The International Monetary System:

Contemporary International Monetary Arrangements

READING ASSIGNMENT: Oatley – Chapter 11

1

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)

2

Plan for today

1. The rise and fall of Bretton Woods

2. Why fail to address a BoP imbalance under fixed XR – why “beggar-thy-neighbor”?

3. The Trilemma

4. France vs. Germany in the 1980s

5. How to deal with imbalances: fix vs. float

6. The US $

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1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

4

THE RISE AND FALL OF BRETTON WOODSA puzzle

BRETTON WOODS PERIOD

Conclusion:

Cannot maintain (global) fixed exchange rates in the presence of

high capital mobility…?

5

1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870

*

6

THE RISE AND FALL OF BRETTON WOODSA puzzle

BRETTON WOODS PERIOD

A puzzle:Why were countries able to maintain fixed exchange

rates with high capital mobility in the late 19th century?

1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870 Interwar period

Fixed exchange rates

+

Open capital flows

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Why?

8

Answer: Democracy

1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870 Interwar period

Fixed exchange rates

+

Open capital flows

Growing #’s of democracies + LABOR UNIONS!

Few democracies

9

Why?

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

10

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

11

With paper money

• Central Banks intervene by adjusting interest rates

• So gold doesn’t actually flow

• Gold Standard strict discipline!

12

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!

13

People don’t eat

Under authoritarianism:

• Let them eat cake

Under democracy:

• Incumbents lose elections

14

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

2015105

0.625

0.5

0.375

0.25

Time (years)

Hazard Rate

Time (years)

Hazard Rate

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Stylized history• Late 19th century:

– Mobile capital, authoritarian governments

• Interwar years:– Mobile capital + democracy beggar-thy-neighbor– http://www.youtube.com/watch?v=3_ex0sTsb_I&feature=channel

• Bretton Woods (1944-1971/3):– Capital controls + democracy– http://www.youtube.com/watch?v=GVytOtfPZe8

• Post Bretton Woods:– Floating exchange rates– http://www.youtube.com/watch?v=iRzr1QU6K1o

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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:

1. Some XR flexibility (fixed-but-adjustable “snake”)

2. Capital controls

3. A stabilization fund (held on reserve at the IMF)

4. The International Monetary Fund – authority over XR changes + conditionality attached to loans

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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

• http://www.youtube.com/watch?v=iRzr1QU6K1o 18

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http://www.youtube.com/watch?v=loBe0WXtts8

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. 22

The saga continues…

The Unholy Trinity

• Fixed Exchange Rate

• Autonomy of Monetary Policy

• Capital Mobility

Mundell-Fleming: Only 2 out of 3 are possible

23

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 http://slate.com/id/36764

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Free Capital Flow

Fixed Exchange Rate Sovereign Monetary Policy

Inconsistent/UnholyTrinity

Or“Trilemma”:

a country can only have 2 out of 3 of these

SwitzerlandPRC

Eurozone countries

The Trilemma

Fixed Exchange Rate

Open Capital Flows

Sovereign Monetary Policy

SwitzerlandPRC

Eurozone countries

26

The Trilemma

Fixed Exchange Rate

Open Capital Flows

Sovereign Monetary Policy

SwitzerlandPRC

Eurozone countries

27

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

28

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

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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

30

To fix or to float?

31

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

32

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

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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

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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 (1991-2002)– 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!!

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Free Capital Flow

Fixed Exchange Rate Sovereign Monetary Policy

Inconsistent/UnholyTrinity

Or“Trilemma”:

a country can only have 2 out of 3 of these

USAPRC

Why is the US dollar special?

37

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%38

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

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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?

• http://www.youtube.com/watch?v=qu2uJWSZkck

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Hope?• Cooperation amongst G5?

– (G5??? p255... China?)

1. US needs to reduce its budget deficit

2. 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!

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Take aways

1. Democracy Fall of the gold standard

2. Fall of Bretton Woods replaced with floating XR

3. The Trilemma

4. France vs. Germany in the 1980s

5. Floating XR allows for flexibility in monetary policy

6. China-US problem – we have incompatible solutions to our trilemmas

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Thank you

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

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