International Economics Tenth Edition CHAPTER T W E N T Y O N E 21 International Economics Tenth Edition The International Monetary System: Past, Present, and Future Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Learning Goals: Understand how the gold standard operated Describe how the postwar Bretton Woods system operated and why it collapsed Know how the present international monetary system works Identify the major international economic problems facing the world today Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

maximizes the flow of international trade and investments. Introduction An international monetary system refers to the rules, customs, instruments, facilities and organizations for effecting international payments. A good international monetary system is one that: maximizes the flow of international trade and investments. Leads to “equitable” distribution of gains from trade among nations. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

An international monetary system can be evaluated in terms of: Introduction An international monetary system can be evaluated in terms of: Adjustment – process by which balance of payments disequilibria are corrected. Liquidity – amount of international reserve assets available to settle temporary balance of payments disequilibria. Confidence – knowledge that the adjustment mechanism is working adequately, and that international reserves will retain their absolute and relative values. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Gold Standard and the Interwar Experience The Gold Standard Period (1880-1914) Nations defined the gold content of its currency and passively stood ready to buy or sell any amount of gold at that price. Exchange rates were fixed at mint parity, allowed to fluctuate by cost of shipping. Adjustment mechanism was Hume’s price-specie flow mechanism (see chapter 16). Nations could not use monetary policy for achieving full employment without inflation. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Gold Standard and the Interwar Experience The Gold Standard Period (1880-1914) In reality, adjustment process worked much too smoothly and quickly, with few actual transfers of gold. Adjustments occurred because of special conditions that existed during this time: Great economic expansion and stability in most of the world. Pound sterling was only important international currency. Greater price flexibility than today. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Gold Standard and the Interwar Experience Classical gold standard ended with outbreak of World War I. Wildly fluctuating exchange rates from 1919 to 1924 led nations to return to a modified gold standard. The gold-exchange standard allowed gold and currencies convertible into gold to be used as international reserves. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Gold Standard and the Interwar Experience Causes of gold-exchange standard collapse: Lack of adequate adjustment mechanisms Huge destabilizing capital flows from London to New York and Paris. Outbreak of the Great Depression. From 1931 to 1936, great instability and competitive devaluations, increased protectionism, international trade cut almost in half. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Bretton Woods System Gold-Exchange Standard (1947-1971) Bretton Woods was a gold-exchange standard, with the United States maintaining the price of gold at $35 per ounce, standing ready to exchange dollars for gold. Other nations fixed their exchange rates in terms of dollars, maintaining rates within one percent above or below par value. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Bretton Woods System Gold-Exchange Standard (1947-1971) System devised at Bretton Woods called for establishment of International Monetary Fund (IMF) for purposes of: Overseeing that nations followed rules of conduct in international trade and finance. Providing borrowing facilities for nations in temporary balance of payments difficulties. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Bretton Woods System In borrowing from the IMF, a nation receives convertible currencies to fund balance of payments disequilibria. A nation may borrow no more than 25 percent of its quota during any given year with a maximum borrowing limit of 125 percent. The first 25 percent borrowed, the gold tranche, comes without restrictions or conditions. Subsequent tranches come with higher interest charges and stricter conditions. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Operation and Evolution of the Bretton Woods System Bretton Woods allowed changes to par values in cases of fundamental disequilibria. Deficit nations saw devaluation as a sign of weakness. Surplus nations resisted revaluation, preferring instead to accumulate international reserves. Since few nations changed par values, adjustment mechanism was hindered. Resulted in destabilizing international capital flows. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

U.S. Balance-of-Payments Deficit and Collapse of the Bretton Woods System Beginning in 1958, the U.S. began running significant balance of payments deficits. Because dollar was an international currency, U.S. felt it could not devalue to correct balance of payments. Effects: Depletion of U.S. gold reserves Declining gold reserves forced the U.S. to suspend gold convertibility in 1971. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

U.S. Balance-of-Payments Deficit and Collapse of the Bretton Woods System The ability to settle its balance of payments deficit with dollars conferred an important privilege on the United States that other nations did not have. Seignorage - benefit accruing to a nation from issuing its currency or when its currency is used as an international currency. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

U.S. Balance-of-Payments Deficit and Collapse of the Bretton Woods System But the United States could not devalue its currency without bringing down the Bretton Woods system. Since the United States could not use monetary policy, it had to rely heavily on fiscal policy to achieve domestic objectives. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

U.S. Balance-of-Payments Deficit and Collapse of the Bretton Woods System Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

U.S. Balance-of-Payments Deficit and Collapse of the Bretton Woods System The unwillingness of Germany and Japan to revalue their currency forced the United States to devalue the dollar, collapsing the Bretton Woods system. This was a political decision to remove the United States from its position as the “world’s banker”. Ironically, the U.S. dollar remained an international currency even without the gold backing. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Smithsonian Agreement (1971) U.S. Balance-of-Payments Deficit and Collapse of the Bretton Woods System Smithsonian Agreement (1971) Dollar price of gold increased to $38/ounce Other major currencies revalued Fluctuation bands increased to +/- 2.25 percent Effectively generates a dollar standard Continuing balance of payments deficits forced a subsequent devaluation of the dollar in 1973 ($42.22 per ounce) and finally a suspension of dollar convertibility to gold. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Following the collapse of the Bretton Woods System, the monetary system moved to a system of managed floats. Officially acknowledged by the Jamaica Accords of 1976. International reserves for currency intervention still provided by the IMF. The lending ability of the IMF was expanded in 1997 by the New Arrangement to Borrow. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future The use of IMF conditionality has come to be a source of great contention within the international monetary system. IMF Conditions for Loans and Special Help: Reductions in government spending Growth of the money supply Wage increases to reduce imports, stimulate exports, and make country more self-sustaining Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Problems with Present Exchange Rate Arrangements Large volatility, and wide and persistent misalignments of exchange rates Dollar overhang – large quantities of dollars held by foreigners and ready to move from monetary center to monetary center in response to fluctuations in exchange rates Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Problems with Present Exchange Rate Arrangements Failure to promote greater coordination of economic policies among leading industrial nations Inability to prevent international financial crises or deal with them adequately when they arise Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Current International Problems Financial crises in emerging market economies. Trade protectionism in advanced countries in a rapidly globalizing world. Structural imbalances in the United States, slow growth in Europe and Japan, and insufficient restructuring in transition economies. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The International Monetary System: Present and Future Current International Problems Deep poverty in many developing countries Resource scarcity, environmental degradation, climate change and sustainable development Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 21-1 Macroeconomic Performance of the United States and the United Kingdom under Different Exchange Rate Regimes, 1970-2011 Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 21-3 Chronology of Economic Crises in Emerging Markets from the Late 1990s Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 21-3 Chronology of Economic Crises in Emerging Markets from the Late 1990s Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 21-5 Trade Imbalances of the Leading Industrial Countries Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

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