Chapter 19ESV S2.1314 - The International Monetary System

8/11/2019 Chapter 19ESV S2.1314 - The International Monetary System

1/61

CHAPTER 19:

The International

Monetary System


2/61

Content

The Gold Standard, 1870

1914

Macroeconomics Policy Goals

The Interwar, 1918 - 1939

The Bretton Woods System and IMF


3/61

Text book: KO textbook, Chapter 19

Readings: IMF Case Studies

Reference


4/61


5/61

Macroeconomic Policy Goals


in an Open Economy

1

The Gold Standard

(1870 1914)

2

The Interwar Years

(1918 1939)

3

The Bretton WoodsSystems and IMF


6/61


Macro-

economic

Policy

External Balance: Optimal Level of Current

Account

Internal Balance: Full Employment

Price Level Stability


7/61


Internal Balance:

Full employment of a countrys resources

Domestic price level stability

Why the government must maintain price levelstability and prevent large output fluctuations?


8/61


Internal Balance:

Employment:

Underemployment

Overemployment WASTE ?


9/61


Internal Balance:

Price Level:

Instability Inflation or Deflation

Less certain real value of money

Less useful guide for economic decisions

Effect on the real value of loan contracts

Controlling money supply growthStability


10/61


External Balance: Balance of Current Account

Imbalance is not necessarily undesirable

Intertemporal trade

Deficit CA

Surplus CA

Borrowing from others

Investing abroad

2. Description of the contents


11/61


External Balance:

Account Deficit = temporarily high consumption+ badly planned investment projects

Sudden stop of lending

Signal government to restore external balance

How?


12/61


External Balance:

Account Surplus:

Accumulating assets located abroad = Lower

investment in domestic plant equipment (S = CA + I)Policy makers prefer higher levels of domestic

investment: Easier to tax on domestic returns

Reduce domestic unemployment and improve nationalincome

Foster technological spillover between domestic industries


13/61


External Balance:

No balanced current account as a policy target inreality

Rules for Current account target:

Avoid extremely large external surpluses or deficit

Be cautious when figuring out the exact currentaccount to maximize the gain from inter-temporaltrade

Optimal balance can change unpredictably over timeas of the economy condition change


14/61

02The Gold Standard,

1870 - 1914


15/61

The Gold Standard, 1870 - 1914

Why not other metal?

The Useof Gold

Medium ofExchange

Store of value

Unit of account


16/61


Origins of the Gold Standard:

1819: The gold standard as a legal institutiondates from 1819 in Britain

Other nations adopted the gold standard toimitating British institutions.

1879: The U.S. pegged to gold the note

London: Center of the IMS built on the goldstandard


17/61


External Balance:

Central banks responsibilities:

To preserve the official parity between its currency

and gold To maintain an adequate stock of gold reserves

Not to make rapid change to gold reserves by:

Gain gold from abroad

Lose gold to foreigners

To keep balance of payments equilibrium


18/61


External Balance:

The Price Specie Flow Mechanism:

Suppose in British:

Current Account + Capital Account surplus > NonreserveFinancial account deficit

Flows of international reserves of gold into Britain

Foreign money supplies reduce, Britain money supply

increaseForeign prices British prices


19/61


External Balance:

The Price Specie Flow Mechanism:

Pound appreciates:

Reduce foreign demand for British goods and services

Increase British demand for foreign goods and services

Reduce Britains current account surplus and foreigncurrent account deficit

BoP equilibrium = Reserve movement stop


20/61


External Balance:

Rules of the Game Myth:

Central banks that were losing gold:

Sell domestic assets

Interest rates

Attract inflows of capital from abroad

Central banks that were gaining gold:

Purchase domestic assets Interest rates

Increase financial outflows and driving gold abroad


21/61


External Balance:

Rules of the Game Reality:

Deficit countries

Had more incentives to obey the rules than surpluscountries

Had burden to bringing all countries BoP into equilibrium

Governments ignored the rules of the game and the

effects of their actions


22/61


Internal Balance:

Change in relative prices of gold and othercommodities

The Gold Standard had not much effect onensuring full employment

Concentration on External Balance rather than

on Internal BalanceResulted in worldwide economic instability of

the interwar years, 1918 - 1939


23/61

The Interwar Years,

1918 - 193903


24/61

The Interwar Years, 1918 - 1939

Background:

Gold standard was suspended during WWI

Government finance their military expenditure

by printing money

Labor forces and productive capacity had beenreduced sharply

Higher price level, sharp rise in money supplies


25/61


Small countries

Large countries

Hold as reserves thecurrencies of several large

countries

Own international reservesconsisting entirely of gold

Partial gold exchange standard

Partial gold exchange standard


26/61


The Return to Gold:

1925: Britain returned to the gold standard bypegging pound to gold at the prewar price

Follow contractionary monetary policies thatcontributed to severe unemployment

1931: Foreign holders of sterling lost confidence

in Britains promise and converted their sterlingto gold

Britain left gold


27/61


International Economic Disintegration:

Great Depression mostly affected on countriespegging to gold standard

International trade and payments wererestricted as of Gold Standard

Uncertain government policies lead to:

Sharp reserve movements for countries with peggedexchange rate

Sharp ex rate movement for those with floating rates


28/61


International Economic Disintegration:

Repudiations of International debts

Prohibitions on private financial account

transactions

Countries must resolve the choice betweenexternal and internal balance

Postwar IMS: Bretton Woods Agreement


29/61

The Bretton Woods

System and the IMF04


30/61

The BWS and the IMF

In 1944:

44 countries in Bretton Woods, New Hampshiredraft and signed the Agreement of IMF

Aims of the Agreement:Foster full employment and price stability

Allow member nations to attain external balancewithout imposing restrictions on international trade


31/61

The BWS and the IMF

Fixed exchange ratesagainst the U.S. dollar

InternationalReserve of Gold

and Dollar Assets

MemberCountries

Pegged dollar price ofgold - $35/ 1oz of gold

InternationalReserve of Gold

The United States

The

BWS

Gold exchange standard, with dollar as its

principle reserve currency


32/61

The BWS and the IMF

Goals and Structure of the IMF:

Avoid interwar experience through disciplineand flexibility

Discipline:Exchange rates to be fixed to the dollar

Dollar to be tied to gold

Why fixed exchange rates? To avoid: Speculative instability Harmful effect to international trade


33/61

The BWS and the IMF

Goals and Structure of the IMF:

Flexibility:

Allow countries to attain external balance without

sacrificing internal objectives or fixed exchange ratesBy how?

Form a pool of financial resources

Exchange rates could be adjusted in cases of an economy in

fundamental disequilibrium - a country with a large andpersistent current account deficit


34/61

The BWS and the IMF

Speculative Capital Flow and Crises:

Fundamental disequilibrium Currencydevaluation

Balance of payments crisisBecoming frequent and severe throughout 1960s -

1970s.

Massive crises brought down the Bretton Woodsstructure of fixed exchange rates


35/61

The BWS and the IMF

Policy Options Under the Bretton WoodsSystem:

Framework:

Assumption: R = R*

P and P* are fixed

Objective:

Show how a countrys position with respect to its internaland external goals depends on the level of its fixedexchange rate and its fiscal policy


36/61

The BWS and the IMF


Condition:

= + + +

,

= + +

= +

,


37/61

The BWS and the IMF


Monetary Policy: Not a tool under fixed

exchange rate Central banks:

Alter the Foreign Reserves by buying or selling assets

Leave money supply unchangedDo not affect the state of employment and output



38/61

The BWS and the IMF

=

ForeignAssets

DomesticAssets

Deposits byprivatebanks

Currency incirculation

Central Bank Balance Sheet

Assets Liabilities


39/61

The BWS and the IMF


Maintaining the Internal Balance:

:

Fiscal expansion ( )

Devaluation of the currency ( ):


40/61

The BWS and the IMF



IISchedule: Downward sloping

To the right of II: More expansionary, overemployment

To the left of II: Too restrictive, underemployment


41/61

The BWS and the IMF




42/61

The BWS and the IMF


Maintaining External Balance:

:

Fiscal contraction ( )

Devaluation of the currency ( )

Assume the government has a target value, X, for thecurrent account surplus:

, =


43/61

The BWS and the IMF



XX Schedule: Upward sloping

To the right of XX: CA deficit

To the left of XX: CA surplus


44/61

The BWS and the IMF




45/61

The BWS and the IMF

Policy Options Underthe Bretton WoodsSystem:

At Point 1: Both internaland external balancehold

At Zone 1, 2, 3, 4: Zonesof economic discomfort


46/61

The BWS and the IMF


Fiscal policy: Expenditure changing policy

Changing the levelof the economys totaldemand for goods and services

Exchange rate adjustment: Expenditure

switching policyChanging thedirection

ofdemand between domestic output and imports


47/61

The BWS and the IMF


Exchange rate adjustment: happened

infrequently Fiscal policy: insufficient to attain the two goals


48/61

The BWS and the IMF


Exchange rate adjustment: happened

infrequently Fiscal policy: insufficient to attain the two goals


49/61

The BWS and the IMF



50/61

The BWS and the IMF

United States Under the Bretton Woods:

Constraints: Confidence Problem

Consequences: Bring down the BWS

Solution: Increase the official price of gold Worsen confidence problem


51/61

The BWS and the IMF

The Mechanics of Imported Inflation:

Suppose:

(abroad inflation)

( ) :


52/61

Analyzing Policy Options Under

the Bretton Woods System



53/61




U.S. inflation -> Global inflation

Increasing trade off between exchange rate

stability and domestic monetary goals Collapse of the BWS


54/61




55/61

The Case for Floating

Exchange Rates05



56/61

The Case for Floating Exchange Rates

Major Claims for Floating Exchange Rates:

Exchange rates asautomatic stabilizers

Monetary policyautonomy

Exchange rates andexternal balance

Symmetry


57/61



Monetary policy autonomy:

Under BWS: Central banks imposes restrictions on

international payments Strengthen the monetary policy but distort international

trade

Under floating exchange rates: Restore monetarycontrol to central banks

Prevent countries from passively imported inflation ratefrom abroad


58/61



Symmetry:

Under BWS - 2 main asymmetries:

U.S. Federal Reserve determined the world money supply,central banks abroad had little scope to determine theirown money supplies

Other central banks but the U.S. could devalue theircurrencies in condition of fundamental disequilibrium

Under Floating Exchange rates: Same opportunities for the US and other countries


59/61



Exchange rates as automatic stabilizers:


60/61



Exchange rates and External balance:

CA surplus (deficit) Require appreciate

(depreciate) currency


61/61

The Open Economy Trilemma

Chapter 19ESV S2.1314 - The International Monetary System

Documents

Transcript of Chapter 19ESV S2.1314 - The International Monetary System