Chapter 7 THE INTERNATIONAL MONETORY SYSTEM 1870-1973.

Chapter 7 THE INTERNATIONAL

MONETORY SYSTEM 1870-1973

THE INTERNATIONAL MONETORY SYSTEM 1870-1973

The interdependence of open national economies The interdependence of open national economies

has made it more difficult for governments to has made it more difficult for governments to

achieve full employment and price stability.achieve full employment and price stability. The channels of interdependence depend on the The channels of interdependence depend on the

monetary and exchange rate arrangements.monetary and exchange rate arrangements. This chapter examines the evolution of the This chapter examines the evolution of the

international monetary system and how it international monetary system and how it influenced macroeconomic policy.influenced macroeconomic policy.


This chapter examines how the international This chapter examines how the international monetary system influenced macroeconomic monetary system influenced macroeconomic policy-making and performance during three policy-making and performance during three period:period: The interwar period (1918-1939)The interwar period (1918-1939) The gold standard era(1870-1914)The gold standard era(1870-1914) The post-World War II years (1946-1973)The post-World War II years (1946-1973)


Gold Standard era

1870 1914 1918 1939

Interwar Years

1946 1973

Under the Bretton Woods System

Macroeconomic Policy Goals In an Open Economy Internal BalanceInternal Balance:Full Employment and :Full Employment and

Price-Level Stability Price-Level Stability When a country’s productive resources are fully employed When a country’s productive resources are fully employed

and its price level is stable,the country is in internal balance.and its price level is stable,the country is in internal balance.

External BalanceExternal Balance:The Optimal Level of the :The Optimal Level of the Current Account Current Account

Because of the existence of intertemporal trade,it’s difficult Because of the existence of intertemporal trade,it’s difficult to make a exact current account balance.So the external to make a exact current account balance.So the external balance goal is The Optimal Level of the CA.balance goal is The Optimal Level of the CA.

Internal Balance: Full Employment and Price-Level Stability A country is in internal balance when its resources are fully A country is in internal balance when its resources are fully

employed and there is price level stability. employed and there is price level stability.

Under-and over-employment lead to price level movements that Under-and over-employment lead to price level movements that

reduce the economy’s efficiency.reduce the economy’s efficiency.

One particularly disruptive effect of an unstable price level is its One particularly disruptive effect of an unstable price level is its

effect on the real value of loan contracts. effect on the real value of loan contracts.

To avoid price-level instability, the government must:To avoid price-level instability, the government must: Prevent substantial movements in aggregate demand relative to its full-Prevent substantial movements in aggregate demand relative to its full-

employment level.employment level.

Ensure that the domestic money supply does not grow too quickly or Ensure that the domestic money supply does not grow too quickly or

too slowly.too slowly.

External Balance: The Optimal Level of the Current Account

External balance has no full employment or stable External balance has no full employment or stable

prices to apply to an economy’s external transactions.prices to apply to an economy’s external transactions.

An economy’s trade can cause macroeconomic An economy’s trade can cause macroeconomic

problems depending on several factors:problems depending on several factors:

The economy’s particular circumstancesThe economy’s particular circumstances

Conditions in the outside worldConditions in the outside world

The institutional arrangements governing its The institutional arrangements governing its

economic relations with foreign countrieseconomic relations with foreign countries

Macroeconomic Policy Goals In an Open Economy

Problems with Excessive Current Account Problems with Excessive Current Account Deficits.Deficits.

A large CA deficit can undermine foreign investors’ A large CA deficit can undermine foreign investors’ confidence and contribute to a lending crisis.confidence and contribute to a lending crisis.

Problems with Excessive Current Account Problems with Excessive Current Account SurplusesSurpluses

The total domestic saving ,S, is divided between foreign The total domestic saving ,S, is divided between foreign asset accumulation,CA,and domestic investment I, S=CA asset accumulation,CA,and domestic investment I, S=CA +I . So for a given level of national saving,an increased +I . So for a given level of national saving,an increased CA surplus implies lower investment in domestic plant CA surplus implies lower investment in domestic plant and equipment. (S , CA , I )and equipment. (S , CA , I )

International Macroeconomic Policy Under the Gold Standard 1870-1914

Origins of the Gold StandardOrigins of the Gold StandardThe Gold Standard had its origin in the use of gold coins The Gold Standard had its origin in the use of gold coins

as a medium of exchange,unit of account and store of as a medium of exchange,unit of account and store of value .value .

External Balance Under the Gold StandardExternal Balance Under the Gold StandardA situation in which the central bank was neither gaining A situation in which the central bank was neither gaining

gold from abroad nor losing gold to foreigners at too gold from abroad nor losing gold to foreigners at too rapid a rate.rapid a rate.

The Price-Specie-Flow MechanismThe Price-Specie-Flow Mechanism Internal Balance Under the Gold StandardInternal Balance Under the Gold Standard

The The Price-Specie-Flow Mechanism

David Hume ,the Scottish philosopher, in 1752 David Hume ,the Scottish philosopher, in 1752 described the The Price-Specie-Flow Mechanismas described the The Price-Specie-Flow Mechanismas follows:follows:

It is to say that in the Gold Standard era the economy can It is to say that in the Gold Standard era the economy can

achieve balance automatically.achieve balance automatically.

Ms P importexportP* CA

National pricelevel

Foreign price level

The The Price-Specie-Flow Mechanism The price-specie-flow mechanism described by David The price-specie-flow mechanism described by David

Hume shows how the gold standard could ensure Hume shows how the gold standard could ensure

convergence to external balance. This model is based convergence to external balance. This model is based

upon three equations:upon three equations: The balance sheet of the central bank. At the most simple level, this The balance sheet of the central bank. At the most simple level, this

is just gold holdings equals the money supply: G = M.is just gold holdings equals the money supply: G = M.

The quantity theory. With velocity and output assumed constant The quantity theory. With velocity and output assumed constant

and both normalized to 1, this yields the simple equation M = P. and both normalized to 1, this yields the simple equation M = P.

A balance of payments equation where the current account is a A balance of payments equation where the current account is a

function of the real exchange rate and there are no private capital function of the real exchange rate and there are no private capital

flows: CA = f(E·P*/P)flows: CA = f(E·P*/P)

The The Price-Specie-Flow Mechanism

The 45The 45 line represents the quantity theory and the line represents the quantity theory and the

vertical line is the price level where the real vertical line is the price level where the real

exchange rate results in a balanced current exchange rate results in a balanced current

account. account.

The economy moves along the 45The economy moves along the 45 line back line back

towards the equilibrium point 0 whenever it is out towards the equilibrium point 0 whenever it is out

of equilibrium. of equilibrium.

For example, the loss of four-fifths of a country's For example, the loss of four-fifths of a country's

gold would put that country at point a with lower gold would put that country at point a with lower

prices and a lower money supply. prices and a lower money supply.

The resulting real exchange rate depreciation The resulting real exchange rate depreciation

causes a current account surplus which restores causes a current account surplus which restores

money balances as the country proceeds up the 45money balances as the country proceeds up the 45 line from a to 0. line from a to 0.

CA=0

M=P

0

a

M

P

These equations can be combined in a figure like the These equations can be combined in a figure like the

one below. one below.

International Macroeconomic Policy Under the Gold Standard 1870-1914 The Gold Standard “Rules of the Game”: Myth and The Gold Standard “Rules of the Game”: Myth and

RealityReality The practices of selling (or buying) domestic assets in the face The practices of selling (or buying) domestic assets in the face

of a deficit (or surplus).of a deficit (or surplus). The efficiency of the automatic adjustment processes inherent The efficiency of the automatic adjustment processes inherent

in the gold standard increased by these rules.in the gold standard increased by these rules. In practice, there was little incentive for countries with In practice, there was little incentive for countries with

expanding gold reserves to follow these rules.expanding gold reserves to follow these rules. Countries often reversed the rules and sterilized gold flows.Countries often reversed the rules and sterilized gold flows.

Internal Balance Under the Gold StandardInternal Balance Under the Gold Standard The gold standard system’s performance in maintaining The gold standard system’s performance in maintaining

internal balance was mixed.internal balance was mixed. Example: The U.S. unemployment rate averaged 6.8% Example: The U.S. unemployment rate averaged 6.8%

between 1890 and 1913, but it averaged under 5.7% between between 1890 and 1913, but it averaged under 5.7% between 1946 and 1992.1946 and 1992.

THE INTERWAR YEARS 1918-1939

With the eruption of WWI in 1914, the gold standard With the eruption of WWI in 1914, the gold standard was suspended.was suspended. The interwar years were marked by severe economic instability.The interwar years were marked by severe economic instability. The reparation payments led to episodes of hyperinflation in The reparation payments led to episodes of hyperinflation in

Europe.Europe.

The German Hyperinflation The German Hyperinflation Germany’s price index rose from a level of 262 in January 1919 Germany’s price index rose from a level of 262 in January 1919

to a level of 126,160,000,000,000 in December 1923 (a factor of to a level of 126,160,000,000,000 in December 1923 (a factor of 481.5 billion).481.5 billion).

THE INTERWAR YEARS 1918-1939 The Fleeting Return to GoldThe Fleeting Return to Gold

1919 1919 U.S. returned to goldU.S. returned to gold 1922 1922 A group of countries (Britain, France, Italy, and Japan) agreed on a A group of countries (Britain, France, Italy, and Japan) agreed on a

program calling for a general return to the gold standard and cooperation program calling for a general return to the gold standard and cooperation among central banks in attaining external and internal objectives.among central banks in attaining external and internal objectives.

1925 1925 Britain returned to the gold standardBritain returned to the gold standard 1929 1929 The Great Depression was followed by bank failures throughout the The Great Depression was followed by bank failures throughout the

world.world. 1931 1931 Britain was forced off gold when foreign holders of pounds lost Britain was forced off gold when foreign holders of pounds lost

confidence in Britain’s commitment to maintain its currency’s value.confidence in Britain’s commitment to maintain its currency’s value.

International Economic disintegrationInternational Economic disintegration Governments effectively suspended the gold standard during world War I Governments effectively suspended the gold standard during world War I

and financed part of their massive military expenditures by printing money. and financed part of their massive military expenditures by printing money. As a result,price levels were higher everywhere . As a result,price levels were higher everywhere .

THE BRETTON WOODS SYSTEM AND THE IMF

The system set up by Bretton Woods agreement, The system set up by Bretton Woods agreement, it’s a gold exchange standard with the dollar as it’s a gold exchange standard with the dollar as its principal reserve currency .its principal reserve currency .

Goals and Structure of the IMFGoals and Structure of the IMF The exchange rates be fixed to the $,which in turn,was tied to The exchange rates be fixed to the $,which in turn,was tied to

gold. gold. The IMF agreement tries to incorporate sufficient flexibility :The IMF agreement tries to incorporate sufficient flexibility :

IMF lending facilities ;IMF lending facilities ; adjustable paritiesadjustable parities..

ConvertibilityConvertibility General inconvertibility would make international trade General inconvertibility would make international trade

extremely difficult,the IMF Articles of Agreement urged extremely difficult,the IMF Articles of Agreement urged members to make their national currencies convertible as soon members to make their national currencies convertible as soon as possible.as possible.

INTERNAL AND EXTERNAL BALANCE UNDER THE BRETTON WOODS SYSTEM

As the world economy evolved in the years after As the world economy evolved in the years after World War ,the meaning of “external balance ⅡWorld War ,the meaning of “external balance Ⅱ”changed and conflicts between internal goals ”changed and conflicts between internal goals increasingly threatened the fixed exchanged rate increasingly threatened the fixed exchanged rate system. The special external balance problem of system. The special external balance problem of the United States, the issuer of the principal the United States, the issuer of the principal reserve currency, was a major concern that led to reserve currency, was a major concern that led to proposals to reform the system.proposals to reform the system.


The Changing Meaning of External BalanceThe Changing Meaning of External Balance In the first decade of the Bretton Woods system, many countries In the first decade of the Bretton Woods system, many countries

ran current account deficits as they reconstructed their war-torn ran current account deficits as they reconstructed their war-torn economies. Since the main external problem of these countries, economies. Since the main external problem of these countries, taken as a group, was to acquire enough dollars to finance taken as a group, was to acquire enough dollars to finance necessary purchase from the United States, these years are often necessary purchase from the United States, these years are often called the period of “dollar shortage”.called the period of “dollar shortage”.

Each country ’s overall current account deficit was limited by the Each country ’s overall current account deficit was limited by the difficulty of borrowing any foreign currencies in an environment of difficulty of borrowing any foreign currencies in an environment of heavily restricted capital account transactions. So these countries heavily restricted capital account transactions. So these countries had to reduce their foreign exchange reserves. Central banks were had to reduce their foreign exchange reserves. Central banks were unwilling to let reserves fall to low levers, in part because their unwilling to let reserves fall to low levers, in part because their ability to fix the exchange rate would be endangered.ability to fix the exchange rate would be endangered.

The restoration of convertibility in 1958 gradually began to The restoration of convertibility in 1958 gradually began to change the nature of policymakers’ external constraints.change the nature of policymakers’ external constraints.


Speculative Capital Flows and CrisesSpeculative Capital Flows and Crises Because of expectation of the overage fluctuation of the Because of expectation of the overage fluctuation of the

current account, the private capital flows. This affects current account, the private capital flows. This affects the foreign reserve and affects the internal and external the foreign reserve and affects the internal and external balances.balances.

Current account deficitsCurrent account deficits→→expectation of devaluation expectation of devaluation → → people people

want to change local currency to foreign currency want to change local currency to foreign currency → → in order to in order to

keeping the fixed exchange rate the central bank has to sale the keeping the fixed exchange rate the central bank has to sale the

foreign currency and buy the local currency foreign currency and buy the local currency → → the decline of the the decline of the

foreign reserve amount foreign reserve amount → → if the foreign reserve decreases to a if the foreign reserve decreases to a

certain level certain level → → this country can not maintain the fixed exchange this country can not maintain the fixed exchange

rate rate → → the devaluation of the local currency.the devaluation of the local currency.

Currency account surplus→ expectation of revaluation→people Currency account surplus→ expectation of revaluation→people

want to change foreign currency to local currency→in order to want to change foreign currency to local currency→in order to

keeping the fixed exchange rate the central bank has to sale the keeping the fixed exchange rate the central bank has to sale the

local currency and buy the foreign currency→the increasing of the local currency and buy the foreign currency→the increasing of the

foreign reserve amount→the money supply increases→the local foreign reserve amount→the money supply increases→the local

price level increases→this destroys the internal balance. price level increases→this destroys the internal balance.

Speculative Capital Flows and Crises

ANALYING POLICY OPTIONS UNDER THE BRETTON WOODS SYSTEM

Maintaining Internal BalanceMaintaining Internal Balance Both Both PP**and and E E are permanently fixed. The condition of are permanently fixed. The condition of

internal balance isinternal balance is

YYff=C(Y=C(Yff -T)+I+G+CA(EP -T)+I+G+CA(EP**/P, Y/P, Yff -T) -T)

YYff: : output at its full employment output at its full employment C: C: consumptionconsumption I: I:

investmentinvestment G: G: government purchasegovernment purchase

CA: CA: current accouncurrent account EPt EP**/P: /P: the real exchange ratethe real exchange rate

Maintaining Internal Balance

The The ⅡⅡschedule in figure 1 schedule in figure 1

shows combinations of shows combinations of

exchange rates and fiscal exchange rates and fiscal

policy that hold output policy that hold output

constant at constant at YYff and thus and thus

maintain internal balance.maintain internal balance.

The schedule is downward-The schedule is downward-

sloping because currency sloping because currency

devaluation (a rise in devaluation (a rise in EE ) and ) and

fiscal expansion (a rise in fiscal expansion (a rise in GG

or a fall in or a fall in TT) both tend to ) both tend to

rise output.rise output.

Overemploymentexcessive

Exchange rateE

Underemploymentexcessive

ⅡFigure1

Fiscal ease(G or T )

Figure1

Maintaining External Balance

The condition of The condition of external balance isexternal balance is

CA(EPCA(EP**/P, Y/P, Yff -T)=X -T)=X Figure 2 shows that the Figure 2 shows that the

XXXX schedule, along schedule, along which external balance which external balance holds, is positively holds, is positively sloped. The sloped. The XXXX schedule shows how schedule shows how much fiscal expansion much fiscal expansion is hold the current is hold the current account surplus at account surplus at XX as as the currency is devalued the currency is devalued by a given amount. by a given amount.

XX

Current accountdeficit

Current accountsurplus

Figure2

Exchange rateE


Internal Balance (II), External Balance (XX), and the “Four Zones of Economic Discomfort”

The diagram shows The diagram shows

what different levels what different levels

of the exchange rate of the exchange rate

and fiscal ease imply and fiscal ease imply

for employment and for employment and

the current account. the current account.

AlongAlongⅡⅡ,output is at ,output is at

its full-employment its full-employment

level,level, Y Yff. Along. Along XX XX, ,

the current account is the current account is

at its target level,at its target level, X X..

Underemploymentexcessive currentaccount surplus

Overemploymentexcessive currentaccount deficit

Exchange rateE


Overemploymentexcessive currentaccount surplus

Overemploymentexcessive currentaccount deficit

XX

Ⅱ

Figue3

Expenditure-Changing and Expenditure-Switching Policies

The expenditure-changing policy is the policy The expenditure-changing policy is the policy

which can alters the level of the economy’s total which can alters the level of the economy’s total

demand for goods and services.demand for goods and services.

The expenditure-switching policy is the policy The expenditure-switching policy is the policy

which can change the direction of demand, which can change the direction of demand,

shifting it between domestic output and import.shifting it between domestic output and import.


Fiscal ease(G or T)

Exchangerate, E

XX

II

1

3

Devaluation that results in internal and external balance 2

4

The expenditure-changing policy is the policy which can alters the level of the economy’s total demand for goods and services.

The expenditure-switching policy is the policy which can change the direction of demand, shifting it between domestic output and import.


Unless the currency is Unless the currency is devalued and the devalued and the degree of fiscal ease degree of fiscal ease increased, internal and increased, internal and external balance (point external balance (point 1) can not be reached. 1) can not be reached. Acting alone, fiscal Acting alone, fiscal policy can attain either policy can attain either internal balance (point internal balance (point 3) or external balance 3) or external balance (point 4), but only at (point 4), but only at the cost of increasing the cost of increasing the economy’s distance the economy’s distance from the goal that is from the goal that is sacrificed.sacrificed.

1

24

3

Exchange rateE


XX

Ⅱ

Figure4

Devaluationthat resultin internal

and externalbalance

Fiscal expansion thatresults in internal and

external balance

THE EXTERNAL BALANCE PROBLEM OF THE UNITED STATES

Triffin dilemma:Triffin dilemma: After World War the foreign countries need a lot ⅡAfter World War the foreign countries need a lot Ⅱ

of money to developing their domestic economy. The of money to developing their domestic economy. The central banks’ international reserve needs grew over central banks’ international reserve needs grew over time, their holdings of dollars would necessarily time, their holdings of dollars would necessarily redeem these dollars at $35 an ounce, it would no redeem these dollars at $35 an ounce, it would no longer have the ability to meet its obligations should longer have the ability to meet its obligations should all dollar holder simultaneously try to convert their all dollar holder simultaneously try to convert their dollars into gold. This would lead to a confidence dollars into gold. This would lead to a confidence problem: central bank, knowing that their dollars problem: central bank, knowing that their dollars were no longer “as good as gold ”, might become were no longer “as good as gold ”, might become unwilling to accumulate more dollars and might even unwilling to accumulate more dollars and might even bring down the system by attempting to cash in the bring down the system by attempting to cash in the dollars they already held.dollars they already held.

Possible solution:Possible solution:

One possible solution at the time was an increase in One possible solution at the time was an increase in

the official price of gold in terms of the dollar and the official price of gold in terms of the dollar and

all other currencies. But this possibly worsening all other currencies. But this possibly worsening

the confidence problem rather than solving it.the confidence problem rather than solving it.

Another is setting up the IMF which issues its own Another is setting up the IMF which issues its own

currency (SDRS), which central banks would holds currency (SDRS), which central banks would holds

as international reserves in place of dollars. as international reserves in place of dollars.

THE EXTERNAL BALANCE PROBLEM OF THE UNITED STATES

WORLDWIDE INFLATION AND THE TRANSITION TO FLOATING RATES

This part mainly talks about the American inflation flowing to the other countries. This part mainly talks about the American inflation flowing to the other countries. And facing the inflation how other countries choose the policy to solve this problem.And facing the inflation how other countries choose the policy to solve this problem.

The acceleration of American inflation in the late 1960’s was a worldwide The acceleration of American inflation in the late 1960’s was a worldwide phenomenon.phenomenon.

It had also speeded up in European economies.It had also speeded up in European economies. When the reserve currency country speeds up its monetary growth, one effect is an When the reserve currency country speeds up its monetary growth, one effect is an

automatic increase in monetary growth rates and inflation abroad.automatic increase in monetary growth rates and inflation abroad. U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the

Bretton Woods system by early 1973.Bretton Woods system by early 1973.

The process of import inflation:The process of import inflation:


American inflation increases

American domestic price level rise

the demand of the foreign commodity

will increases

when the price level is higher than the other

countries’the import will increase

the other countries’ domestic amount of

commodity will decrease

the demand of commodity will

increase

the price level will rise in the other countries

the inflation will spread from

America to other countries

Exchange rateE XX1

XX2

Ⅱ2

Ⅱ1 2

1


Distance=

EΔP*/ P*

Figure 5


The other countries’ governments have two choices:The other countries’ governments have two choices: If nothing is done by the government, overemployment If nothing is done by the government, overemployment

puts upward pressure on the domestic price level, and puts upward pressure on the domestic price level, and this pressure gradually shifts the two schedules back to this pressure gradually shifts the two schedules back to their original positions. The schedules stop shifting their original positions. The schedules stop shifting onceonce P P has risen in proportion to has risen in proportion to PP**. At this stage the . At this stage the real exchange rate, employment, and the current real exchange rate, employment, and the current account are at their initial levels, so point 1 is once account are at their initial levels, so point 1 is once again a position internal and external balance.again a position internal and external balance.


The way to avoid the imported inflation is to revalue the currency The way to avoid the imported inflation is to revalue the currency (that is ,lower (that is ,lower EE) and move to point 2. A revaluation restores ) and move to point 2. A revaluation restores internal and external balance immediately, without domestic internal and external balance immediately, without domestic inflation, by using the nominal exchange rate to offset the effect inflation, by using the nominal exchange rate to offset the effect of the rise in of the rise in PP** on the real exchange rate .only an expenditure- on the real exchange rate .only an expenditure-switching policy is needed to respond to a pure increase in foreign switching policy is needed to respond to a pure increase in foreign prices.prices.

In order to maintain the internal balance the government chooses In order to maintain the internal balance the government chooses the last policy to remove the effect of importing inflation. And the the last policy to remove the effect of importing inflation. And the exchange rate begins to float. So at this situation the fixed exchange rate begins to float. So at this situation the fixed exchanged rate system is hard to maintain. And then the fixed exchanged rate system is hard to maintain. And then the fixed exchanged rate system transforms to the floating exchanged rate exchanged rate system transforms to the floating exchanged rate system.system.


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Chapter 7 THE INTERNATIONAL MONETORY SYSTEM 1870-1973.

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