International Monetary Arrangements

1
International Monetary Arrangements
2
Introduction

• What were the various international monetary
  system that existed from late 1800s to the
  present?
• How did adjustments to external balances occur
  under these systems?
• What are the discussions around international
  monetary reform?

3
The Gold Standard

• Operated from 1870 to 1914
• Each country defined the gold content of its
  currency
• Could exchange a piece of paper for gold
• Primary function of central bank was to preserve
  parity between currency and gold by buying or
  selling gold at official parity price
• Price of each currency in terms of gold

4
The Gold Standard

• Since each currency was known and fixed, exchange
  rates between countries were also fixed
• Little to no inflation
• Fixed exchange rates gave significant security to
  overseas business
• Some costs also associated with gold standard

5
Gold Standard Monetary Policy

• Countrys monetary base consisted of gold or
  currency backed by gold
• Any balance of payments imbalance at current
  fixed exchange rate would set into motion a
  correction process to correct the imbalance

6
Gold Standard Monetary Policy

• Balance of payments deficit
• Rest of world accumulates more dollars than
  desired
• Gold outflows from US to rest of world
• Occurred automatically as dollars become cheaper
  in foreign exchange market
• Traders could make small profit purchasing gold
  at fixed price with cheaper dollars
• Exchange rate would be stable in short run

7
Gold Standard Monetary Policy

• Long run would not hold without other adjustments
• Outflow of gold causes monetary base to fall or
  grow at slower rate
• Change in money supply would affect interest rate
  and aggregate demand to correct balance of
  payments deficit
• Opposite is also true (inflow of gold)

8
Gold Standard Monetary Policy

• Under current system
• Contractionary money decrease in money supplys
  growth rate
• Expansionary money increase in money supplys
  growth rate
• Under gold standard
• Would actually have a decrease or increase in
  money supply
• Makes domestic economic relatively unstable
• But, fixed exchange rate and long run stable
  prices

9
Macroeconomics Gold Standard

• Assume economy is expanding
• Higher income in domestic economy leading to
  increased level of imports
• Higher domestic prices make imports relatively
  cheaper
• Balance of payments deficit at current fixed
  exchange rate
• Demand for foreign exchange increases causing
  gold to flow out of country (A to B)

10
Foreign Exchange Market
11
Macroeconomics Gold Standard

• Gold outflow causes countrys money supply to
  decrease
• Consumption and investment decline as interest
  rates increase
• Aggregate demand decreases
• Output and price level fall
• Recession in domestic economy in order to bring
  external balance back into balance at the fixed
  exchange rate

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Domestic Economy
13
Macroeconomics Gold Standard

• Decrease in consumption spending leads to
  decrease in imports
• Domestic goods become relatively cheaper
• Exports increase
• Balance of payments improves
• Outflows of gold decline (eventually to zero)
• Money supply stabilized (stops falling) at lower
  level
• Domestic economy completes automatic adjustment

14
Gold Standard Costs Benefits

• Benefits
• Adjustment of price level and output to an
  external imbalance is completely automatic
• Country only needs to be willing to buy and sell
  gold at stated price
• No question what would happen if experience an
  external imbalance

15
Gold Standard Costs Benefits

• Benefits
• Long run price stability for economy
• Average inflation rate for US during gold
  standard was 0.1 percent
• Costs
• Does not guarantee short run price stability
• Could have inflation some years and deflation
  others
• Could vary significantly from year to year
• Deflation as common as inflation

16
Gold Standard Costs Benefits

• Costs
• Overall balance of payments position heavily
  influences countrys money supply
• Balance of payments deficit means contracting
  money and contracting economy
• Balance of payments surplus means overheated
  economy with inflation
• With completely fixed exchange rates came
  extremely unstable GDP growth rate

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Bretton Woods System

• After gold standard ended, exchange rates were
  extremely unstable
• Desire for some form of international monetary
  system was desirable
• Conference in Bretton Woods, NH
• 44 countries met to create a new international
  monetary system
• Press referred to it as the Bretton Woods System

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Bretton Woods System

• Gold Exchange Standard
• US dollar tied to gold but all other foreign
  currencies tied to dollar
• Countries agreed to creation of International
  Monetary Fund (IMF)
• International monetary institution

19
Bretton Woods System

• Purpose
• Countries strong desire for a monetary system
  with fixed exchange rates
• Design a method to decouple the link between
  balance of payments and money supply
• Necessary to link currencies to something other
  than gold

20
Bretton Woods System

• Solutions
• Price of gold fixed at 35
• US to maintain fixed price
• US would exchange dollars for gold at stated
  price without limitation or restrictions
• Other currencies fixed to US dollar
• Meant other currencies fixed in relation to one
  another
• No longer necessary to sacrifice internal balance
  to maintain external balance

21
Bretton Woods System

• Faults
• Logically impossible to have balanced balance of
  payments in both short and long run
• Long run balancing important for sustaining
  monetary system
• Government had to actively intervene in the
  foreign exchange market
• Governments would have to buy or sell domestic or
  foreign currency to keep domestic currency from
  appreciating or depreciating

22
Bretton Woods System

• Example
• Country in a recession with balance of payments
  deficit
• Policies to obtain external and internal balances
  did not match
• Internal balance requires expansionary monetary
  or fiscal policy
• Would make external deficit worse

23
Bretton Woods System

• Example (cont.)
• Government might choose to fight recession and
  sell accumulated foreign exchange to keep
  exchange rate fixed
• Once domestic economy recovers, can reestablish
  external balance
• Only if country had sufficient international
  reserves could it deal with internal balance
  ignoring external balances in short run

24
Bretton Woods System

• Example (cont.)
• If country kept pursuing policies that were
  inconsistent with external and internal balances,
  country might have no choice but to devalue
  currency
• In this occurred in many countries, then no
  longer have a fixed exchange rate
• Need mechanism to encourage countries to maintain
  policies producing external balance and stable
  exchange rates
• Mechanism unclear in Bretton Woods system

25
International Monetary Fund

• They were to oversee the reconstruction of the
  worlds international payments system
• Also allowed for creation of a pool of reserved
  from which funds could be drawn by countries with
  temporary payments imbalances

26
International Monetary Fund

• Pool of funds
• Each country in IMF assigned a quota of money to
  contribute to pool
• One quarter of quota in gold, the rest in that
  countrys currency
• A country could borrow up to ¼ of its quota at
  anytime without restrictions
• A country trying to borrow more came with
  restrictions

27
International Monetary Fund

• IMF restricted borrowing government to pursue
  monetary and fiscal policies consistent with long
  run external balance
• Most borrowing counties carried external deficits
  so required tighter policies
• Once own reserves were used, country was limited
  on pursuing inconsistent policies
• IMF loans are short term to be paid back in three
  to five years

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International Monetary Fund

• Loans from IMF to countries have problems
• If country has serious imbalances, may be
  difficult to correct in short run
• Policies to correct imbalances may lead to short
  run economic contraction
• Cost of lost output may be high
• IMF often involved in solution to country not
  performing well IMF not popular

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Demise of Bretton Woods

• Problems developed with Bretton Woods
• Not symmetrical
• A country with balance of payment deficit must
  follow policies to fix problem or no new loans
• A country with balance of payments surpluses
  could not be dealt with
• Could not force country to pursue policies to
  correct surpluses

30
Demise of Bretton Woods

• Problems developed with Bretton Woods
• All currencies fixed to dollar, but US developed
  persistent balance of payments deficits
• Foreign banks increased holding of dollars
• Surplus countries had to sell domestic currency
  for dollars to keep domestic currency from
  appreciating
• Foreign central banks holding amount of dollars
  larger than US stock of gold at 35/ounce

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Demise of Bretton Woods

• End of Bretton Woods
• US faced with choices
• Change macroeconomic policies to reduce or
  eliminate external deficit
• Have foreign central banks demand gold in
  exchange for dollars held
• Devalue dollar and let it float against gold and
  other currencies
• US chose to devalue dollar ending system

32
Post Bretton Woods Era

• Two options since breakup of Bretton Woods
• Clean float government essentially leaves
  exchange rate alone and lets market determine
  value of currency
• Fix or peg exchange rate to the currency of
  another country or group of countries

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Clean Floats

• Decide internal balances are more important than
  external balances
• Set monetary and fiscal policy to achieve
  acceptable levels of economic growth and
  inflation
• Resulting mix determines current and capital
  account balances
• Monetary policy is very effective and fiscal
  policy is less so
• Leads to exchange rate value inconsistent with PPP

34
Clean Floats

• Macroeconomic policy mix could lead to real
  appreciation of currency where the economy is
  doing well
• Might cause significant hardship of tradable
  goods portion of economy
• Exporters could lose business because of
  overvaluation of exchange rate

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Clean Floats

• Policy mix could lead to depreciated exchange
  rate
• Could lead to boom in tradable goods sectors
• Imports become more expensive
• Countrys goods become cheaper so exports rise
• If at full employment, resources need to come
  from somewhere

36
Clean Floats

• Policy mix could lead to depreciated exchange
  rate (cont.)
• Prices and output increase
• Can lead to decreasing prices in non-tradable
  goods sector
• Letting exchange rate find its own level maybe
  optimal, but not costless
• Tradeoff is overall internal balance versus
  potential hardship for certain parts of the
  economy

37
Pegging the Exchange Rate

• If international trade is significant portion of
  GDP, then ignoring external balances may not be
  optimal
• Country may wish to peg exchange rate
• Country sets value of nominal exchange rate
  against another countrys
• Likely to choose a country with whom it trades a
  significant amount and/or has large cross border
  financial flows

38
Pegging the Exchange Rate

• If the pegged rate is credible, it creates
  security for investors and traders
• However, if currency it is pegged against is
  floating, then that currency is still changing
• Value against other currencies changes as the
  other countrys exchange rate changes

39
Pegging the Exchange Rate

• Example Mexico wishes to peg peso to US dollar
• In long run, Mexicos inflation rate must match
  that of the US
• Mexico must keep domestic real interest rates
  similar to those of US to keep capital from
  flowing between the countries
• Mexico cannot use policies to target internal
  balance

40
Pegging the Exchange Rate

• Example Mexico wishes to peg peso to US dollar
  (cont.)
• If conditions in Mexico are similar to US then
  fairly costless.
• If conditions in Mexico are different from US,
  must choose to focus on external or internal (no
  peg) balance
• Price of pegging currency is willingness to
  sometimes sacrifice internal balance to keep
  fixed exchange rate

41
Pegging the Exchange Rate

• Internal versus external balance choice may be
  partially avoided
• Fix exchange rate in real terms instead of
  nominal terms
• In long run real exchange rate is what matters
• Government could periodically change nominal rate
  based on changes in inflation between the
  countries
• Could peg real exchange rate and keep some
  control over macroeconomic policies

42
Pegging the Exchange Rate

• Fix exchange rate in real terms instead of
  nominal terms (cont.)
• Still uncertainty in nominal rate
• Governments may target a rate of devaluation to
  keep it somewhat constant
• Still requires some changes in nominal rates
• Domestic policy may diverge from other country
  causing inflation rates to diverge
• Generally more certain that free float

43
Pegging the Exchange Rate

• Internal versus external balance choice may be
  partially avoided
• Fix countrys currency to basket of currencies
• If depreciates against one currency in basket, my
  appreciate against another
• Long run may be more stable than fixing to one
  currency

44
Pegging the Exchange Rate

• Fix countrys currency to basket of currencies
  (cont.)
• Problems
• Construction of basket is not clear how many
  currencies, which currencies, etc.
• Should government tell which currencies are in
  the basket?
• More difficult for private markets to handle
• Traders exposed to more risk than fixed rate

45
Options for Monetary Reform

• Current System Problems
• Businesses dislike floating exchange rates since
  volatility increases risk
• Can choose between taking risk or protection
  through hedging neither of which are costless
• Current system forces businesses to implicitly
  forecast exchange rates

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Options for Monetary Reform

• Current System Problems
• Floating exchange rates impose externality of
  world economy
• Varying exchange rates make international trade
  and investment riskier
• Higher risk and higher costs lead to less of that
  activity
• Lower total volume of trade and investment with
  volatile exchange rates

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Options for Monetary Reform

• Current System Problems
• Governments have similar views as business
• Overvalued currency can hurt tradable goods
  sector
• Undervalued currency can create a boom that
  cannot be sustained
• Collapse in currency can cause microeconomic
  crisis

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Options for Monetary Reform

• Why not change the system?
• Note figure 18.3
• Horizontal axis shows level of cooperation in
  international system
• Left set own policies for internal balance
• Right complete cooperation
• Vertical axis shows degree of rules in system
• Top rigid rules
• Bottom much discretion (no agreed upon rules)

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Exchange Rate Map (Fig. 18.1)
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Exchange Rate Map

• Gold Standard
• Rigid rules since each country defined currency
  in terms of gold
• Significant discretion no need to coordinate
  policies
• Took monetary policy out of government control
• Other trade policies could be freely set

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Exchange Rate Map

• Bretton Woods System
• More rules but less rigid than gold standard
• Obligations with IMF
• Required more cooperation
• Countries with imbalances had to fix them
• Fixing imbalances often required working with
  other countries

52
Exchange Rate Map

• Current System
• No rules
• Each country can pursue their own choices of
  policies
• Countries are free to target internal balances

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Exchange Rate Map

• Why no new system?
• Movement toward more stable exchange rates
  requires more rules and/or more cooperation
• Moving toward gold standard takes away monetary
  policy so unlikely
• Increasing cooperation in almost impossible if
  there are no rules
• Unlikely to move from current system