Money, Banking, and International Financecentral bank monetizes the debt, it increases in the money supply, creating inflation.
Consequently, many developing countries suffer from high inflation rates.
A Central Bank Intervenes with its Currency Exchange Rate
The United States financial system is linked to the international financial markets.
Investors, savers, households, businesses, and governments in foreign countries can influence
the financial markets in the United States, while the U.S. financial markets similarly affect
foreign financial markets. Consequently, governments intervene into the international markets to
affect their financial markets.
The Federal Reserve tries to manage the value of the U.S. dollar in the international
markets. However, governments and central banks have difficulties in influencing the exchange
rate of their currency because over $1 trillion in transactions occur daily in the foreign-exchange
market. Foreign-exchange market is the largest international market in the world. As countries
engage in international trade, goods move in one direction while money moves in the opposite
direction. When a central bank tries to control the foreign-exchange rate of its currency,
economists call this foreign-exchange market intervention.
The Federal Reserve and U.S. Treasury Department intervene in the foreign-exchange
markets, manipulating the U.S. dollar exchange rate. Usually the Federal Reserve and Treasury
coordinate their policies together. For example, the Federal Reserve holds foreign currencies,
such as British pounds, European euros, and Japanese yen. Foreign currencies are an asset to the
Federal Reserves, which are called international reserves. The Federal Reserve can sell or
purchase U.S. dollars on the international markets that impact the U.S. exchange rates and U.S.
money supply. Table 2 summarizes the impact of a strong or weak U.S. dollar on the U.S.
economy.
Table 2. Impact of a Strong or Weak Dollar on the U.S. Economy
Strong U.S. Dollar Weak U.S. Dollar
Foreign-produced goods are cheaper.
U.S. customers benefit.
U.S. produced goods become more expensive.
U.S. export businesses are hurt in foreign markets.
Trade deficit worsens.
Foreign-produced goods are more expensive.
U.S. customers are hurt.
U.S. produced goods are cheaper in foreign markets.
U.S. export businesses benefit in international markets.
Trade deficit becomes smaller, or becomes a trade surplusThe Fed believes the dollar is too weak and strengthens the dollar. The Fed will sell foreign
currencies and buy U.S. dollars. The Fed sells $10,000 in foreign currency, and we record the
transaction in the T-account below.
The Federal Reserve
Assets Liabilities
- $10,000 Foreign currencies – $10,000 Currency in circulation