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
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
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
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

51. Exchange Rate Map Bretton Woods System
More rules but less rigid than gold standard
Obligations with IMF
Required more cooperation
Countries with imbalances had to fix them
Fixing imbalances often required working with other countries

52. Exchange Rate Map Current System No rules
Each country can pursue their own choices of policies
Countries are free to target internal balances

53. Exchange Rate Map Why no new system?
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