Download International Monetary Arrangements

International Monetary
Arrangements
Introduction
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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?
The Gold Standard
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Operated from 1870 to 1914
Each country defined the gold content of its
currency
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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
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Price of each currency in terms of gold
The Gold Standard
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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
Gold Standard & Monetary Policy
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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
Gold Standard & Monetary Policy
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Balance of payments deficit
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Rest of world accumulates more dollars
than desired
Gold outflows from US to rest of world
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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
Gold Standard & Monetary Policy
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Long run would not hold without other
adjustments
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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)
Gold Standard & Monetary Policy
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Under current system
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Contractionary money – decrease in money
supply’s growth rate
Expansionary money – increase in money supply’s
growth rate
Under gold standard
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Would actually have a decrease or increase in
money supply
Makes domestic economic relatively unstable
But, fixed exchange rate and long run stable
prices
Macroeconomics & Gold Standard
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Assume economy is expanding
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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)
Foreign Exchange Market
Macroeconomics & Gold Standard
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Gold outflow causes country’s money
supply to decrease
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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
Domestic Economy
Macroeconomics & Gold Standard
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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
Gold Standard – Costs & Benefits
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Benefits
1.
Adjustment of price level and output to
an external imbalance is completely
automatic
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Country only needs to be willing to buy and
sell gold at stated price
No question what would happen if experience
an external imbalance
Gold Standard – Costs & Benefits
Benefits
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2.
Long run price stability for economy
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Average inflation rate for US during gold standard was
0.1 percent
Costs
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1.
Does not guarantee short run price stability
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Could have inflation some years and deflation others
Could vary significantly from year to year
Deflation as common as inflation
Gold Standard – Costs & Benefits
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Costs
2.
Overall balance of payments position
heavily influences country’s money supply
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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
Bretton Woods System
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After gold standard ended, exchange rates
were extremely unstable
Desire for some form of international
monetary system was desirable
Conference in Bretton Woods, NH
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44 countries met to create a new international
monetary system
Press referred to it as the “Bretton Woods” System
Bretton Woods System
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Gold Exchange Standard
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US dollar tied to gold but all other foreign
currencies tied to dollar
Countries agreed to creation of
International Monetary Fund (IMF)
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International monetary institution
Bretton Woods System
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Purpose
1.
2.
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
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Necessary to link currencies to something
other than gold
Bretton Woods System
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Solutions
1.
Price of gold fixed at $35
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2.
US to maintain fixed price
US would exchange dollars for gold at stated
price without limitation or restrictions
Other currencies fixed to US dollar
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Meant other currencies fixed in relation to one
another
No longer necessary to sacrifice internal
balance to maintain external balance
Bretton Woods System
Faults
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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
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Governments would have to buy or sell domestic or
foreign currency to keep domestic currency from
appreciating or depreciating
Bretton Woods System
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Example
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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
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Would make external deficit worse
Bretton Woods System
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Example (cont.)
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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
Bretton Woods System
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Example (cont.)
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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
International Monetary Fund
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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
International Monetary Fund
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Pool of funds
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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
International Monetary Fund
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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
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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
International Monetary Fund
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Loans from IMF to countries have
problems
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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
Demise of Bretton Woods
Problems developed with Bretton
Woods
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1.
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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
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Could not force country to pursue policies to
correct surpluses
Demise of Bretton Woods
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Problems developed with Bretton Woods
2.
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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
Demise of Bretton Woods
End of Bretton Woods
US faced with choices
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1.
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3.
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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
Post Bretton Woods Era
Two options since breakup of Bretton
Woods
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1.
2.
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
Clean Floats
Decide internal balances are more
important than external balances
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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
Clean Floats
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Macroeconomic policy mix could lead to
real appreciation of currency where the
economy is doing well
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Might cause significant hardship of tradable
goods portion of economy
Exporters could lose business because of
overvaluation of exchange rate
Clean Floats
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Policy mix could lead to depreciated
exchange rate
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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
Clean Floats
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Policy mix could lead to depreciated exchange
rate (cont.)
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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
Pegging the Exchange Rate
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If international trade is significant
portion of GDP, then ignoring external
balances may not be optimal
Country may wish to peg exchange rate
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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
Pegging the Exchange Rate
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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
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Value against other currencies changes as
the other country’s exchange rate changes
Pegging the Exchange Rate
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Example – Mexico wishes to peg peso
to US dollar
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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
Pegging the Exchange Rate
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Example – Mexico wishes to peg peso to US
dollar (cont.)
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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
Pegging the Exchange Rate
Internal versus external balance choice may
be partially avoided
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1.
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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
Pegging the Exchange Rate
Fix exchange rate in real terms instead of
nominal terms (cont.)
1.
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Still uncertainty in nominal rate
Governments may target a rate of devaluation to
keep it somewhat constant
Still requires some changes in nominal rates
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Domestic policy may diverge from other country
causing inflation rates to diverge
Generally more certain that free float
Pegging the Exchange Rate
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Internal versus external balance
choice may be partially avoided
2.
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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
Pegging the Exchange Rate
2.
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Fix country’s currency to basket of
currencies (cont.)
Problems
a.
b.
c.
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
a.
Traders exposed to more risk than fixed rate
Options for Monetary Reform
Current System Problems
Businesses dislike floating exchange
rates since volatility increases risk
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1.
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Can choose between taking risk or
protection through hedging – neither of
which are costless
Current system forces businesses to
implicitly forecast exchange rates
Options for Monetary Reform
Current System Problems
Floating exchange rates impose
externality of world economy
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2.
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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
Options for Monetary Reform
Current System Problems
Governments have similar views as
business
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3.
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Overvalued currency can hurt tradable
goods sector
Undervalued currency can create a boom
that cannot be sustained
Collapse in currency can cause
microeconomic crisis
Options for Monetary Reform
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Why not change the system?
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Note figure 18.3
Horizontal axis shows level of cooperation in
international system
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Left – set own policies for internal balance
Right – complete cooperation
Vertical axis shows degree of rules in system
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Top – rigid rules
Bottom – much discretion (no agreed upon rules)
Exchange Rate Map (Fig. 18.1)
Exchange Rate Map
Gold Standard
1.
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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
Exchange Rate Map
Bretton Woods System
2.
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More rules but less rigid than gold
standard
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Obligations with IMF
Required more cooperation
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Countries with imbalances had to fix them
Fixing imbalances often required working with
other countries
Exchange Rate Map
Current System
3.
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No rules
Each country can pursue their own
choices of policies
Countries are free to target internal
balances
Exchange Rate Map
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Why no new system?
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Movement toward more stable exchange
rates requires more rules and/or more
cooperation
Moving toward gold standard takes away
monetary policy so unlikely
Increasing cooperation in almost
impossible if there are no rules
Unlikely to move from current system