aate *ehavior of Indian Au$ee: 5 +ointe ration 5$$roach" ,ournal of "ndian .chool of 2olitical <conomy! Qanuary ? March " 1//8! &&&&&&&&&&&&&&&&&&&" 5n 6m$irical Study of Bemand for International Aeserve" ,ournal of *oreign <xchange and "nternational *inance 6 QF6IF1" 5$ril& Qune " 1//0! &&&&&&&&&&&&&&&&&&&" 6xchan e Aate of Indian Au$ee and Crice ,evel *ehaviour in India" in B! O! Bas .ed1" Trade ad 5evelopment& <xperiences and )hallenges! Ne' Belhi" Bee$ and Bee$ Cu#lications" 1///! &&&&&&&&&&&&&&&&&&&" Mon Oon Bollar and +hinese Aenmin#i .AM*1" %'o +urrencies in One country" QF6IF" Quly& Se$tem#er " 1//:! Nayyar" B!" %ransnational +or$orations and Manufacturin ,ournal" ::" 1/=:! ex$orts from Coor +ountries" <conomic
Neumann" M!Q!M! " Sei nora e in the Enited States: Mo' Much Boes the E! S! >overnment Make from Money Croduction:! *ederal 3eserve (ank of .t. 4ouis 3<I"<#! =8 .)1" March ? 5$ril" 1//)" )/\8<! Noussair" +!N!" +!A! Clott and A!>! Aeizman" %he Crinci$le of 6xchan e Aate Betermination in an International Finance 6x$eriment" ,ournal of 2olitical <conomy" 1<;" 1//=" :)) ? 01! O#stfeld" Maurice" %he >lo#al +a$ital market: *enefactor of MenaceV ,ournal of <conomic 2erspective" 1) .81" Fall" 1//:" /\@<! &&&&&&&&&&&&&&&&&&&&&" Aational and Self&Fulfillin *alance of Cayments +rises" American <conomic 3eview! March" 1/:0" =0" =)\:1! &&&&&&&&&&&&&&&&&&&&" %he ,o ic of +urrency +rises" cahiers <conomi$ues et 1//8" 1:/\)1@ ! onetaires ?;! *ank of France"
O#stfeld" Maurice" International +a$ital Mo#ility in the 1//<s" in Ceter Oenen .ed!1" /nderstanding "nterdependence" Crinceton Eniversity Cress" 1//;! O#stfeld" Maurice" and Oenneth Ao off" Ne' Birections for Stochastic O$en economy Models" ,ournal of "nternational <conomics! ;<" Fe#ruary" )<<<" 11= ? ;@! &&&&&&&&&&&&&&&&&&&&&&&&&&&&&&" 6xchan e Aate Bynamics Aedux! ,ournal of 2olitical <conomy" 1<@" 1//;a" 0)8 &00<!
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World Financial Infrastructure and Money : Sukumar Nandi O#stfeld" Maurice" and Oenneth Ao off" %he Intertem$oral 5$$roach to the +urrent 5ccount" in" >! >rossman and O! Ao off" . eds!1" Handbook of "nternational <conomics! vol. ;" 5msterdam" North& Molland" 1//;#! 77777777777777777777777777777777! *oundations of "nternational 1//0! acroeconomics" +am#rid e" Mass!" MI% Cress"
&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&" Aisk and 6xchan e Aates" #orking 2aper -o. 998?" National *ureau of 6conomic Aesearch" 5u ust" 1//:! &&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&" Ne' Birections for Stochastic O$en 6conomy Models" ,ournal of "nternational <conomics" ;<" )<<<" 11= ? 1;@! Officer" ,!M!" %he Curchasin Co'er Carity %heory of 6xchan e Aates: 5 Aevie' 5rticle" " * .taff 2apers! :@" 1/=0" 1\0<! Cayne" A! " "nformed Trade in .pot *oreign <xchange market markets& An <mpirical "nvestigation" ,ondon School of 6conomics" . %y$escri$t1" 1///! Cick" F!" 2ickKs )urrency Eearbook! Cick Cu#lishin +or$oration" Ne' Work" 1/0<" 1/0:! Colak" Q! Q! " Monetary 5nalysis of Income Formation" " * .taff 2apers" 8" 1/;=! Colak" Q! Q!" %he IMF Monetary Model : 5 Mardy Cerennial" *inance and 5evelopment! Becem#er" 1//=" 10\1/! &&&&&&&&&&&&&&&&&&&" %he IMF Monetary Model at Forty" " * #orking 2aper -o. 8A L ?8" Washin ton B!+!" 5$ril" 1//=! Corter" A!B! and A!5! Qudson" %he ,ocation of the ES +urrency: Mo' Much is 5#roadV" *ederal 3eserve (ulletin" Octo#er" 1//0" ::@\/<@! Nuirk" Ceter Q! " Money ,aunderin : Muddyin the Macroeconomy" *inance and 5evelopment" IMF" @8 .11" 1//=! Aeinhart" +! and J! Aeinhart" What Murts MostV >&@ 6xchan e Aate or Interest rate Jolatility" -(<3 working 2aper -o. F@;@" )<<)! Aicardo" Bavid" Hn the 2rinciples of 2olitical <conomy and Taxation! edited #y Ciero Sraffa" +am#rid e" EO" +am#rid e Eniversity Cress" 1/;1! Ao off" Oenneth" %he Curchasin Co'er Carity Cuzzle! ,ournal of <conomic 4iterature! @8" Qune" 1//0" 08= & 0:! Sachs" Q! B!" 5! %ornell and 5! Jelasco" %he +olla$se of the Mexican $eso: 'hat have 'e learnedV <conomic 2olicy! ))" 5$ril" 1//0" 1;\0@! Sachs" Q! B! and F! ,arrain *!" 1//@! acroeconomics in the +lobal <conomy" 6n le'ood +liffs" Crentice Mall"
Samuelson" Caul" %heoretical Note on %rade Cro#lems" 3eview of <conomics and .tatistics! 80" May 1/08" 18; ? 1;8 ! Sar ent" %!" 5ynamic acroeconomic Theory" +am#rid e" Marvard Eniversity Cress" 1/:=!
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World Financial Infrastructure and Money : Sukumar Nandi Sarno" ,ucio" %o'ards a Ne' Caradi m in O$en 6conomy Modelin : Where Bo We StandV" *ederal 3eserve (ank of .t. 4ouis 3eview" :@ .@ 1" May& Qune" )<<1! Smith" J!,!" 6x$erimental Methods in 6conomics" in The -ew 2algrave& A 5ictionary of <conomics" ,ondon" Macmillan" Jol! )" 1/:=! Stern" A!" (alance of 2ayments Theory and <conomic 2olicy! ,ondon" Macmillan" 1/=@! %aylor" 5lan" Cotential Citfalls for the Curchasin & Co'er ? Carity CuzzleV Sam$lin and S$ecification *iases in Mean& Aeversion tests of the ,a' of One Crice" <conometrica" 0/" March" )<<1" 8=@ &/:! %o#in" Q!" 5 enda for International +oordination of Macroeconomic Colicies" in "nternational onetary )ooperation & <ssays in honor of Henry ). #allich! <ssays on "nternational *inance! -o. '98! 2rinceton! 2rinceton /niversity 2ress! '8FA! 9'M98. %riffin" A!" +old and the 5ollar )risis& Eesterday and Tomorrow! 6ssaays in International Finance" No! 1@)" Crinceton Eniversity" Becem#er" 1/=:! E ur" Mehmet" 6xtensions on the Mundell ? Flemin ModelG Cerfect ca$ital mo#ility and Flexi#le Crices" in E ur" M! .ed1" An Hpen <conomy acroeconomics 3eader! Ne' Work" Aoutled e" )<<)" 8)\;<! EN+%5B" #orld "nvestment 3eport '88F& Trend and 5eterminants! >eneva" EN+%5B" 1//:! EN+%5B" #orld "nvestment 3eport '888& *oreign 5irect "nvestment and the )hallenge of 5evelopment! >eneva" 1///! Wacziard" A!" Measurin the Bynamic >ains From %rade" #orld (ank <conomic 3eview! 1;.@1" )<<1! Wallich" M! +!" Institutional +oo$eration in the World 6conomy" in Q! a! Frenkel and M! ,! Mussa . eds1" The #orld <conomic .ystem & 2erformance and 2rospects" Bover" M5!" 5u#urn Mouse" 1/:8! Wan " Q! W! and M! *lomstrom" Forei n Investment and %echnolo y %ransfer: 5 Sim$le Model" <uropean <conomic 3eview" @0" 1//)! Williamson" Q!" 5 Survey of the ,iterature on the O$timal Ce " ,ournal of 5evelopment <conomics" 11" 1/:)" @/\01! Williamson" Q!" Bemocracy and the Washin ton +onsensus" #orld 5evelopment! )1.:1" 1//@! Williamson" Q .ed1" 4atin American Adjustment& How International economics" 1//<! uch Has happened" Washin ton B!+!" Institute of
Williamson" Q! and M! M! Miller" %ar ets and Indicators: 5 *lue$rint for International +oordination of 6conomic Colicy" 2olicy Analysis in "nternational <conomics" ))!" Washin ton B!+! Institute for International 6conomics" 1/:=! World *ank" The <ast Asia miracle& <conomic +rowth and 2ublic 2olicies! Washin ton B+! World *ank" 1//@!
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