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Copyright 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 19

InternationalMonetary

Systems: AnHistoricalOverview

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Copyright 2012 Pearson Addison-Wesley. All rights reserved. 19-2

Preview

Goals of macroeconomic policiesinternal andexternal balance

Gold standard era 18701914

International monetary system during interwarperiod 19181939

Bretton Woods system of fixed exchange rates19441973

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Preview

Collapse of the Bretton Woods system

Arguments for floating exchange rates

Macroeconomic interdependence under a floating

exchange rate

Foreign exchange markets since 1973

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Macroeconomic Goals

Internal balance describes the macroeconomic goals ofproducing at potential output(at full employment) andof price stability (low inflation).

An unsustainable use of resources (overemployment) tends to

increase prices; an ineffective use of resources(underemployment) tends to decrease prices.

Volatile aggregate demand and output tend to createvolatile prices.

Price level movements reduce the economys efficiency by

making the real value of the monetary unit less certain andthus a less useful guide for economic decisions.

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Macroeconomic Goals (cont.)

External balance achieved when a current account is

neither so deeply in deficit that the country may be unable torepay its foreign debts,

nor so strongly in surplus that foreigners are put in that position. For example, pressure on Japan in the 1980s and China in the 2000s.

An intertemporal budget constraint limits each countrysspending over time to levels that it can repay (with interest).

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The Open-Economy Trilemma

A country that fixes its currencys exchange ratewhile allowing free international capitalmovements gives up control over domesticmonetary policy.

A country that fixes its exchange rate can havecontrol over domestic monetary policy if itrestricts international financial flows so thatinterest parity R= R*need not hold.

Or a country can allow international capital toflow freely and have control over domesticmonetary policy if it allows the exchange rate tofloat.

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The Open-Economy Trilemma(cont.)

Impossible for a country to achieve more thantwo items from the following list:

1. Exchange rate stability.

2. Monetary policy oriented toward domestic goals.

3. Freedom of international capital movements.

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Fig. 19-1: The Policy Trilemma for OpenEconomies

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Macroeconomic Policy Under the GoldStandard 18701914

The gold standard from 1870 to 1914 and after1918 had mechanisms that prevented flows of goldreserves (the balance of payments) from becomingtoo positive or too negative.

Prices tended to adjust according the amount of goldcirculating in an economy, which had effects on the flowsof goods and services: the current account.

Central banks influenced financial asset flows, so that the

nonreserve part of the financial account matched thecurrent account in order to reduce gold outflows orinflows.

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Macroeconomic Policy Under the GoldStandard (cont.)

Price-specie-flow mechanismis theadjustment of prices as gold (specie) flows intoor out of a country, causing an adjustment in theflow of goods.

An inflow of gold tends to inflate prices. An outflow of gold tends to deflate prices.

If a domestic country has a current account surplus inexcess of the nonreserve financial account, gold earnedfrom exports flows into the countryraising prices inthat country and lowering prices in foreign countries.

Goods from the domestic country become expensive andgoods from foreign countries become cheap, reducing thecurrent account surplus of the domestic country and thedeficits of the foreign countries.

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Thus, price-specie-flow mechanism of the goldstandard could automatically reduce currentaccount surpluses and deficits, achieving ameasure of external balance for all countries.

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Macroeconomic Policy under the GoldStandard (cont.)

The Rules of the Game under the gold standardrefer to another adjustment process that wastheoretically carried out by central banks:

The selling of domestic assets to acquire money when gold

exited the country as payments for imports. Thisdecreased the money supply and increased interest rates,attracting financial inflows to match a current accountdeficit.

This reversed or reduced gold outflows.

The buying of domestic assets when gold enters thecountry as income from exports. This increased the moneysupply and decreased interest rates, reducing financialinflows to match the current account.

This reversed or reduced gold inflows.

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Banks with decreasing gold reserves had a strongincentive to practice the rules of the game: theycould not redeem currency without sufficient gold.

Banks with increasing gold reserves had a weak

incentive to practice the rules of the game: golddid not earn interest, but domestic assets did.

In practice, central banks with increasing goldreserves seldom followed the rules.

And central banks often sterilized gold flows,trying to prevent any effect on money suppliesand prices.

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The gold standards record for internal balancewas mixed.

The U.S. suffered from deflation, recessions, andfinancial instability during the 1870s, 1880s, and 1890s

while trying to adhere to a gold standard.

The U.S. unemployment rate was 6.8% on average from1890 to 1913, but it was less than 5.7% on averagefrom 1946 to 1992.

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Interwar Years: 19181939

The gold standard was stopped in 1914 due towar, but after 1918 it was attempted again.

The U.S. reinstated the gold standard from 1919 to 1933at $20.67 per ounce and from 1934 to 1944 at $35.00

per ounce (a devaluation of the dollar).

The U.K. reinstated the gold standard from 1925 to1931.

But countries that adhered to the gold standard

for the longest time, without devaluing theircurrencies, suffered most from reduced outputand employment during the 1930s.

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Bretton Woods System 19441973

In July 1944, 44 countries met in BrettonWoods, NH, to design the Bretton Woodssystem: a fixed exchange rate against the U.S. dollar and a

fixed dollar price of gold ($35 per ounce). They also established other institutions:

1. The International Monetary Fund

2. The World Bank

3. General Agreement on Trade and Tariffs (GATT), the

predecessor to the World Trade Organization (WTO).

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International Monetary Fund

The IMF was constructed to lend to countries withpersistent balance of payments deficits (or currentaccount deficits), and to approve of devaluations.

Loans were made from a fund paid for by members in gold

and currencies. Each country had a quota, which determined its

contribution to the fund and the maximum amount it couldborrow.

Large loans were made conditional on the supervision of

domestic policies by the IMF: IMF conditionality.

Devaluations could occur if the IMF determined that theeconomy was experiencing a fundamentaldisequilibrium.

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International Monetary Fund (cont.)

Due to borrowing and occasional devaluations, theIMF was believed to give countries enoughflexibility to attain an external balance, yet allowthem to maintain an internal balance and stable

exchange rates. The volatility of exchange rates during 19181939, caused

by devaluations and the vagaries of the gold standard, wasviewed as a source of economic instability.

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Bretton Woods System

In order to avoid sudden changes in the financialaccount (possibly causing a balance of paymentscrisis), countries in the Bretton Woods systemoften prevented flows of financial assets across

countries.

Yet they encouraged flows of goods and servicesbecause of the view that trade benefits alleconomies.

Currencies were gradually made convertible(exchangeable) between member countries to encouragetrade in goods and services valued in differentcurrencies.

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Bretton Woods System (cont.)

Under a system of fixed exchange rates, allcountries but the U.S. had ineffective monetarypolicies for internal balance.

The principal tool for internal balance was fiscalpolicy (government purchases or taxes).

The principal tools for external balance wereborrowing from the IMF, restrictions on financialasset flows, and infrequent changes in exchange

rates.

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Policies for Internal and External Balance

Suppose internal balance in the short run occurswhen production is at potential output or whenfull employment equals aggregate demand:

Yf

=C+

I+

G+

CA(EP

*/P,A

)= A + CA(EP*/P,A) (19-1)

An increase in government purchases (or adecrease in taxes) increases aggregate demand

and output above its full employment level.

To restore internal balance in the short run, arevaluation (a fall in E) must occur.

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Policies for Internal and External Balance(cont.)

Suppose external balance in the short run occurswhen the current account achieves some valueX:

CA(EP*/P, YT) =X (19-2)

An increase in government purchases (or adecrease in taxes) increases aggregate demand,output and income, decreasing the currentaccount.

To restore external balance in the short run, adevaluation (a rise in E) must occur.

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Fig. 19-2: Internal Balance (II), ExternalBalance (XX), and the Four Zones ofEconomic Discomfort

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Fig. 19-3: Policies to Bring About Internaland External Balance

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But under the fixed exchange rates of the BrettonWoods system, devaluations were supposed to beinfrequent, and fiscal policy was supposed to bethe main policy tool to achieve both internal and

external balance.

But in general, fiscal policy cannot attain bothinternal balance and external balance at the sametime.

A devaluation, however, can attain both internalbalance and external balance at the same time.

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Under the Bretton Woods system, policy makersgenerally used fiscal policy to try to achieveinternal balance for political reasons.

Thus, an inability to adjust exchange ratesleft countries facing external imbalancesover time.

Infrequent devaluations or revaluations helped restoreexternal and internal balance, but speculators also tried toanticipate them, which could cause greater internal orexternal imbalances.

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U.S. External Balance Problems UnderBretton Woods

The collapse of the Bretton Woods system wascaused primarily by imbalances of the U.S. duringthe 1960s and 1970s.

The U.S. current account surplus became a deficit in 1971.

Rapidly increasing government purchases increasedaggregate demand and output, as well as prices.

Rising prices and a growing money supply caused the U.S.dollar to become overvalued in terms of gold and in terms

of foreign currencies.

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U.S. External Balance Problems underBretton Woods (cont.)

Another problem was that as foreign economiesgrew, their need for official international reservesto maintain fixed exchange rates grew as well.

But this rate of growth was faster than the growthrate of the gold reserves that central banks held.

Supply of gold from new discoveries was growing slowly.

Holding dollar-denominated assets was the alternative.

At some point, dollar-denominated assets held byforeign central banks would be greater than theamount of gold held by the Federal Reserve.

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U.S. External Balance Problems underBretton Woods (cont.)

The Federal Reserve would eventually not haveenough gold: foreigners would lose confidenceinthe ability of the Federal Reserve to maintain thefixed price of gold at $35/ounce, and therefore

would rush to redeem their dollar assets before thegold ran out.

This problem is similar to what any central bank may facewhen it tries to maintain a fixed exchange rate.

If markets perceive that the central bank does not haveenough official international reserve assets to maintain afixed rate, a balance of payments crisis is inevitable.

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Collapse of the Bretton Woods System

The U.S. was not willing to reduce government purchases orincrease taxes significantly, nor reduce money supplygrowth.

These policies would have reduced aggregate demand,output, and inflation and increased unemployment.

The U.S. could have attained some semblance of externalbalance at a cost of a slower economy.

A devaluation, however, could have avoided the costs of lowoutput and high unemployment and still have attained

external balance (an increased current account and officialinternational reserves).

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Collapse of the Bretton Woods System(cont.)

The imbalances of the U.S., in turn, causedspeculation about the value of the U.S. dollar,which caused imbalances for other countries andmade the system of fixed exchange rates harder

to maintain.

Financial markets had the perception that theU.S. economy was experiencing a fundamentaldisequilibrium and that a devaluation wouldbe necessary.

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First, speculation about a devaluation of the dollar causedinvestors to buy large quantities of gold.

The Federal Reserve sold large quantities of gold in March 1968,but closed markets afterwards.

Thereafter, individuals and private institutions were no longerallowed to redeem gold from the Federal Reserve or othercentral banks.

The Federal Reserve would sell only to other central banks at$35/ounce.

But even this arrangement did not hold: the U.S. devalued its

dollar in terms of gold in December 1971 to $38/ounce.

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Second, speculation about a devaluation of the dollar interms of other currencies caused investors to buy largequantities of foreign currency assets.

A coordinated devaluation of the dollar against foreigncurrencies of about 8% occurred in December 1971.

Speculation about another devaluation occurred: Europeancentral banks sold huge quantities of European currencies inearly February 1973, but closed markets afterwards.

Central banks in Japan and Europe stopped selling their

currencies and stopped purchasing of dollars in March 1973,and allowed demand and supply of currencies to push the valueof the dollar downward.

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Table 19-1: Inflation Rates in IndustrialCountries, 19661972 (percent per year)

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The Bretton Woods system collapsed in 1973 becausecentral banks were unwilling to continue to buy overvalueddollar-denominated assets and to sell undervalued foreigncurrencydenominated assets.

In 1973, central banks thought they would temporarily stoptrading in the foreign exchange market and wouldletexchangeratesadjusttosupplyanddemand, and thenwould reimpose fixed exchange rates soon.

But no new global system of fixed rates was started again.

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Case for Floating Exchange Rates

1. Monetary policy autonomy

Without a need to trade currency in foreign exchangemarkets, central banks are more free to influence thedomestic money supply, interest rates, and inflation.

Central banks can more freely react to changes inaggregate demand, output, and prices in order toachieve internal balance.

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Case for Floating Exchange Rates (cont.)

2. Automatic stabilization

Flexible exchange rates change the prices of a countrysproducts and help reduce fundamental disequilibria.

One fundamental disequilibrium is caused by anexcessive increase in money supply and governmentpurchases, leading to inflation, as we saw in the USduring 19651972.

Inflation causes the currencys purchasing power to fall,

both domestically and internationally, and flexibleexchange rates can automatically adjust to account forthis fall in value, as purchasing power parity predicts.

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Another fundamental disequilibrium could be caused by achange in aggregate demand for a countrys products.

Flexible exchange rates would automatically adjust to stabilizehigh or low aggregate demand and output, thereby keepingoutput closer to its normal level and also stabilizing price

changes in the long run.

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Fig. 19-5: Effectsof a Fall in Export

Demand

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In the long run, a real depreciation of domestic productsoccurs as prices fall (due to low aggregate demand,output, and employment) under fixed exchange rates.

In the short run and long run, a real depreciation of

domestic products occurs through a nominal depreciationunder flexible exchange rates.

Fixed exchange rates cannot survive for long in aworld with divergent macroeconomic policies and

other changes that affect national aggregatedemand and national income differently.

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3. Flexible exchange rates may also preventspeculation in some cases.

Fixed exchange rates are unsustainable if marketsbelieve that the central bank does not have enough

official international reserves.

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4. Symmetry (not possible under Bretton Woods)

The U.S. is now allowed to adjust its exchange rate,like other countries.

Other countries are allowed to adjust their money

supplies for macroeconomic goals, like the U.S. could.

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Since 1973

In 1975, IMF members met in Rambouillet,France to allow flexible exchange rates, but toprevent erratic fluctuations.

In 1976 in Kingston, Jamaica, they amended the

articles of agreement for IMF membership toformally endorse flexible rates, but prevented members from manipulating exchange

rates to gain an unfair competitive advantage: noexpenditure-switching policies were allowed.

The articles allowed surveillance of members by othermembers to be sure they were acting fairly.

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Since 1973 (cont.)

Due to contractionary monetary policy andexpansive fiscal policy in the U.S., the dollarappreciated by about 50% relative to 15currencies from 1980 to 1985.

This contributed to a growing current account deficit bymaking imports cheaper and U.S. goods more expensive.

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Table 19-2: Macroeconomic Data for KeyIndustrial Regions, 19632009

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Fig. 19-6: Nominal and Real EffectiveDollar Exchange Rate Indexes, 19752010

Source: International Monetary Fund, International Financial Statistics.

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Since 1973 (cont.)

To reduce the value of the U.S. $, the U.S.,Germany, Japan, Britain, and France announcedin 1985 that their central banks would jointlyintervene in the foreign exchange markets in

order to reduce the value of the dollar. The dollar dropped sharply the next day and continued to

drop as the U.S. continued a more expansionarymonetary policy, pushing down interest rates.

The agreement was called the Plaza Accords, because itwas announced at the Plaza Hotel in New York.

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Since 1973 (cont.)

After the value of the dollar fell, countries wereinterested in stabilizing exchange rates.

U.S., Germany, Japan, Britain, France, and Canadaannounced renewed cooperation in 1987, pledging to

stabilize exchange rates. They calculated zones of about +/5% around which

current exchange rates were allowed to fluctuate.

The agreement was called the Louvre Accords, because itwas announced at the Louvre in Paris.

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Since 1973 (cont.)

It is not at all apparent that the Louvre Accordssucceeded in stabilizing exchange rates.

The stock market crash in October 1987 madeproduction, employment, and price stability the primary

goals for the U.S. central bank, and exchange ratestability became less important.

New targets were (secretly) made after October 1987,but central banks had abandoned these targets by theearly 1990s.

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Since 1973 (cont.)

Many fixed exchange rate systems havenonetheless developed since 1973.

European monetary system and euro zone (studied inChapter 20).

The Chinese central bank currently fixes the value of itscurrency.

ASEAN countries have considered a fixed exchange ratesand policy coordination.

No system is right for all countries at all times.

Fi 19 7 U S H P i 2000

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Fig. 19-7: U.S. Home Prices 20002010

Source: Case-Shiller 20-city composite index, fromhttp://www.macromarkets.com/csi_housing/sp_caseshiller.asp

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Macroeconomic Interdependence UnderFloating Exchange Rates

Previously, we assumed that countries are smallin that their policies do not affect world markets.

For example, a depreciation of the domestic currencywas assumed to have no significant influence on

aggregate demand, output, and prices in foreigncountries.

For countries like Costa Rica, this may be an accuratedescription.

However, large economies like the U.S., EU,Japan, and China are interdependent becausepolicies in one country affect other economies.

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Macroeconomic Interdependence UnderFloating Exchange Rates (cont.)

If the U.S. permanently increases the moneysupply, the DD-AAmodel predicts for the shortrun:1. an increase in U.S. output and income

2. a depreciation of the U.S. dollar

What would be the effects for Japan?1. an increase in U.S. output and income would raise demand

for Japanese products, thereby increasing aggregate demandand output in Japan.

2. a depreciation of the U.S. dollar means an appreciation of theyen, lowering demand for Japanese products, therebydecreasing aggregate demand and output in Japan.

The total effect of (1) and (2) is ambiguous.

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If the U.S. permanently increases governmentpurchases, the DD-AAmodel predicts:

an appreciation of the U.S. dollar.

What would be the effects for Japan?

an appreciation of the U.S. dollar means an depreciation ofthe yen, raising demand for Japanese products, therebyincreasing aggregate demand and output in Japan.

What would be the subsequent effects for the

U.S.? Higher Japanese output and income means that more income

is spent on U.S. products, increasing aggregate demand andoutput in the U.S. in the short run.

i d d d

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In fact, the U.S. has depended on savedfunds from many countries, while it hasborrowed heavily.

The U.S. has run a current account deficit formany years due to its low saving and highinvestment expenditure.

Fi 19 8 Gl b l E t l

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Fig. 19-8: Global ExternalImbalances, 19992009

Source: International Monetary Fund, World Economic Outlookdatabase.

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Fig 19 9 Long Te m Real Inte est Rates

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Fig. 19-9: Long-Term Real Interest Ratesfor the United States, Canada, andSweden, 19992010

Source: Global Financial Data and Datastream. Real interest rates are six-month movingaverages of monthly interest rate observations on ten-year inflation-indexed governmentbonds.

Fi 19 10 E h R t T d d

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Fig. 19-10: Exchange Rate Trends andInflation Differentials, 19732009

Source: International Monetary Fund and Global Financial Data.

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Summary

1. Internal balance means that an economy enjoysnormal output and employment and pricestability.

2. External balance roughly means a stable level of

official international reserves or a currentaccount that is not too positive or too negative.

3. The gold standard had two mechanisms thathelped to prevent external imbalances:

Price-specie-flow mechanism: the automatic adjustmentof prices as gold flows into or out of a country.

Rules of the game: buying or selling of domestic assetsby central banks to influence flows of financial assets.

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Summary (cont.)

4. The Bretton Woods agreement in 1944established fixed exchange rates, using the U.S.dollar as the reserve currency.

5. The IMF was also established to provide

countries with financing for balance of paymentsdeficits and to judge if changes in fixed rateswere necessary.

6. Under the Bretton Woods system, fiscal policieswere used to achieve internal and externalbalance, but they could not do bothsimultaneously, so external imbalances oftenresulted.

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Summary (cont.)

7. Internal and external imbalances of the U.S.caused by rapid growth in government purchasesand the money supplyand speculation aboutthe value of the U.S. dollar in terms of gold and

other currencies ultimately broke the BrettonWoods system.

8. High inflation from U.S. macroeconomic policieswas transferred to other countries late in the

Bretton Woods system.

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Summary (cont.)

9. Arguments for flexible exchange rates are thatthey allow monetary policy autonomy, canstabilize the economy as aggregate demand andoutput change, and can limit some forms of

speculation.

10. Arguments against flexible exchange rates arethat they allow expenditure switching policies,can make aggregate demand and output more

volatile because of uncoordinated policies acrosscountries, and make exchange rates morevolatile.

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Summary (cont.)

11. Since 1973, countries have engaged in 2 majorglobal efforts to influence exchange rates:

The Plaza Accords reduced the value of the dollarrelative to other major currencies.

The Louvre Accords agreement was intended tostabilize exchange rates, but it was quickly abandoned.

12. Models of large countries account for theinfluence that domestic macroeconomic policies

have in foreign countries.

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Fig 19A-1: Hypothetical Effects of

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Fig. 19A-1: Hypothetical Effects ofDifferent Monetary Policy Combinationson Inflation and Unemployment

Fig 19A 2: Payoff Matrix for Different

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Fig. 19A-2: Payoff Matrix for DifferentMonetary Policy Moves

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