International Monetary Arrangements

1. International Monetary Arrangements

2. Introduction • What were the various international monetary system that existed from late 1800’s 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 • Country’s 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 supply’s growth rate • Expansionary money – increase in money supply’s 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 country’s 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

12. 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 country’s 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

17. 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

18. 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 world’s 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 country’s 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

28. 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

29. 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

31. 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

33. 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

35. Clean Floats • Policy mix could lead to depreciated exchange rate • Could lead to boom in tradable goods sectors • Imports become more expensive • Country’s 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 country’s • 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 country’s exchange rate changes

39. Pegging the Exchange Rate • Example – Mexico wishes to peg peso to US dollar • In long run, Mexico’s 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 country’s 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 country’s 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

46. 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

47. 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

48. 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)

49. Exchange Rate Map (Fig. 18.1)

50. 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