Chapter 7 THE INTERNATIONAL MONETORY SYSTEM 18701973

1
Chapter 7 THE INTERNATIONAL MONETORY SYSTEM
1870-1973
2
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.

3
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)

4
THE INTERNATIONAL MONETORY SYSTEM 1870-1973
5
Macroeconomic Policy Goals In an Open Economy

• Internal BalanceFull Employment and Price-Level
  Stability
• When a countrys productive resources are
  fully employed and its price level is stable,the
  country is in internal balance.
• External BalanceThe Optimal Level of the Current
  Account
• Because of the existence of intertemporal
  trade,its difficult to make a exact current
  account balance.So the external balance goal is
  The Optimal Level of the CA.

6
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 economys 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.

7
External Balance The Optimal Level of the
Current Account

• External balance has no full employment or stable
  prices to apply to an economys external
  transactions.
• An economys trade can cause macroeconomic
  problems depending on several factors
• The economys particular circumstances
• Conditions in the outside world
• The institutional arrangements governing its
  economic relations with foreign countries

8
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, SCA I . So for a given
  level of national saving,an increased CA surplus
  implies lower investment in domestic plant and
  equipment. (S , CA , I )

9
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

10
The The Price-Specie-Flow Mechanism

• David Hume ,the Scottish philosopher, in 1752
  described the The Price-Specie-Flow Mechanismas
  follows
• It is to say that in the Gold Standard era
  the economy can achieve balance automatically.

Ms
P
import
export
P
CA
National price level
Foreign price level
11
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(EP/P)

12
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.
• 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.

13
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 systems 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.

14
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
• Germanys 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).

15
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 Britains
  commitment to maintain its currencys 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 .

16
THE BRETTON WOODS SYSTEM AND THE IMF

• The system set up by Bretton Woods agreement,
  its 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.

17
INTERNAL AND EXTERNAL BALANCE UNDER THE BRETTON
WOODS SYSTEM

• As the world economy evolved in the years after
  World War ?,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.

18
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.

19
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.

20
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.

21
ANALYING POLICY OPTIONS UNDER THE BRETTON WOODS
SYSTEM

• Maintaining Internal Balance
• Both Pand E are permanently fixed. The condition
  of internal balance is
• YfC(Yf -T)IGCA(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

22
Maintaining Internal Balance
Overemployment excessive

• The ?schedule in figure 1 shows combinations of
  exchange rates and fiscal policy that hold output
  constant at Yf and thus maintain internal
  balance.
• The schedule is downward-sloping because currency
  devaluation (a rise in E ) and fiscal expansion
  (a rise in G or a fall in T) both tend to rise
  output.

Exchange rate E
23
Maintaining External Balance

• The condition of external balance is
• CA(EP/P, Yf -T)X
• Figure 2 shows that the XX schedule, along which
  external balance holds, is positively sloped. The
  XX schedule shows how much fiscal expansion is
  hold the current account surplus at X as the
  currency is devalued by a given amount.

24
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. Along?,output
  is at its full-employment level, Yf. Along XX,
  the current account is at its target level, X.

Underemployment excessive current account surplus
Overemployment excessive current account deficit
25
Expenditure-Changing and Expenditure-Switching
Policies

• The expenditure-changing policy is the policy
  which can alters the level of the economys 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.

26
Expenditure-Changing and Expenditure-Switching
Policies
The expenditure-changing policy is the policy
which can alters the level of the economys 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.
27
Expenditure-Changing and Expenditure-Switching
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
  economys distance from the goal that is
  sacrificed.

28
THE EXTERNAL BALANCE PROBLEM OF THE UNITED STATES

• Triffin dilemma
• After World War ? 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.

29
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.

30
(No Transcript)
31
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 1960s 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.

32
WORLDWIDE INFLATION AND THE TRANSITION TO
FLOATING RATES

• The process of import inflation

the demand of the foreign commodity will increases
American inflation increases
American domestic price level rise
when the price level is higher than the other
countries
the inflation will spread from America to 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
33
WORLDWIDE INFLATION AND THE TRANSITION TO
FLOATING RATES
34
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.

35
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 expenditure-switching
  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.

36
Question
37

• Thanks