Title: Chapter 14 The Evolution of the International Financial System
1Chapter 14The Evolution of the International
Financial System
2The Goals of This Chapter
- Present the history of the international
financial system that existed before todays
mixture of floating, fixed, and manipulated
exchange rates. - Use the historical examples to illustrate how the
trilemma was dealt with and how well each system
promoted human welfare. - Show why financial orders tend to change when
changing economic, social, and political
conditions cause policy makers to address the
trilemma differently. - Enable students to better judge the pros and
cons of the different financial orders.
3Time Line of International Financial Orders
4The Rules of the Game
- The set of rules and other formal and informal
incentives under which a financial system
operates is called an order. - An international monetary order is sometimes
referred to in the international finance
literature as the rules of the game, a term
reportedly coined by John Maynard Keynes. - A monetary order is to a monetary system somewhat
like a constitution is to a political system.
5Judging Past International Financial Systems
- 1. How fast did economies grow and raise
standards of living? - 2. How fast did international trade and
investment expand? - 3. How compatible was the order with sound
monetary policies and price stability? - 4. How well were outside economic shocks
dissipated and negative consequences to
employment and inflation avoided? - 5. How much flexibility did individual countries
have in setting policies aimed at specific
national economic objectives? - 6. How were the benefits and costs of operating
under the order spread across the different
countries that adhered to the system? - 7. Was the system was largely self-regulating or
did it require costly institutional guidance and
frequent policy adjustments by individual
countries?
6Report Card
- The textbook evaluates each international
financial order according to seven criteria. - A report card covering each of the criteria will
be used to summarize the conclusions, with a P
awarded for success and a Ðfor failures. - Sometimes it will be necessary to leave a grade
undetermined with a ? when conflicting evidence
makes it difficult to pass judgment. - Students are encouraged to reach their own
conclusions and apply their own evaluations.
- Economic growth
- Globalization
- Price stability
- Output stability
- Policy flexibility
- Mutually beneficial
- Self-regulating
7The Order of the Gold Standard
- Under the Gold Standard, the order effectively
followed by national government required that
they - Fix an official gold price or parity for the
national currency in terms of a fraction of an
ounce of pure gold - Permit the free conversion of gold into domestic
money and domestic money into gold at the parity
price in unlimited amounts and without question - Eliminate all restrictions on foreign exchange
transactions and allow the import and export of
gold.
8The Order of the Gold Standard
-
- A gold standard has a serious weakness, which is
that revenue-hungry governments are tempted to
issue more paper currency than they can back with
the gold stored in their vaults. - Suspicious holders of paper money could then
panic and start a run on gold, in which case
the government would have to suspend
convertibility of paper money into gold and
effectively leave the gold standard. - The Gold Standard was an order built on the faith
that paper money and bank accounts could always
be converted to pure gold at any time without
restrictions.
9The Order of the Gold Standard
- To enhance faith in the system, several other
rules of the game had to be respected by
governments - Back domestic coin and currency fully with gold
reserves, and link the growth of domestic money
to the availability of reserves. - Effectively allow the domestic price level to be
determined by the worldwide supply and demand for
gold. - If the central bank must serve as a lender of
last resort in the case of short-term credit
crises in the domestic banking sector, always
charge interest rates well above market.
10The Gold Standard and Exchange Rates
- Fixed gold parities, free convertibility, and
credible economic policies meant that exchange
rates remained fixed. - For example, the British government set the
pounds for gold parity rate at 4.24 pounds per
one ounce of gold, and the U.S. government set
its parity at the rate of 20.67 per ounce of
gold. - These two parities defined the exchange rate to
be 4.24 pounds per 20.67 dollars, or 1.00
4.87.
11(No Transcript)
12The Gold Standard and Exchange Rates
- The free export and import of gold was an
important rule of the game. - The potential movement of gold along with free
convertibility kept exchange rates within a
narrow band of the fixed exchange rate defined by
the cost of shipping gold (gold points).
13The Gold Standard and Exchange Rates
- For example, if the supply of foreign exchange
increases from S to S, without the gold standard
rules, e would fall to 4.00. - Demanders of dollars will not buy dollars at e
4.00 they will instead buy gold at the official
price of 4.24 per ounce, ship it to the U.S.,
and exchange it at 20.67 per ounce. - This effectively gives them 4.87 for every
pound, minus the expense of shipping the gold.
14Humes Specie-Flow Mechanism
- The specie flow mechanism and was first described
as far back as 1752 by David Hume, before the
establishment of the gold standard. - Humes reasoning was used to argue that the gold
standard was self-correcting. - If a trade deficit caused gold to flow out of a
country, its money supply would fall and prices
would decline, thus restoring international
competitiveness without changing the exchange
rate. - Similarly, a trade surplus would cause gold to
flow into the country, increasing the money
supply, and eventually reducing exports and
increasing imports.
15Report CardThe Gold Standard
- 1. Economic growth P
- 2. Globalization P
- 3. Price stability P
- 4. Output stability Ð
- 5. Policy flexibility Ð
- 6. Mutually beneficial ?
- 7. Self-regulating ?
16Figure 14.2The Trilemma and the Gold Standard
17Returning to the Gold Standard under Changed
Circumstances After World War I
- Inflation during the war years meant that
countries would have to deflate if they were to
return to the gold standard under the old gold
parities. - John Maynard Keynes argued that the tight
monetary policies required to restore the real
value of gold relative to the worlds money
supplies cost too much in terms of unemployment,
falling investment, and lost output. - He suggested that countries forget trying to
return to the gold standard under the old gold
parities and that they should set new parities
and simply seek to maintain price stability at
the higher price levels instead of trying to
deflate prices.
18Returning to the Gold Standard under Changed
Circumstances After World War I
- A strong case can be made that the deflationary
policies of the 1920s, driven by the desire to
return to the gold standard under the traditional
gold parities, caused the Great Depression. - According to Nobel-laureate Robert Mundell
- Had the price of gold been raised in the late
1920's, or, alternatively, had the major central
banks pursued policies of price stability
instead of adhering to the gold standard, there
would have been no Great Depression, no Nazi
revolution, and no World War II. - Policy makers would design a very different
financial order after World War II.
19Report CardThe Inter-War Period
- 1. Economic growth Ð
- 2. Globalization Ð
- 3. Price stability Ð
- 4. Output stability Ð
- 5. Policy flexibility Ð
- 6. Mutually beneficial Ð
- 7. Self-regulating Ð
20The Extraordinary Bretton Woods Conference
- In July of 1944, while the Second World War was
still raging, the economic policy makers from the
allied countries met in the U.S. to establish the
order that would guide the post-World War II
international system. - The motivation for the Bretton Woods Conference
was to reverse the trend toward economic
isolation and growth-retarding economic policies
during the inter-war years. - The purpose of the Bretton Woods conference was
to design a world economic order that would
minimize economic conflict, encourage sound
macroeconomic policies to generate growth and
employment in all economies, and restore the flow
of goods and investments between countries.
21The Bretton Woods Order
- 1. Countries other than the U.S. intervene in the
foreign exchange market to keep their exchange
rate within 1 of the dollar peg. - 2. The U.S. does not intervene in the foreign
exchange markets, but will convert dollars to
gold at 35/oz. for foreign central banks. - 3. The International Monetary Fund (IMF) serves
as the central bankers central bank, providing
liquidity to intervene in the foreign exchange
markets. - 4. Pegs should be adjusted in the exceptional
circumstances of a fundamental disequilibrium
otherwise adjust domestic monetary policies to
keep the exchange rate fixed. - 5. The U.S. and its large economy effectively
anchors the world price level with its monetary
policy. - 6. Currency should be freely convertible for
current account transactions.
22Devaluation? Depreciation?Whats the Difference?
- The term depreciation (appreciation) refers to a
decline (rise) in value of a currency relative to
other currencies under a regime of floating
exchange rates. - The term devaluation (revaluation) refers to an
intentional one-time lowering (raising) of the
fixed value of a currency under a fixed exchange
rate arrangement.
23Figure 14.7The Trilemma and the Bretton Woods
System
Early Bretton Woods 1944-1958
24Report Card Bretton Woods
- 1. Economic growth P
- 2. Globalization P
- 3. Price stability ?
- 4. Output stability ?
- 5. Policy flexibility Ð
- 6. Mutually beneficial ?
- 7. Self-regulating Ð
25Figure 14.8The Trilemma The Post-Bretton Woods
Float
26Report Card Post-1973 Floating Rates
- 1. Economic growth ?
- 2. Globalization P
- 3. Price stability Ð
- 4. Output stability Ð
- 5. Policy flexibility P
- 6. Mutually beneficial ?
- 7. Self-regulating P
27Figure 14.10The Real Effective Exchange Rate of
the U.S. Dollar 1973-2000
28Establishing a European Monetary Union
- At a meeting in Madrid in December of 1995, the
European Union, jus having expanded to 15
members, reconfirmed its intent to create a
single currency. - The new currency was to be called the euro and
denoted by the symbol i. - European governments agreed to a three-step
procedure for moving toward a single currency. - Most importantly, a set of specific economic
goals were set, and these goals would have to be
met by a country before it could become part of
the single currency area. - At the start of 2002, the euro became the
currency of Austria, Belgium, Finland, France,
Germany, Greece, Ireland, Italy, Luxemburg, the
Netherlands, Portugal, and Spain.
29The 5 Criteria for Joining the Euro
- 1. The currencys exchange rate must have
remained within a tight band for two years. - 2. Inflation must be less than 1.5 percent above
the average inflation rate of the three European
countries with the lowest inflation. - 3. Interest rates on openly-traded government
bonds must be less than 2 percentage points above
the average rates for the three European
countries with the lowest rates. - 4. The government budget deficit must be less
than 3 percent of GDP. - 5. Total government debt must be less than 60
percent of GDP.
30Figure 14.11Summary of 1870-2003 Financial Orders