THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 578

546 PA R T V I International Finance and Monetary Policy a country adopting dollarization no longer has its own currency, it loses the revenue that a government receives by issuing money, which is called seignorage Because governments (or their central banks) not have to pay interest on their currency, they earn revenue (seignorage) by using this currency to purchase income-earning assets such as bonds In the case of the Federal Reserve in the United States, this revenue is on the order of US$30 billion per year If an emerging-market country dollarizes and gives up its currency, it needs to make up this loss of revenue somewhere, which is not always easy for a poor country S U M M A RY An unsterilized central bank intervention in which the domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency Available evidence suggests, however, that sterilized central bank interventions have little long-term effect on the exchange rate The balance of payments is a bookkeeping system for recording all payments between a country and foreign countries that have a direct bearing on the movement of funds between them The official reserve transactions balance is the sum of the current account balance plus the items in the capital account It indicates the amount of international reserves that must be moved between countries to finance international transactions Before World War I, the gold standard was predominant Currencies were convertible into gold, thus fixing exchange rates between countries After World War II, the Bretton Woods system and the IMF were established to promote a fixed exchange rate system in which the U.S dollar was convertible into gold The Bretton Woods system collapsed in 1971 We now have an international financial system that has elements of a managed float and a fixed exchange rate system Some exchange rates fluctuate from day to day, although central banks intervene in the foreign exchange market, while other exchange rates are fixed Controls on capital outflows receive support because they may prevent domestic residents and foreigners from pulling capital out of a country during a crisis and make devaluation less likely Controls on capital inflows make sense under the theory that if speculative capital cannot flow in, then it cannot go out suddenly and create a crisis However, capital controls suffer from several disadvantages: They are seldom effective, they lead to corruption, and they may allow governments to avoid taking the steps needed to reform their financial systems to deal with the crises The IMF has recently taken on the role of an international lender of last resort Because central banks in emerging-market countries are unlikely to be able to perform a lender-of-last-resort operation successfully, an international lender of last resort like the IMF is needed to prevent financial instability However, the IMF s role as an international lender of last resort creates a serious moral hazard problem that can encourage excessive risk taking and make a financial crisis more likely, but refusing to lend may be politically hard to In addition, it needs to be able to provide liquidity quickly during a crisis to keep manageable the amount of funds lent Three international considerations affect the conduct of monetary policy: direct effects of the foreign exchange market on the money supply, balance-ofpayments considerations, and exchange rate considerations Inasmuch as the United States has been a reserve currency country in the post World War II period, U.S monetary policy has been less affected by developments in the foreign exchange market and its balance of payments than is true for other countries However, in recent years, exchange rate considerations have been playing a more prominent role in influencing U.S monetary policy Exchange-rate targeting has the following advantages as a monetary policy strategy: (1) It directly keeps inflation under control by tying the inflation rate for internationally traded goods to that found in the anchor country to which its currency is pegged; (2) it provides an automatic rule for the conduct of monetary policy that helps mitigate the time-inconsistency problem; and (3) it is simple and clear Exchange-rate targeting also has serious disadvantages: (1) It results in a loss of independent monetary policy; (2) it leaves the country open to speculative attacks; and (3) it can weaken the accountability of policymakers because the exchange-rate signal is lost Two strategies that make it less likely that the exchange-rate regime will break down are currency boards, in which the central bank stands ready to automatically exchange domestic for foreign currency at a fixed rate, and dollarization, in which a sound currency like the U.S dollar is adopted as the country s money