The International Financial System
The international financial system links national economies through trade and capital flows, recorded in the balance of payments. Central banks hold foreign-exchange reserves and intervene to influence their currencies, and institutions such as the IMF lend to countries in crisis. A currency crisis erupts when a peg becomes impossible to defend.
Try it yourself
The Policy Trilemma
A country can lock in at most two of these three goals at once. Switch on the two you want and see which one you are forced to give up.
Reflection: the eurozone fixes exchange rates between members and allows free capital, so each member gives up its own monetary policy to the ECB. Which corner did your country choose, and what did it pay to keep the other two?
Why it matters
Money, goods, and investment cross borders constantly, and the balance of payments is the accounting record of those flows. The deep constraint on any country in this system is the policy trilemma, which says it can hold at most two of three goals, namely a fixed exchange rate, free capital flows, and an independent monetary policy. When confidence in a currency collapses, reserves drain fast and a peg can break almost overnight.
Worked examples
A central bank sells US dollars from its reserves and buys its own currency. What is it trying to do, and what is the limit?
It is intervening to prop up its currency’s value. The limit is its stock of reserves, because once they run low it can no longer defend the rate and may be forced to devalue.
Common mistakes
- ✗A balance-of-payments deficit means a country is going bankrupt. The accounts must net to zero, so a current-account deficit is matched by an offsetting inflow on the financial account.
- ✗IMF lending is a free bailout. It comes with policy conditions and must be repaid, and it aims to stop a crisis from spreading.
Revision bullets
- •The balance of payments records cross-border flows
- •Central banks hold and use FX reserves to intervene
- •Currency crises hit when a peg cannot be defended
Quick check
A central bank defending a fixed exchange rate is ultimately constrained by
Connected topics
Sources
- Mishkin (2018), Ch. 19Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The international financial system: the balance of payments, foreign-exchange intervention and reserves, and the role of the IMF.