Transcript Document

Chapter 18
THE INTERNATIONAL
MONETORY SYSTEM
1870-1973
THE INTERNATIONAL MONETORY
SYSTEM 1870-1973

The interdependence of open national economies
has made it more difficult for governments to
achieve full employment and price stability.
The channels of interdependence depend on the
monetary and exchange rate arrangements.
This chapter examines the evolution of the
international monetary system and how it
influenced macroeconomic policy.


THE INTERNATIONAL
MONETORY SYSTEM 1870-1973

This chapter examines how the international
monetary system influenced macroeconomic
policy-making and performance during three
period:
 The interwar period (1918-1939)
 The gold standard era(1870-1914)
 The post-World War II years (1946-1973)
THE INTERNATIONAL MONETORY
SYSTEM 1870-1973
Gold Standard
era
1870
Interwar
Years
1914 1918
Under the Bretton
Woods System
1939 1946
1973
Macroeconomic Policy Goals In an
Open Economy

Internal Balance:Full Employment and
Price-Level Stability
When a country’s productive resources are fully employed
and its price level is stable,the country is in internal
balance.

External Balance:The Optimal Level of the
Current Account
Because of the existence of intertemporal trade,it’s difficult
to make a exact current account balance.So the external
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
employed and there is price level stability.

Under-and over-employment lead to price level
movements that reduce the economy’s efficiency.

One particularly disruptive effect of an unstable price level
is its effect on the real value of loan contracts.

To avoid price-level instability, the government must:

Prevent substantial movements in aggregate demand relative to
its full-employment level.

Ensure that the domestic money supply does not grow too quickly
or too slowly.
External Balance: The Optimal Level of
the Current Account

External balance has no full employment or stable
prices to apply to an economy’s external transactions.

An economy’s trade can cause macroeconomic
problems depending on several factors:

The economy’s particular circumstances

Conditions in the outside world

The institutional arrangements governing its
economic relations with foreign countries
Macroeconomic Policy Goals In an Open
Economy

Problems with Excessive Current Account
Deficits.
A large CA deficit can undermine foreign investors’
confidence and contribute to a lending crisis.

Problems with Excessive Current Account
Surpluses
The total domestic saving ,S, is divided between foreign
asset accumulation,CA,and domestic investment I, S=CA
+I . So for a given level of national saving,an increased
CA surplus implies lower investment in domestic plant
and equipment. (S , CA , I )
International Macroeconomic Policy
Under the Gold Standard 1870-1914

Origins of the Gold Standard
The Gold Standard had its origin in the use of gold
coins as a medium of exchange,unit of account and
store of value .

External Balance Under the Gold
Standard
A situation in which the central bank was neither
gaining gold from abroad nor losing gold to
foreigners at too rapid a rate.


The Price-Specie-Flow Mechanism
Internal Balance Under the Gold Standard
The The Price-Specie-Flow Mechanism

David Hume ,the Scottish philosopher, in 1752
described the The Price-Specie-Flow
Mechanismas follows:
Ms
P
National price
level
P*
export
import
CA
Foreign price
level
It is to say that in the Gold Standard era the economy can
achieve balance automatically.
The The Price-Specie-Flow Mechanism

The price-specie-flow mechanism described by David
Hume shows how the gold standard could ensure
convergence to external balance. This model is based
upon three equations:

The balance sheet of the central bank. At the most simple level, this
is just gold holdings equals the money supply: G = M.

The quantity theory. With velocity and output assumed constant and
both normalized to 1, this yields the simple equation M = P.

A balance of payments equation where the current account is a
function of the real exchange rate and there are no private capital
flows: CA = f(E·P*/P)
The The Price-Specie-Flow Mechanism
These
equations can be combined in a figure like the
one below.




The 45 line represents the quantity theory and the
vertical line is the price level where the real
exchange rate results in a balanced current
account.
M
CA=0
M=P
The economy moves along the 45 line back
towards the equilibrium point 0 whenever it is out
of equilibrium.
For example, the loss of four-fifths of a country's
gold would put that country at point a with lower
prices and a lower money supply.
The resulting real exchange rate depreciation
causes a current account surplus which restores
money balances as the country proceeds up the
45 line from a to 0.
0
a
P
International Macroeconomic Policy Under
the Gold Standard 1870-1914

The Gold Standard “Rules of the Game”: Myth and
Reality


The practices of selling (or buying) domestic assets in the face
of a deficit (or surplus).
 The efficiency of the automatic adjustment processes inherent
in the gold standard increased by these rules.
 In practice, there was little incentive for countries with
expanding gold reserves to follow these rules.
 Countries often reversed the rules and sterilized gold flows.
Internal Balance Under the Gold Standard

The gold standard system’s performance in maintaining
internal balance was mixed.
 Example: The U.S. unemployment rate averaged 6.8% between
1890 and 1913, but it averaged under 5.7% between 1946 and
1992.
THE INTERWAR YEARS 1918-1939

With the eruption of WWI in 1914, the gold standard
was suspended.



The interwar years were marked by severe economic instability.
The reparation payments led to episodes of hyperinflation in
Europe.
The German Hyperinflation

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
481.5 billion).
THE INTERWAR YEARS 1918-1939

The Fleeting Return to Gold






1919 U.S. returned to gold
1922 A group of countries (Britain, France, Italy, and Japan) agreed on a
program calling for a general return to the gold standard and cooperation
among central banks in attaining external and internal objectives.
1925 Britain returned to the gold standard
1929 The Great Depression was followed by bank failures throughout the
world.
1931 Britain was forced off gold when foreign holders of pounds lost
confidence in Britain’s commitment to maintain its currency’s value.
International Economic disintegration

Governments effectively suspended the gold standard during world War I
and financed part of their massive military expenditures by printing money.
As a result,price levels were higher everywhere .
THE BRETTON WOODS SYSTEM
AND THE IMF


The system set up by Bretton Woods agreement,
it’s a gold exchange standard with the dollar as
its principal reserve currency .
Goals and Structure of the IMF



The exchange rates be fixed to the $,which in turn,was tied to
gold.
The IMF agreement tries to incorporate sufficient flexibility :
 IMF lending facilities ;
 adjustable parities.
Convertibility

General inconvertibility would make international trade
extremely difficult,the IMF Articles of Agreement urged
members to make their national currencies convertible as soon as
possible.
INTERNAL AND EXTERNAL BALANCE
UNDER THE BRETTON WOODS SYSTEM

As the world economy evolved in the years after
World War Ⅱ,the meaning of “external
balance ”changed and conflicts between internal
goals increasingly threatened the fixed exchanged
rate system. The special external balance problem
of the United States, the issuer of the principal
reserve currency, was a major concern that led to
proposals to reform the system.
INTERNAL AND EXTERNAL BALANCE
UNDER THE BRETTON WOODS
SYSTEM

The Changing Meaning of External Balance



In the first decade of the Bretton Woods system, many countries ran
current account deficits as they reconstructed their war-torn
economies. Since the main external problem of these countries,
taken as a group, was to acquire enough dollars to finance
necessary purchase from the United States, these years are often
called the period of “dollar shortage”.
Each country ’s overall current account deficit was limited by the
difficulty of borrowing any foreign currencies in an environment of
heavily restricted capital account transactions. So these countries
had to reduce their foreign exchange reserves. Central banks were
unwilling to let reserves fall to low levers, in part because their
ability to fix the exchange rate would be endangered.
The restoration of convertibility in 1958 gradually began to change
the nature of policymakers’ external constraints.
INTERNAL AND EXTERNAL BALANCE
UNDER THE BRETTON WOODS
SYSTEM

Speculative Capital Flows and Crises

Because of expectation of the overage fluctuation of the
current account, the private capital flows. This affects
the foreign reserve and affects the internal and external
balances.
Speculative Capital Flows and Crises


Current account deficits→expectation of devaluation → people
want to change local currency to foreign currency → in order to
keeping the fixed exchange rate the central bank has to sale the
foreign currency and buy the local currency → the decline of the
foreign reserve amount → if the foreign reserve decreases to a
certain level → this country can not maintain the fixed exchange
rate → the devaluation of the local currency.
Currency account surplus→ expectation of revaluation→people
want to change foreign currency to local currency→in order to
keeping the fixed exchange rate the central bank has to sale the
local currency and buy the foreign currency→the increasing of the
foreign reserve amount→the money supply increases→the local
price level increases→this destroys the internal balance.
ANALYING POLICY OPTIONS UNDER
THE BRETTON WOODS SYSTEM

Maintaining Internal Balance

Both P*and E are permanently fixed. The condition of
internal balance is

Yf=C(Yf -T)+I+G+CA(EP*/P, Yf -T)

Yf: output at its full employment C: consumption I:
investment G: government purchase

CA: current account EP*/P: the real exchange rate
Maintaining Internal Balance


The Ⅱschedule in figure 1 Exchange rate
E
shows
combinations
of
exchange rates and fiscal
policy that hold output
constant at Yf and thus
maintain internal balance.
The schedule is downwardsloping because currency
devaluation (a rise in E ) and
fiscal expansion (a rise in G
or a fall in T) both tend to rise
output.
Overemployment
excessive
Underemployment
excessive
Figure1
Figure1
Ⅱ
Fiscal ease
(G or T )
Maintaining External Balance


The
condition
of Exchange rate
E
external balance is
XX
CA(EP*/P, Yf -T)=X
Figure 2 shows that the
Current account
XX schedule, along
surplus
which external balance
holds, is positively
sloped.
The
XX
schedule shows how
Current account
much fiscal expansion is
deficit
hold the current account
surplus at X as the
currency is devalued by
a given amount.
Figure2
Fiscal ease
(G or T )
Internal Balance (II), External Balance (XX), and
the “Four Zones of Economic Discomfort”

The diagram shows
what different levels
of the exchange rate
and fiscal ease imply
for employment and
the current account.
AlongⅡ,output is at
its full-employment
level, Yf. Along XX,
the current account is
at its target level, X.
Exchange rate
E
Overemployment
excessive current
account surplus
Underemployment
excessive current
account surplus
Overemployment
excessive current
account deficit
Overemployment
excessive current
account deficit
Figue3
XX
Ⅱ
Fiscal ease
(G or T )
Expenditure-Changing and
Expenditure-Switching Policies

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.
Expenditure-Changing and ExpenditureSwitching Policies
Exchange
rate, E
XX
Devaluation
that results
in internal
and external
balance
The expenditure-changing
policy is the policy which
can alters the level of the
economy’s total demand
for goods and services.
1
4
3
2
II
The expenditure-switching
policy is the policy which
can change the direction of
demand, shifting it between
domestic output and
import.
Fiscal ease
(G or T)
Expenditure-Changing and ExpenditureSwitching Policies
Unless the currency is
devalued and the
degree of fiscal ease
increased, internal and
external balance (point
1) can not be reached.
Acting alone, fiscal
policy can attain either
internal balance (point
3) or external balance
(point 4), but only at
the cost of increasing
the economy’s distance
from the goal that is
sacrificed.
Exchange rate
E
XX
1
Devaluation
that result
in internal
and external
balance
3
4
Figure4
2
Ⅱ
Fiscal expansion that Fiscal ease
results in internal and (G or T )
external balance
THE EXTERNAL BALANCE PROBLEM
OF THE UNITED STATES

Triffin dilemma:
 After World War Ⅱ the foreign countries need a lot
of money to developing their domestic economy. The
central banks’ international reserve needs grew over
time, their holdings of dollars would necessarily
redeem these dollars at $35 an ounce, it would no
longer have the ability to meet its obligations should
all dollar holder simultaneously try to convert their
dollars into gold. This would lead to a confidence
problem: central bank, knowing that their dollars
were no longer “as good as gold ”, might become
unwilling to accumulate more dollars and might even
bring down the system by attempting to cash in the
dollars they already held.
THE EXTERNAL BALANCE PROBLEM
OF THE UNITED STATES

Possible solution:

One possible solution at the time was an increase in
the official price of gold in terms of the dollar and
all other currencies. But this possibly worsening the
confidence problem rather than solving it.

Another is setting up the IMF which issues its own
currency (SDRS), which central banks would holds
as international reserves in place of dollars.
WORLDWIDE INFLATION AND THE
TRANSITION TO FLOATING RATES

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.

The acceleration of American inflation in the late 1960’s was a worldwide
phenomenon.
 It had also speeded up in European economies.

When the reserve currency country speeds up its monetary growth, one effect is an
automatic increase in monetary growth rates and inflation abroad.

U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the
Bretton Woods system by early 1973.
WORLDWIDE INFLATION AND THE
TRANSITION TO FLOATING RATES

The process of import inflation:
American inflation
increases
the inflation will
spread from
America to other
countries
the price level
will rise in the
other countries
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 demand of
commodity will
increase
the other countries’
domestic amount of
commodity will
decrease
WORLDWIDE INFLATION AND THE
TRANSITION TO FLOATING RATES
Exchange rate
E
XX1
1
XX2
Distance=
EΔP*/ P*
2
Ⅱ1
Ⅱ2
Figure 5
Fiscal ease
(G or T )
WORLDWIDE INFLATION AND THE
TRANSITION TO FLOATING RATES
 The other countries’ governments have two choices:
 If nothing is done by the government, overemployment
puts upward pressure on the domestic price level, and
this pressure gradually shifts the two schedules back to
their original positions. The schedules stop shifting
once P has risen in proportion to P*. At this stage the
real exchange rate, employment, and the current
account are at their initial levels, so point 1 is once
again a position internal and external balance.
WORLDWIDE INFLATION AND THE
TRANSITION TO FLOATING RATES

The way to avoid the imported inflation is to revalue the currency
(that is ,lower E) and move to point 2. A revaluation restores
internal and external balance immediately, without domestic
inflation, by using the nominal exchange rate to offset the effect of
the rise in P* on the real exchange rate .only an expenditureswitching policy is needed to respond to a pure increase in foreign
prices.

In order to maintain the internal balance the government chooses
the last policy to remove the effect of importing inflation. And the
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 transforms to the floating exchanged rate
system.
Question
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