The International Monetary System: Contemporary International Monetary Arrangements

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The International Monetary System Contemporary
International Monetary Arrangements

• READING ASSIGNMENT Oatley Chapter 11

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Exchange-Rate Systems

• A set of rules governing how much national
  currencies can appreciate and depreciate in the
  foreign exchange market
• FIXED governments allow for only very small
  changes. The government maintains this fixed
  price by buying selling currencies in the
  foreign exchange market (e.g., China until 2005,
  European currencies before euro, Argentina
  Brazil in 1990s)
• FIXED-BUT-ADJUSTABLE Governments intervene under
  a set of well defined circumstances (e.g.,
  Bretton Woods note well defined circumstances
  can be devastating with speculators surprise is
  important when it comes to monetary policy!)
• MANAGED FLOAT Governments intervene but there
  are no rules (surprise!) these days many
  governments do this (Switzerland, Japan during
  financial crisis)
• FLOATING governments do not intervene. There are
  no limits on how much the XR can move up or down
  (e.g., US, British pound)

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Plan for today

1. The rise and fall of Bretton Woods
2. Why fail to address a BoP imbalance under fixed
   XR why beggar-thy-neighbor?
3. The Trilemma
4. France vs. Germany in the 1980s
5. How to deal with imbalances fix vs. float
6. The US

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THE RISE AND FALL OF BRETTON WOODSA puzzle
Degree of global capital mobility
Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1944
BRETTON WOODS PERIOD
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Conclusion

• Cannot maintain (global) fixed exchange rates in
  the presence of high capital mobility?

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THE RISE AND FALL OF BRETTON WOODSA puzzle
Degree of global capital mobility

Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1944
1870
BRETTON WOODS PERIOD
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A puzzleWhy were countries able to maintain
fixed exchange rates with high capital mobility
in the late 19th century?
Fixed exchange rates Open capital flows
Degree of global capital mobility
Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1870
Interwar period
1944
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Why?
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Answer Democracy
Growing s of democracies LABOR UNIONS!
Few democracies
Fixed exchange rates Open capital flows
Degree of global capital mobility
Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1870
Interwar period
1944
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Why?

• So, why do fixed exchange rates pose a problem
  for democracies in the face of highly mobile
  capital?

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Pure gold standard

• Country A imports from Country B
• Gold moves from A to B (re-coined/minted)
• Less money in A ? lower prices
• More money in B ? higher prices
• ? Country B imports from Country A
• Balance is restored

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With paper money

• Central Banks intervene by adjusting interest
  rates
• So gold doesnt actually flow
• Gold Standard ? strict discipline!

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What is discipline?

• What do lower prices in Country A mean?
• Supply of money down
• More expensive to borrow
• Jobs cut!
• People dont eat!

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People dont eat

• Under authoritarianism
• Let them eat cake

• Under democracy
• Incumbents lose elections

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Hazard Rate over Time for Democracies (Solid
Line) Dictatorships (Dotted Line) Time in
years
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Stylized history

• Late 19th century
• Mobile capital, authoritarian governments
• Interwar years
• Mobile capital democracy ? beggar-thy-neighbor
• http//www.youtube.com/watch?v3_ex0sTsb_Ifeature
  channel
• Bretton Woods (1944-1971/3)
• Capital controls democracy
• http//www.youtube.com/watch?vGVytOtfPZe8
• Post Bretton Woods
• Floating exchange rates
• http//www.youtube.com/watch?viRzr1QU6K1o

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What were the goals of Bretton Woods?

• Attempted to establish a system of fixed XR in a
  world where governments were unwilling to
  sacrifice employment to address imbalances
• 4 INNOVATIONS
• Some XR flexibility (fixed-but-adjustable
  snake)
• Capital controls
• A stabilization fund (held on reserve at the IMF)
• The International Monetary Fund authority over
  XR changes conditionality attached to loans

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Bretton Woods failed for several reasons

• IMF lacked true authority over XR governments
  did as they saw fit
• Governments did not like IMF conditionality
• The stabilization fund was never large enough to
  deal with the potentially massive imbalances that
  come with growing globalized economic integration
• Straws that broke the BW back
• USA VIETNAM SOCIAL SPENDING INTERNATIONAL
  RESERVE CURRENCY
• ? SPECULATION that the US cannot maintain the
  fixed convertibility to gold the French
  regularly demanded American gold from the US for
  the s they accumulated
• http//www.youtube.com/watch?viRzr1QU6K1o

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http//www.youtube.com/watch?vloBe0WXtts8
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The saga continues

• The story of the contemporary international
  monetary system is the story about the search for
  the elusive ideal-balance between domestic
  economic autonomy and exchange rate stability.

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The Unholy Trinity

• Fixed Exchange Rate
• Autonomy of Monetary Policy
• Capital Mobility
• Mundell-Fleming Only 2 out of 3 are possible

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The point of the unholy trinity you cant have
it all

• The point is that you can't have it all A
  country must pick two out of three. It can fix
  its exchange rate without emasculating its
  central bank, but only by maintaining controls on
  capital flows (like China today) it can leave
  capital movement free but retain monetary
  autonomy, but only by letting the exchange rate
  fluctuate (like Britain--or Canada) or it can
  choose to leave capital free and stabilize the
  currency, but only by abandoning any ability to
  adjust interest rates to fight inflation or
  recession (like Argentina today, or for that
  matter most of Europe).
• Paul Krugman http//slate.com/id/36764

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Free Capital Flow
Eurozone countries
Switzerland
PRC
Inconsistent/Unholy Trinity Or Trilemma a
country can only have 2 out of 3 of these
Fixed Exchange Rate
Sovereign Monetary Policy
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Fixed Exchange Rate
Eurozone countries
Switzerland
PRC
The Trilemma
Open Capital Flows
Sovereign Monetary Policy
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Fixed Exchange Rate
Eurozone countries
Switzerland
PRC
The Trilemma
Open Capital Flows
Sovereign Monetary Policy
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The European Monetary System

• 1979
• Fixed but adjustable
• The Bundesbank (Germany) used monetary policy to
  keep inflation low, and other countries engaged
  in foreign exchange market intervention to fix
  their currencies to the German mark

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French-German fight in 1981-3

• Mitterand socialist president believed German
  monetary policy was strangling
• Expansionist monetary policy (e.g., lowered
  interest rates)
• French inflation began to rise
• Called on Germany to lower their interest rates
• 18 month stand-off the French backed down

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1988-2002 Monetary Union

• 1988 Planning begins
• Gradually moved towards fixing their currency
  XRs (1999 permanently fixed)
• Jan 2002 The Euro!
• Why union?
• High degree of economic openness across Europe ?
• Sacrificed monetary autonomy for XR stability

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To fix or to float?
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Trade international capital flows lead to
imbalances

• How do governments deal with these imbalances?
• Fixed exchange rate ? sacrifice monetary policy
• OR
• Floating exchange rate ? uncertainty
• Trade-off between
• exchange rate stability
• versus
• domestic price stability with monetary policy
  autonomy

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Why are there imbalances?

• These days, foreign exchange markets conduct
  between 1 trillion and 1.5 trillion worth of
  business PER DAY!!
• ? Exchange rate volatility!
• ? Exchange rate misalignments

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Consequences of XR volatility?

• Uncertainty hurts international transactions?
• Suppose you work on a profit margin of 5-9 and
  the XR changes 5 between the time you ship an
  export and the time it arrives
• But businesses can purchase options to buy a
  foreign currency 30, 60, or 90 days in the future
  at todays XR, thereby insuring themselves
  against short-term XR volatility
• Nevertheless, a reduction in investment is one
  possible consequence of currency misalignments

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Fixed XR

• A kind of commitment
• To avoid SPECULATATION governments try to make a
  credible commitment to a fixed XR
• If the commitment is not credible, speculation
  can be disastrous
• Argentine Currency Board (1991-2002)
• Pegged the Argentine peso to the U.S. dollar in
  an attempt to eliminate hyperinflation
• Credibility? Required legislative vote to change
  the value of the currency (public discussion
  undermines the point of a devaluation!)
• But deficit spending ultimately undermined
  confidence
• And tied hands prevented the government from
  acting
• Run on the currency in 2002 ? disaster!!

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Free Capital Flow
USA
PRC
Inconsistent/Unholy Trinity Or Trilemma a
country can only have 2 out of 3 of these
Fixed Exchange Rate
Sovereign Monetary Policy
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Why is the US dollar special?
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Overvaluation of the Dollar

• International reserve currency
• Early 1980s Reagans fiscal expansion cut
  taxes, increased spending ?
• Current account deficit ?
• Increased interest rates and capital inflows
  (from, e.g., Japan)?
• Value of the dollar goes up!
• Plaza Accord (fall 1985) G5 agreed to reduce the
  value of the dollar against the yen mark by
  10-12 sell dollars if it appeared the value
  was going to increase
• By early 1987, dollar had depreciated 40

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Similar situation today

• US twin deficits fiscal current account
• Japan, Europe, China, current account surpluses ?
• Finance the American deficit
• US absorbs about 6 of the worlds savings
• US international investment position
• foreign-owned assets in 2007 17.8 trillion
• US residents foreign assets in 2007 15.4
  trillion
• international investment position 2.4 trillion

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Whats the worry?

• Catastrophe!
• Doubts about the solvency of American financial
  institutions American assets?
• Foreign lenders reluctant to continue to
  accumulate dollar-denominated assets?
• Trigger massive sales of current holdings?
• http//www.youtube.com/watch?vqu2uJWSZkck

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Hope?

• Cooperation amongst G5?
• (G5??? p255... China?)
• US needs to reduce its budget deficit
• Countries with surpluses need to expand demand in
  their own countries
• Macroeconomic coordination along these lines
  would reduce American imports expand
  consumption in surplus countries
• Cooperation could also guide a gradual decline of
  the , rather than a fast catastrophic drop
• Problem for China adjustment moving from the US
  market to the domestic market would create
  economic dislocation, winners losers ?
  political instability?
• This is a reality that the Chinese government
  must deal with and therefore the American
  government must also!
• But a catastrophic drop would hurt the
  export-oriented sectors of all countries with
  current account surpluses with the US!

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Take aways

1. Democracy ? Fall of the gold standard
2. Fall of Bretton Woods replaced with floating XR
3. The Trilemma
4. France vs. Germany in the 1980s
5. Floating XR allows for flexibility in monetary
   policy
6. China-US problem we have incompatible solutions
   to our trilemmas

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Thank you
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Source http//www.fas.org/sgp/crs/row/RS22860.pdf