Eco 328Managing reserves, the gold standard and monetary history

1

Why Does the Composition of the Money Supply Fluctuate?

• If depositors fear that banks are either insolvent or illiquid, a bank run may occur, and if the problem spreads to other banks, the panic may lead to a flight from domestic deposits to foreign bank deposits.

• As depositors demand foreign currency, they drain reserves and make it more likely that devaluation will happen. Devaluation leads to a higher-risk premium, worsening economic conditions and a flight from the currency.

2

Risk Premiums in Advanced and Emerging Markets

• Uncovered interest parity (UIP) requires that the domestic return equal the foreign interest rate plus the expected rate of depreciation of the home currency.

• When additional risks affect home bank deposits, a risk premium is added to compensate investors for the perceived risk of holding a home domestic currency deposit.

3

Risk Premiums in Advanced and Emerging Markets

• The first part of the interest rate spread is the currency premium:

• The second part of the interest rate spread is known as the country premium:

Currency premium =DEpeso/$

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Epeso/$

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risk premium

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Country premium =Default

risk premium

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4

When advanced countries peg, the interest rate spread is usually close to zero, and we can assume i = i*. An example is Denmark’s peg to the euro in panel (a), where the correlation between the krone and euro interest rates is 0.96.

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The Argentine Convertibility Plan After the Tequila Crisis

Banking Crisis, 1995

• After the Mexican Tequila crisis in December 1994, higher interest rates, a budget deficit, and damage to commercial banks’ balance sheets, Argentina faced a banking crisis.

• Reserves drained, casting more doubt on the viability of the fixed exchange rate, raising the currency premium, and draining more reserves. Given the fears of a banking crisis and exchange rate crisis, cash and bank deposits were switched into dollars and moved to banks in offshore locations. People were now starting to run from the currency, too.

• The country was getting perilously close to the floating line, the dangerous place where reserves run out.

6

When emerging markets peg, interest rate spreads can be large and volatile. An example is Argentina’s peg to the U.S. dollar in panel (b), where the correlation between the peso interest rate and the U.S. interest rate is only 0.38. 7

In this period, one peso was worth one U.S. dollar. Panel (a) shows the money supply and reserves. The difference between the two is domestic credit. Six key dates are highlighted around the Mexican Tequila crisis. 8

Argentina’s Central Bank Operations, 1993-1997

The balance sheet of the central bank at these key dates is shown. Prior to the crisis, domestic credit was essentially unchanged, and reserves grew from $8 billion to $11 billion as money demand grew from M1 to M2 in line with rapid growth in incomes (move from point 1 to 2).

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Argentina’s Central Bank Operations, 1993-1997

After the crisis hit in December 1994, interest rate spreads widened, money demand fell from M2 to M3, but domestic credit stood still (to point 3) and $1 billion in reserves were lost.

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Argentina’s Central Bank Operations, 1993-1997

The Argentine Convertibility Plan after the Tequila Crisis

Help From the IMF and Recovery

• After the Tequila crisis, the United States advanced a large assistance package to Mexico, and the IMF took a more lenient view of the Argentine situation, fearing the possibility of a global financial crisis if Argentina crashed, too.

• The economy recovered, capital flows resumed, and eventually the central bank’s emergency loans were paid back.

• By 1996 economic growth had picked up, interest rate spreads eased, and confidence returned.

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In this period, one peso was worth one U.S. dollar. Panel (a) shows the money supply and reserves. The difference between the two is domestic credit. Six key dates are highlighted around the Mexican Tequila crisis. 12

Argentina’s Central Bank Operations, 1993-1997

In 1995 there was a run on banks and on the currency, and the central bank sterilized by expanding domestic credit by 5 billion pesos and selling $5 billion of reserves as money demand remained constant (to point 4). Reserves reached a low level of $5 billion.

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Argentina’s Central Bank Operations, 1993-1997

By 1996 the crisis had passed and the central bank replenished its reserves, reversing the earlier sterilization. Domestic credit fell by 5 billion pesos and reserves increased by $5 billion (to point 5, same as point 3). Further sterilized purchases of $4 billion of reserves brought the backing ratio up to 100% in 1997 (to point 6).

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Argentina’s Central Bank Operations, 1993-1997

In general, money supply is equal to net foreign assets plus net domestic assets. The only real difference is the ability of the central bank to borrow by issuing nonmonetary liabilities, whether domestic or foreign.

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The Gold Standard

• Historically, the only true symmetric systems have been those

in which countries fixed the value of their currency relative to

some commodity.

• The most famous and important of these systems was the gold

standard.

• The gold standard had no center country because countries did

not peg the exchange rate at ത𝐸, the local currency price of some

base currency.

• Instead they pegged at ത𝑃g, the local currency price of gold.

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The Gold Standard

• For example, consider two countries, Britain pegging to gold at ത𝑃g

(pounds per ounce of gold) and France pegging to gold at ത𝑃*g

(francs per ounce of gold).

• Under this system, one pound cost 1/ ത𝑃g ounces of gold, and each

ounce of gold cost ത𝑃g francs, according to the fixed gold prices set

by the central banks in each country.

• One pound cost ത𝐸par = ത𝑃*g / ത𝑃g francs, and this ratio defined the

par exchange rate implied by the gold prices in each country.

• The gold standard rested on the principle of free convertibility.

Central banks in both countries stood ready to buy and sell gold in

exchange for paper money at these mint prices, and the export and

import of gold were unrestricted.

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• Our model suggests that as the volume of trade and other economic

transactions between nations increase, there will be more to gain

from adopting a fixed exchange rate.

• In the nineteenth century it is likely that more countries crossed the

FIX line and met the economic criteria for fixing.

• There were other forces at work encouraging a switch to the gold

peg before 1914.

• But the benefits were often less palpable than the costs, particularly

in times of deflation or in recessions.

• By the 1930s, world trade had fallen to close to half of its 1914

level and the rationale for fixing based on gains from trade was

being weakened.

The Rise and Fall of the Gold Standard

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Each corner of the triangle represents a viable policy choice. The labels on the two adjacent edges of the triangle are the goals that can be

attained; the label on the opposite edge is the goal that has to be sacrificed. Trade gains and an absence of (or political indifference to) stability

costs help explain how the gold standard came into being before 1914 (top corner).19

Subsequently, reduced trade gains and higher actual (or politically relevant) stability costs help explain the ultimate demise of the gold standard

in the 1920s and 1930s. Countries sought new solutions to the trilemma to achieve policy autonomy, either by floating (bottom right corner) or

by adopting capital controls (bottom left corner).20

• The architects of the postwar order, notably Harry Dexter White

and John Maynard Keynes, constructed a system that preserved

one key tenet of the gold standard regime—by keeping fixed

rates—but discarded the other by imposing capital controls.

• The trilemma was resolved in favor of exchange rate stability to

encourage the rebuilding of trade in the postwar period.

• Countries would peg to the U.S. dollar; this made the U.S.

dollar the center currency and the United States the center

country.

• The U.S. dollar was, in turn, pegged to gold at a fixed price, a

last vestige of the gold standard.

Bretton Woods to the Present

21

In the 1960s, the Bretton Woods system became unsustainable because capital mobility could not be contained. Thus, countries could no

longer have fixed rates and monetary autonomy (bottom left corner).

22

In the advanced countries, the trilemma was resolved by a shift to floating rates, which preserved autonomy and allowed for the present

era of capital mobility (bottom right corner).

23

The main exception was the currency union of the Eurozone. In developing countries and emerging markets, the “fear of floating” was

stronger; when capital markets were opened, monetary policy autonomy was more often sacrificed and fixed exchange rates were

maintained (top corner).24

• As capital mobility grew and controls failed to hold, the

trilemma tells us that countries pegged to the dollar stood to lose

their monetary policy autonomy.

• The devaluation option came to be seen as the most important

way of achieving policy compromise in a “fixed but adjustable”

system. But increasingly frequent devaluations (and some

revaluations) undermined the notion of a truly fixed rate system,

and made it more unstable.

• It was also believed that this inflation would eventually conflict

with the goal of fixing the dollar price of gold and that the

United States would eventually abandon its commitment to

convert dollars into gold, which happened in August 1971.

Bretton Woods to the Present

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• How did the world react to the collapse of the Bretton Woods

system?

o Most advanced countries have opted to float and preserve

monetary policy autonomy.

o A group of European countries instead decided to try to

preserve a fixed exchange rate system among themselves.

o Some developing countries have maintained capital controls,

but many of them (especially the emerging markets) have

opened their capital markets.

Bretton Woods to the Present

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• How did the world react to the collapse of the Bretton Woods

system?

o Some countries, both developed and developing, have

camped in the middle ground: they have attempted to

maintain intermediate regimes, such as “dirty floats” or pegs

with “limited flexibility.”

o Finally, some countries still impose some capital controls

rather than embrace globalization.

Bretton Woods to the Present

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