CHAPTER 20 The International Financial System LE A RNI NG OB J ECTI VES After studying this chapter you should be able to describe central bank intervention in the foreign exchange market and its effects on the money supply and the exchange rate discuss international financial transactions and the balance of payments summarize the arguments for and against capital controls depict the role of the IMF as an international lender of last resort PRE V IE W As the Canadian economy and the economies of the rest of the world grow more interdependent, a country s monetary policy can no longer be conducted without taking international considerations into account In this chapter we examine how international financial transactions and the structure of the international financial system affect monetary policy We also examine the evolution of the international financial system during the past half-century and consider where it may be heading in the future IN T ERV EN T IO N I N T HE FO REI G N E XCHA NG E M ARKE T In Chapter 19 we analyzed the foreign exchange market as if it were a completely free market that responds to all market pressures Like many other markets, however, the foreign exchange market is not free of government intervention; central banks regularly engage in international financial transactions called foreign exchange interventions in order to influence exchange rates In our current international environment, exchange rates fluctuate from day to day, but central banks attempt to influence their countries exchange rates by buying and selling currencies We can use the exchange rate analysis we developed in Chapter 19 to explain the impact of central bank intervention on the foreign exchange market Foreign Exchange Intervention and the Money Supply 518 The first step in understanding how central bank intervention in the foreign exchange market affects exchange rates is to see the impact on the monetary base from a central bank sale in the foreign exchange market of some of its holdings of assets denominated in a foreign currency (called international reserves) Suppose that the Bank of Canada decides to sell $1 billion of its foreign assets in exchange for $1 billion of Canadian currency The Bank s purchase of dollars has two effects