THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 571

CHAPTER 20 The International Financial System 539 IN T ERN ATI O NA L CO NSI DE RATI O NS AN D MO N ETARY PO LI CY Our analysis in this chapter so far has suggested several ways in which monetary policy can be affected by international matters Awareness of these effects can have significant implications for the way monetary policy is conducted Direct Effects of the Foreign Exchange Market on the Money Supply When central banks intervene in the foreign exchange market, they acquire or sell off international reserves, and their monetary base is affected When a central bank intervenes in the foreign exchange market, it gives up some control of its money supply For example, in the early 1970s, the German central bank faced a dilemma In attempting to keep the German mark from appreciating too much against the U.S dollar, the Germans acquired huge quantities of international reserves, leading to a rate of money growth that the German central bank considered inflationary The Bundesbank could have tried to halt the growth of the money supply by stopping its intervention in the foreign exchange market and reasserting control over its own money supply Such a strategy has a major drawback when the central bank is under pressure not to allow its currency to appreciate: the lower price of imports and higher price of exports as a result of an appreciation in its currency will hurt domestic producers and increase unemployment The ability to conduct monetary policy is typically easier when a country s currency is a reserve currency For example, because the U.S dollar has been a reserve currency, the U.S monetary base and money supply have been less affected by developments in the foreign exchange market As long as other central banks, rather than the Fed, intervene to keep the value of the dollar from changing, U.S holdings of international reserves are unaffected However, the central bank of a reserve currency country must worry about a shift away from the use of its currency for international reserves Under the Bretton Woods system, balance-of-payments considerations were more Balance-ofimportant than they are under the current managed float regime When a non Payments Considerations reserve-currency country is running balance-of-payments deficits, it necessarily gives up international reserves To keep from running out of these reserves, under the Bretton Woods system it had to implement contractionary monetary policy to strengthen its currency This is exactly what occurred in the United Kingdom before its devaluation of the pound in 1967 When policy became expansionary, the balance of payments deteriorated, and the British were forced to slam on the brakes by implementing a contractionary policy Once the balance of payments improved, policy became more expansionary until the deteriorating balance of payments again forced the British to pursue a contractionary policy Such on-again, off-again actions became known as a stop-go policy, and the domestic instability it created was criticized severely Because the United States is a major reserve currency country, it can run large balance-of-payments deficits without losing huge amounts of international reserves This does not mean, however, that the Federal Reserve is never influenced by developments in the U.S balance of payments Current account deficits in the United States suggest that American businesses may be losing some of their ability to compete because the value of the dollar is too high In addition, large U.S balance-of-payments deficits lead to balance-of-payments surpluses in other countries, which can in turn lead to large increases in their holdings of international reserves (this was especially true under the Bretton Woods system) Because