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The International Monetary System: Contemporary International Monetary Arrangements

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Title: The International Monetary System: Contemporary International Monetary Arrangements


1
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
  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

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

Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1944
1870
BRETTON WOODS PERIOD
7
A puzzleWhy 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
1971-3
1870
Interwar period
1944
8
Why?
9
Answer Democracy
Growing s of democracies LABOR UNIONS!
Few democracies
Fixed exchange rates Open capital flows
Degree of global capital mobility
Fixed exchange rates Capital controls
Floating exchange rates Open capital flows
1971-3
1870
Interwar period
1944
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 doesnt 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 dont eat!

14
People dont 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
  • Mobile capital, authoritarian governments
  • Interwar years
  • Mobile capital democracy ? beggar-thy-neighbor
  • http//www.youtube.com/watch?v3_ex0sTsb_Ifeature
    channel
  • Bretton Woods (1944-1971/3)
  • Capital controls democracy
  • http//www.youtube.com/watch?vGVytOtfPZe8
  • Post Bretton Woods
  • Floating exchange rates
  • http//www.youtube.com/watch?viRzr1QU6K1o

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
  • http//www.youtube.com/watch?viRzr1QU6K1o

19
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20
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21
http//www.youtube.com/watch?vloBe0WXtts8
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
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 cant 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

25
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
Fixed Exchange Rate
Eurozone countries
Switzerland
PRC
The Trilemma
Open Capital Flows
Sovereign Monetary Policy
27
Fixed Exchange Rate
Eurozone countries
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
    XRs (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 todays 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 (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!!

36
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 Reagans 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 worlds 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
Whats 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?vqu2uJWSZkck

41
Hope?
  • Cooperation amongst G5?
  • (G5??? p255... 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
  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

43
Thank you
44
Source http//www.fas.org/sgp/crs/row/RS22860.pdf
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