1. READING ASSIGNMENT: Oatley – Chapter 11
The International Monetary System: Contemporary International Monetary Arrangements
READING ASSIGNMENT: Oatley – Chapter 11

2. Exchange-Rate Systems
A set of rules governing how much national currencies can appreciate and depreciate in the foreign exchange market
FIXED: governments allow for only very small changes. The government maintains this fixed price by buying & selling currencies in the foreign exchange market (e.g., China until 2005, European currencies before euro, Argentina & Brazil in 1990s)
FIXED-BUT-ADJUSTABLE: Governments intervene under a set of well defined circumstances (e.g., Bretton Woods… note: well defined circumstances can be devastating with speculators – surprise is important when it comes to monetary policy!)
MANAGED FLOAT: Governments intervene but there are no rules (surprise!) – these days many governments do this… (Switzerland, Japan during financial crisis)
FLOATING: governments do not intervene. There are no limits on how much the XR can move up or down (e.g., US$, British pound)

3. Plan for today The rise and fall of Bretton Woods
Why fail to address a BoP imbalance under fixed XR – why “beggar-thy-neighbor”?
The Trilemma
France vs. Germany in the 1980s
How to deal with imbalances: fix vs. float
The US $

4. THE RISE AND FALL OF BRETTON WOODS A puzzle
Degree of global capital mobility
Fixed exchange rates +
Capital controls
Floating exchange rates +
Open capital flows
1944
1971-3
BRETTON WOODS PERIOD

5. Conclusion:
Cannot maintain (global) fixed exchange rates in the presence of high capital mobility…?

6. THE RISE AND FALL OF BRETTON WOODS A puzzle*
Degree of global capital mobility
Fixed exchange rates +
Capital controls
Floating exchange rates +
Open capital flows
1870
1944
1971-3
BRETTON WOODS PERIOD

7. A puzzle: Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19th century?
Fixed exchange rates +
Open capital flows
Degree of global capital mobility
Fixed exchange rates +
Capital controls
Floating exchange rates +
Open capital flows
1870
Interwar period
1944
1971-3

8. Why?

9. Answer: Democracy Few democracies
Growing #’s of democracies + LABOR UNIONS!
Fixed exchange rates +
Open capital flows
Degree of global capital mobility
Fixed exchange rates +
Capital controls
Floating exchange rates +
Open capital flows
1870
Interwar period
1944
1971-3

10. Why?
So, why do fixed exchange rates pose a problem for democracies in the face of highly mobile capital?

11. Pure gold standard Country A imports from Country B
Gold moves from A to B (re-coined/minted)
Less money in A  lower prices
More money in B  higher prices
 Country B imports from Country A
Balance is restored

12. With paper money Central Banks intervene by adjusting interest rates
So gold doesn’t actually flow
Gold Standard  strict discipline!

13. What is “discipline”? What do “lower prices in Country A” mean?
Supply of money down
More expensive to borrow
Jobs cut!
People don’t eat!

14. Under authoritarianism:
People don’t eat
Under authoritarianism:
Let them eat cake
Under democracy:
Incumbents lose elections

15. Hazard Rate over Time for Democracies (Solid Line) & Dictatorships (Dotted Line) – Time in years

16. Stylized history Late 19th century: Interwar years:
Mobile capital, authoritarian governments
Interwar years:
Mobile capital + democracy  beggar-thy-neighbor
Bretton Woods ( /3):
Capital controls + democracy
Post Bretton Woods:
Floating exchange rates

17. What were the goals of Bretton Woods?
Attempted to establish a system of fixed XR in a world where governments were unwilling to sacrifice employment to address imbalances
4 INNOVATIONS:
Some XR flexibility (fixed-but-adjustable “snake”)
Capital controls
A stabilization fund (held on reserve at the IMF)
The International Monetary Fund – authority over XR changes + conditionality attached to loans

18. Bretton Woods failed for several reasons
IMF lacked true authority over XR – governments did as they saw fit
Governments did not like IMF conditionality
The stabilization fund was never large enough to deal with the potentially massive imbalances that come with growing globalized economic integration
Straws that broke the BW back:
USA: VIETNAM + SOCIAL SPENDING + INTERNATIONAL RESERVE CURRENCY
 SPECULATION that the US cannot maintain the fixed convertibility to gold + the French – regularly demanded American gold from the US for the $’s they accumulated

22. The saga continues…
The story of the contemporary international monetary system is the story about the search for the elusive ideal-balance between domestic economic autonomy and exchange rate stability.

23. Mundell-Fleming: Only 2 out of 3 are possible
The Unholy Trinity
Fixed Exchange Rate
Autonomy of Monetary Policy
Capital Mobility
Mundell-Fleming: Only 2 out of 3 are possible

24. The point of the unholy trinity – you can’t have it all…
“The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).”
– Paul Krugman

25. a country can only have 2 out of 3 of these
Free Capital Flow
Eurozone countries
Switzerland
PRC
Inconsistent/Unholy
Trinity Or
“Trilemma”:
a country can only have 2 out of 3 of these
Fixed Exchange Rate
Sovereign Monetary Policy

26. Eurozone countries
Fixed Exchange Rate
Switzerland
PRC
The Trilemma
Open Capital Flows
Sovereign Monetary Policy

27. Eurozone countries
Fixed Exchange Rate
Switzerland
PRC
The Trilemma
Open Capital Flows
Sovereign Monetary Policy

28. The European Monetary System
1979
Fixed but adjustable
The Bundesbank (Germany) used monetary policy to keep inflation low, and other countries engaged in foreign exchange market intervention to fix their currencies to the German mark

29. French-German fight in 1981-3
Mitterand – socialist president – believed German monetary policy was strangling
Expansionist monetary policy (e.g., lowered interest rates)
French inflation began to rise
Called on Germany to lower their interest rates
18 month stand-off… the French backed down

30. 1988-2002: Monetary Union 1988: Planning begins
Gradually moved towards fixing their currency XR’s (1999 – “permanently” fixed)
Jan 2002: The Euro!
Why union?
High degree of economic openness across Europe 
Sacrificed monetary autonomy for XR stability

31. To fix or to float?

32. Trade & international capital flows lead to imbalances
How do governments deal with these imbalances?
Fixed exchange rate  sacrifice monetary policy
OR:
Floating exchange rate  uncertainty
Trade-off between
exchange rate stability
versus
domestic price stability with monetary policy autonomy

33. Why are there imbalances?
These days, foreign exchange markets conduct between $1 trillion and $1.5 trillion worth of business… PER DAY!!
 Exchange rate volatility!
 Exchange rate misalignments

34. Consequences of XR volatility?
Uncertainty hurts international transactions?
Suppose you work on a profit margin of 5%-9% and the XR changes 5% between the time you ship an export and the time it arrives…
But businesses can purchase options to buy a foreign currency 30, 60, or 90 days in the future at today’s XR, thereby insuring themselves against short-term XR volatility
Nevertheless, a reduction in investment is one possible consequence of currency misalignments

35. Fixed XR A kind of commitment
To avoid SPECULATATION governments try to make a credible commitment to a fixed XR
If the commitment is not credible, speculation can be disastrous
Argentine Currency Board ( )
Pegged the Argentine peso to the U.S. dollar in an attempt to eliminate hyperinflation
Credibility? Required legislative vote to change the value of the currency (public discussion undermines the point of a devaluation!)
But deficit spending ultimately undermined confidence
And tied hands prevented the government from acting
Run on the currency in 2002  disaster!!

36. a country can only have 2 out of 3 of these
Free Capital Flow
USA
PRC
Inconsistent/Unholy
Trinity Or
“Trilemma”:
a country can only have 2 out of 3 of these
Fixed Exchange Rate
Sovereign Monetary Policy

37. Why is the US dollar special?

38. Overvaluation of the Dollar
International reserve currency
Early 1980s: Reagan’s fiscal expansion – cut taxes, increased spending 
Current account deficit 
Increased interest rates and capital inflows (from, e.g., Japan)
Value of the dollar goes up!
Plaza Accord (fall 1985): G5 agreed to reduce the value of the dollar against the yen & mark by 10-12% – sell dollars if it appeared the value was going to increase
By early 1987, dollar had depreciated 40%

39. Similar situation today
US twin deficits: fiscal & current account
Japan, Europe, China, current account surpluses 
Finance the American deficit
US absorbs about 6% of the world’s savings
US international investment position:
foreign-owned assets in 2007: $17.8 trillion
US residents’ foreign assets in 2007: $15.4 trillion
international investment position: –$2.4 trillion

40. What’s the worry? Catastrophe!
Doubts about the solvency of American financial institutions & American assets
Foreign lenders reluctant to continue to accumulate dollar-denominated assets
Trigger massive sales of current holdings?

41. Hope? Cooperation amongst G5? US needs to reduce its budget deficit
(G5??? p China?)
US needs to reduce its budget deficit
Countries with surpluses need to expand demand in their own countries
Macroeconomic coordination along these lines would reduce American imports & expand consumption in surplus countries
Cooperation could also guide a gradual decline of the $, rather than a fast catastrophic drop
Problem for China: adjustment moving from the US market to the domestic market would create economic dislocation, winners & losers…  political instability?
This is a reality that the Chinese government must deal with and therefore the American government must also!
But a catastrophic drop would hurt the export-oriented sectors of all countries with current account surpluses with the US!

42. Take aways Democracy  Fall of the gold standard
Fall of Bretton Woods replaced with floating XR
The Trilemma
France vs. Germany in the 1980s
Floating XR allows for flexibility in monetary policy
China-US problem – we have incompatible solutions to our trilemmas

43. Thank you

44. Source: http://www.fas.org/sgp/crs/row/RS22860.pdf