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Lecture 9:International monetary regimes in history
This power point presentations have been revised by Paul Sharp (Ph.D.
student)
on the basis of my slides
Last time
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We looked at some similarities and differences between the
world before WW1 and the world today.
We saw why many economists believe that there are
“gains from trade”.
We discussed the importance of trade policy by showing
the impact of extreme protectionism on the interwar
period.
This time: We turn to monetary policy.
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How have international monetary regimes evolved through
history?
How did they work?
How well did they work?
Again, we will see the importance of getting economic policy
“right”.
First, some important definitions
and concepts (Mankiw chapters 29-31)
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Commodity vs. fiat money, see lecture 4
Fixed vs. floating exchange rates
If Danmark’s Nationalbank has decided to keep the Danish
kroner per US$ at a constant rate, say 5 kroner per US$
then it is a fixed exchange rate.This was the case in the
Bretton Woods system after WWII.
In the Gold standard currencies had legally determined
gold content. and exchange rates were anchored by
relative gold content of the currencies.
If Sweden decides to let its exchange rate to the US$ be
determined in the foreign currency markets then it is a
floating exchange rate. It changes a little from day to day
and can change a lot from year to year.
Dk has now pegged( approximately fixed) its exchange
rate to the Euro while the Swedish krona floats.
Real exchange rate
Real exchange rate = Nominal exchange rate *US price
level/Denmark’s price level
for example (5 * 100)/500 = 1
Nominal exchange rate is domestic currency per 1 US$
At this nominal exchange rate purchasing power parity
(PPP) is established
PPP means that at the prevailing nominal exchange
rate 500 Dkr buys the same basket of goods in DK
as it does in the US, since 500 Dkr is exchanged for
100US$, which is the price in US for the same
basket of goods
Undervalued or overvalued?
Assume that the Danish price level increases to 600
while the price level in US and the nominal
exchange rate are constant
RER = (5*100)/600 = 0.83
The DKR buys more goods in US than in Denmark;
Imports from US increases. DK exports fall. DKR is
overvalued, relative to PPP
Assume that the Danish price level falls to 400 while
the price level in US and the nominal exchange rate
are constant
RER = (5*100)/ 400 = Now the Dkr buys less goods in
the US than in Denmark, US exports fall, DK exports
increase. The DKR is undervalued.
Adjustments
In a fixed exchange rate regime an economy that
has experienced an isolated inflationary shock
will see its RER appreciate and export (import)
demand will fall (increase); employment falls,
money supply is supposed to fall bringing
about deflation. Eventually PPP is restored.
In a floating exchange rate regime an isolated
inflationary shock leads to a depreciation of the
nominal exchange rate, for example
RER = (4.17*120)/500 = 1
Effects on price levels of fixed and floating
regimes
p.76
The recent history of international monetary
regimes in a nutshell
Earlier
ca. 1870-1914
1914-1918
1919-1925
1925-1931
1931-1939
1939-1945
1945-1950
1950-1973
1973-present
Often bimetallism, gold and silver
Fixed: International Gold Standard
World War 1 - Gold standard
suspended
Movement toward returning to gold
Fixed: International Gold Standard
Managed floating
World War 2
Gradual return to fixed rates
Fixed-but-adjustable: Bretton Woods dollar
exchange standard
Regionally fixed, globally floating
The importance of an international monetary
order
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A foreign exchange market allows exchange rates to be
determined and a global capital market to form.
Allows current account deficits to be financed.
With no foreign exchange market trade tends to be
balanced bilateral trade – tends to reduce trade.
E.g. if Denmark wants 10 billion kroner of goods from
Norway and Norway only wants 5 billion kroner of goods
from Denmark, then Denmark can only import 5 billion
kroner of goods.
Think of two people trading without money!
Foreign exchange markets also provide opportunity for
international lending, so savings not constrained by
investment demand.
To float or to fix?
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Historically, it was believed that a fixed exchange rate was
essential for a well-functioning international monetary
order.
There are many examples in history of fixed exchange
rates.
Prior to the first world war, there was an almost universal
long-lasting fixed exchange rate system.
Since the first world war various unsuccessful attempts
have been made to resurrect this.
Today, the most important currencies are floating.
An important exception is Denmark. The kroner is pegged
to the euro.
Why have fixed exchange rates been so unstable and
short-lived after 1913?
(Simplified) macroeconomic policy goals
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Policymakers can often be thought of as aiming for both
internal balance and external balance.
Internal balance: Full employment of resources; price level
stability.
External balance: Current account should be neither too
far in deficit nor too far in surplus.
The choice of exchange rate regime impacts on these
aims.
We can use these definitions to analyze the successes and
failures of historical monetary regimes.
Why internal balance?
Full employment
• Underemployment of resources: Waste.
• Overemployment of resources: Less leisure for workers,
more breakdowns for machines.
Price level stability
• Price level instability can be caused by over- and
underemployment or by expectations of price changes.
• Unexpected price level changes cause redistribution
between creditors and debtors.
Why external balance?
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Remember: Y = C + I + G + NX, so NX = S – I
So a current account deficit means that the country is
borrowing from the rest of the world to finance
investment. Not necessarily bad if the investment is
profitable after paying the interest on the loans.
Current account surplus can be OK if investment is more
profitable abroad.
But excessive current account deficits can result in a
lending crisis, if creditors do not believe that their interest
payments can be met.
Excessive current account surpluses can mean that too
little is being invested domestically and may be
internationally unpopular, e.g. leading to tariffs.
The International Gold Standard ca. 18701914
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Gold has been used as money (medium of exchange, unit
of account and store of value) since ancient times.
1819 UK Resumption Act:
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Resumed (after Napoleonic Wars) and institutionalized the
practice of exchanging currency notes for gold on demand at a
fixed rate.
Repealed restrictions on export of gold.
Britain becomes leading economic power.
Other countries followed Britain’s lead, e.g. US in 1870s.
Previously bimetallic systems were popular (silver and
gold).
London became centre of international monetary system.
Attempts at currency unions
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Some countries tried to take the gold standard further and
form monetary unions:
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1865 Latin Monetary Union
1875 Scandinavian Monetary Union
etc.
If we do nothing, what then? Why, we shall be left out in
the cold. Before long, all Europe, save England, will have
one money, and England be left standing with another
money.
– The Economist, 1860
Working of the pre-WW1 gold standard
No formal rules, but the following were usually
observed:
1. Currency freely convertible to gold at a set price or
“mint parity”.
2. Free flow of gold between countries.
3. Money supply expected to vary positively with gold
reserves in national bank.
4. If losing gold in liquidity crisis, raise interest rates.
5. Temporary suspension should be followed by
restoration of mint parity as soon as possible.
6. Prices determined by demand for and supply of
gold.
Why was the gold standard a fixed exchange
rate system?
Example:
• US mint parity: $20.646 / ounce.
• UK mint parity: £4.252 / ounce.
• Exchange rate must be 20.646 / 4.252 = $4.856 / £
• Reason: Any other exchange rate gives possibility of
arbitrage.
• E.g. Use rules 1-3 to see that $1/£ gives possibility
of:
1. Presenting £1 to Bank of England. Get 1/4.252=0.23
ounces of gold.
2. Presenting gold to US Treasury. Get 0.23*$20.646 =
$4.85
3. Exchange dollars on foreign exchange market for
£4.85!
4. Flow of gold to US leads to increase in $ supply,
decrease in £ supply. The £ strengthens on the foreign
exchange market.
How fixed was it?
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In reality small deviations within the so-called “gold
points” were possible due to transport/transaction costs.
Transporting gold between countries is not costless.
Arbitrage will only take place as long as the gains from
doing so outweigh the costs.
I.e. as long as one of the following:
$MP  T US
SER 
£ MP
(1) Get less dollars for a pound on the foreign exchange market than
by using gold. (SER is spot exchange rate: $/£)
1
£ MP  T GB
$MP

 SER 
SER
$MP
£ MP  T GB
(2) Get less pounds for a dollar on the foreign exchange market than
by using gold.
Illustration of gold arbitrage
Let’s speculate!
Currency traders London are unhappy with the fact that
the number of dollars they get for a pound note is
much below the mint parity at 4.856
Assume the SER is 4.787 US$ per £ 1.
Buy 1 ounce of gold in London at the official price and
ship it to New York at the cost of 0.12 US$.
Present the gold in NY and you will receive 20.646
US$ but you have to deduct the transport cost so
your net dollar holdings will be 20.526.
The gold arbitrage exchange rate will be your net
holding of US$ divided by the price in £ for 1 ounce
of gold, that is 20.526/4.252= 4.827.
There is an arbitrage profit of 4.827-4.787 =0.04US$
per ounce of gold shipped.
Gold arbitrage and interest rate adjustments
If there was an outflow of gold the National Bank
was expected to raise interest rates and shrink
the money supply.
If the public buys gold from the National Bank in
order to do arbitrage the domestic money
supply falls unless the National Bank sterilizes
the gold flow by buying domestic assets.
Rules of the game prescribed: if the National
Bank loses foreign assets (gold) sell domestic
assets.
External balance under the Gold Standard
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Central banks should be neither gaining nor losing too
much gold from abroad.
I.e. avoid sharp fluctuations in balance of payments.
Surplus or deficit financed by gold shipments between
central banks.
Many governments took a laissez-faire attitude, i.e.
Britain’s surplus was 5.2% of GNP on average!
Price-specie-flow mechanism (Hume, 1752). Automatically
ensured balance of payments equilibrium.
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If gold is flowing to Britain, money supply increases and then
British prices are rising, and foreign prices are falling.
Increases British demand for foreign goods and decreases
foreign demand for British goods.
So gold flows out again! Equilibrium restored.
Reinforced by central bank practice of raising interest rates if
losing gold, lowering rates when there is a gold inflow: “Rules
of the game”.
Violations of rules of the game
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In practise, central banks were more worried about gold
losses than gold gains.
Continental Europe:
• Even when not under pressure, sterilized gold inflows, so
money supply did not increase, gave excess gold reserves.
Bank of England:
• Active interest rate policy to stem anticipated gold losses.
• Reason: If pound weakened, investors withdrew bank
deposits, converted pounds to gold and exported it.
• If there was a loss of gold Bank of England should actively
reduce money supply (by selling domestic assets).
• Bank did often violate this rule
• If critical, could rely on loans from other central banks.
So why did the system survive so long?
• Commitment – Deviations from the gold standard
would be followed by a return to the original parity.
• Confidence – People believed that rates would
remain fixed, so speculation was equilibrating.
• Symmetry – All national price levels dictated by
gold demand/supply. No one country had
overwhelming influence on price level.
Internal balance under the gold standard
• Economic policy subordinate to external
objectives.
• Gold standard ensured price stability over
longer periods.
• For shorter periods there was inflation or
deflation depending on the worldwide demand
and supply of gold.
• Internal policy objectives (e.g. combating
unemployment) not considered important
before WW1.
World War 1 and after (1914-1918-1925)
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Gold standard suspended.
Expenditures financed by printing
money.
Inflation!
After the war: some governments
financed reconstruction by printing
more money!
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e.g. German hyperinflation, reached
3.25 million percent per month!
Money was useful for lighting the
stove…
Return to gold
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1919 US returns to gold.
Pre-WW1 seen as a golden age. Return to gold a priority.
But inflation increased at different rates in different
countries during the war.
Restoring gold standard at original parities would mean
deflation.
Deflation can be painful for economies since nominal
wages do not normally fall easily, labour becomes
relatively expensive and output declines and
unemployment increases.
But now internal objectives were much more important:
spread of democracy, powerful trade unions. (Socialism,
communism on the rise.
Deflationary vs. inflationary countries
• Some countries return to gold at the pre-war
parity.
• E.g. 1925 UK returns to gold at pre-war price:
• UK wanted to restore confidence in the gold
standard and its ability to manage the system.
• Required deflation – contractionary monetary
policy.
• Led to severe unemployment.
• Other countries reduced the mint parity.
• E.g. France rejoined at 20% of pre-war level.
Industrial growth in deflationary and
inflationary nations in Europe in the 1920’s.
1929 Wall Street Crash and the Great
Depression
• US trying to slow overheated economy through
monetary contraction.
• France ending inflationary period with return to
gold.
• France and US sterilizing gold inflows and absorbing
world’s gold (reached 70% of world supply!).
• Other countries forced to restrict money supply.
• This worldwide monetary contraction and the Wall
Street Crash led to the Depression.
• 1931 UK losing reserves and forced off gold.
• Other countries follow e.g. Scandinavia.
• France leaves last in 1936.
What was the impact of the gold standard?
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The Great Depression had worldwide impact.
Wall Street crash, unemployment and bank failures.
Recent research suggests that the gold standard played a
large part in prolonging and worsening the Depression.
Bank failures worsened because countries refused to
provide liquidity since they needed to protect their gold
reserves.
Countries (such as the UK) which left the gold standard
early enjoyed faster recovery than countries like France,
which did not.
Devaluation meant that
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industry became more competitive.
real wages and real interest rates declined
monetary policy could be used.
Changes in exchange rates and
industrial growth, the 1930s.
Reaction to the Great Depression
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Countries gradually left the gold standard.
Beggar-thy-neighbour policies (such as the US SmootHawley tariff) were implemented.
Restrictions on capital flows were implemented to offset
reserve movements caused by uncertainty.
Countries became more autarkic.
Avoided external imbalance…
…at a terrible cost to the world economy.
World trade declined.
Fascism in Europe.
The progress of the nineteenth century was put back
almost to square one.
Bretton Woods and the International
Monetary Fund (IMF)
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July 1944: 44 countries sign Articles of Agreement of IMF.
Hoped to design system that would allow both internal and external
balance without trade restrictions.
Result of interwar experience. Floating exchange rates seen to be
cause of instability and harmful to trade.
BW system was a gold exchange standard:
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Fixed dollar price of gold: $35 an ounce.
Member countries hold reserves in gold or dollar assets as buffer stocks,
and no link to money supply.
National banks had right to sell dollars to Federal Reserve for gold at
official price. Meant to discipline US.
Currencies fixed to dollar in a narrow band: N-1 exchange rates to US$.
So countries responsible for maintaining exchange rate, US responsible
for maintaining dollar price of gold.
Some flexibility allowed.
Flexibility
1. IMF lending facilities: Pool of gold and currencies from
member countries could be used to lend to members who
were experiencing current account deficits, but where
contractionary policy would lead to unemployment.
Members who borrowed from the IMF would be supervised
by the IMF.
2. Adjustable parities: If balance of payments in
“fundamental disequilibrium” (not defined!). Allowed
devaluation against dollar if countries suffered permanent
adverse international shifts in the demand for their
products. Not available to Nth currency, the dollar.
Convertibility
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IMF articles of agreement urged convertibility as soon as
possible. (Important efficiency implications)
Only required convertibility on current account (goods and
services) not capital account (financial assets).
Interwar experience led to belief that private capital
movements and speculation led to instability.
US & Canadian dollars convertible from 1945.
US dollar becomes key international currency.
Why the restriction on capital mobility?
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An expansionary monetary policy results in a tendency
towards depreciation of the domestic currency.
Since exchange rate adjustments were permitted currency
traders would speculate in a devaluation and sell the
domestic currency
To stop speculation the central bank is forced to restrict
monetary supply.
The monetary policy instrument is thus unavailable when
exchange rates are fixed and free capital mobility.
However, limiting capital flows limits arbitrage and
speculation, and expansionary monetary policy is again
possible, at least in the short run.
External balance under Bretton Woods
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First decade of Bretton Woods: Reconstruction after war.
Dollars needed to finance reconstruction: “dollar shortage”.
Helped by Marshall Plan in 1948.
Current account deficits limited by difficulty of obtaining
foreign credit.
Convertibility restored in 1958.
Although still capital restrictions, was possible to borrow
from abroad by delaying payments for goods and vice
versa. “Leads” and “lags”.
Much more financial integration. Gave possibility of
speculation.
Special Drawing Rights
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Introduced in late 1960s.
1 SDR = 1 USD
Allocated in proportion to subscription to IMF.
Could be used to settle current account imbalances.
A country in deficit could deposit SDRs in a surplus country
in return for foreign currency.
Allowed for greater international liquidity, but in practise
the main provider of foreign reserves was the US.
US has almost permanent deficit due to heavy investment
abroad (paid for with dollar assets).
Most countries were happy to hold dollar assets, since they
gave interest (which gold does not).
An exception was - of course - France!
Speculative problems
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If countries had large and persistent current account
deficits, then they might be suspected of being in
“fundamental disequilibrium”.
Prompted destabilizing speculation.
Bretton Woods lacked the credibility of the pre-WW1 gold
standard.
UK devalued in 1967.
France devalued in 1957, 1958 and 1969.
Triffin credibility problem
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By 1960s the Federal Reserve gold stock was a small
fraction of US international liabilities.
Triffin suggested that a credibility problem destroyed the
Bretton Woods system, as foreigners worried that the
dollar was not “as good as gold”.
Dilemma:
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If US does not have balance of payments deficit, then there
will not be sufficient international liquidity, which might lead to
a recession.
If US does have balance of payments deficit, then the gold
convertibility and credibility vanishes, destroying the system.
But this was not what destroyed the Bretton Woods
system!
The N-1 problem
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The Bretton Woods system was asymmetrical (unlike the
gold standard).
Only the US had the freedom to set its interest rate / use
monetary policy.
All other countries had to use monetary policy to keep
their currencies tied to the dollar.
They could in principle discipline the US, but they needed
the dollar reserves to finance fast expanding trade!
Remember: if the domestic currency is fixed to the dollar,
then domestic prices will move with US prices.
Inflation in the US forced on Europe
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In the 1960s Democratic administrations
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expanded welfare spending: the “Great Society”.
got involved in the Vietnam war.
Led to budget deficits and expansionary monetary policy.
Inflation doubled.
European governments had other inflation targets, but
were forced to import US monetary policy.
German solution was to revalue: in 1961 and 1969.
US inflation made the dollar overvalued and devalued
against gold in 1971.
But inflation continued, and gold convertibility was
abandoned in 1973.
1970s to today
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Initially floating exchange rates seen as a temporary
measure.
However, no new worldwide fixed exchange rate system
seems likely.
There have been and are regional attempts at regional
cooperation, e.g. European ERM which collapsed in 1992.
Recently, the problems of fixed exchange rates have been
sought avoided by abolishing exchange rates altogether:
the euro.
There is now little interest in an international fixed
exchange rate system, since floating exchange rates have
shown themselves to be compatible with free capital flows
and trade.
The open economy trilemma
A summary: Fixed exchange rates are made
to be broken!
1. Prior to WW1 governments emphasized external balance at
the expense of internal balance. The gold standard thus
combined free capital mobility and a fixed exchange rate,
whilst leaving little room for monetary policy.
2. After WW1 governments desired a return to the stability of
the Gold Standard, but could no longer ignore internal
objectives. This led to a collapse in the gold standard.
3. After WW2 governments desired fixed rates with the
flexibility to use monetary policy to reach internal balance.
The Bretton Woods system thus required capital controls.
4. Increasing trade and economic integration meant that
capital controls were no-longer feasible and the Bretton
Woods system collapsed.
5. From the 1970s the goal of fixed exchange rates has been
dropped.
References
For an (excellent and brief) description of monetary regimes
in history, and the macro theory of fixed exchange rates,
see:
Krugman, P.R. & Obstfeld, M. (2003) International Economics:
Theory and Policy.
For more basic macro see:
Mankiw, N.G. (2004) Principles of Economics.
And of course the following is compulsory reading!
Persson, K.G. & Sharp, P.R. A Note on International Monetary
Regimes in History. Available on the course homepage:
www.econ.ku.dk/kgp