International Monetary System

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International Monetary System
Linda Young POLS 400 International Political
Economy Wilson Hall Room 1122
Fall 2005
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The International Monetary and Financial Systems

• International monetary system facilitate
  transactions
• International financial systems provide
  investment capital throughout the world
• No integrated and operative international
  financial system until late 1960s due to controls
  by most countries
• US dollar as basis meant that the US could
  print more money when needed other countries
  lacked that option

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International Monetary and Financial Systems
(cont)

• Exchange rate crises, debt crises, availability
  of capital are all important in understanding
  outcomes

• Political outcomes elections and other
• Economic outcomes
• volatility discourages investment
• impacts growth
• availability of credit (capital) critical

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International Capital Flows

• Motivation for huge increase
• reduced barriers
• investor diversification
• new financial instruments
• Categories
• foreign direct investment (less volatile, about ¼
  total now)
• 10 or more of the publicly traded shared of an
  enterprise in another country
• establishment of a firm lasting influence

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International Capital Flows (cont)

• Portfolio (stocks and bonds)
• Cross border sales of bonds, money market
  accounts, purchase of foreign equity securities,
  financial derivatives such as future contracts
  and options
• Bank deposits bank loans, short term in nature

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Basic Concepts

• Monetary transaction converting money from one
  currency to another
• Financial transaction movement of capital from
  one country to another

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Viewpoints

• Realists
• States (largely) have independent currencies
• EU a real exception
• Increased financial flows due to encouragement of
  the most powerful states who benefit from the
  current structure
• Liberals growth of financial flows and
  interdependence means that states have difficulty
  in enacting policies to regulate economic
  activities

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Your Finances

• Keep track of your inflows and outflows
• Daily payments and receipts checking account
• living within your means day-to-day
• Longer term borrowing, savings, investment in a
  different form capital and financial account
• wealthier or falling into debt
• What happens in one affects the other
• Income greater than expenses transfer surplus
  from checking (current account) to your capital
  and financial account
• If expenses higher than income, then build up
  credit card or other debt
• Surplus, deficit or equilibrium

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Balance of Payments
Cat KOt ORTt 0

• Record of a countrys transactions with the rest
  of the world (ROW) measures inflows and
  outflows to other countries in current dollars

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CA Current Account (your checking account)

• Money Inflows money received for exports of
  goods and services to foreign buyers, profit and
  interest received from US owned foreign assets
  and unilateral transfers from other nations
• Money Outflows money paid for imports of goods,
  services, profit and interests paid to the
  foreign owners of US assets and unilateral
  transfers to foreign persons
• While income from a factory abroad would show up
  here, the investment to build the factory would
  be in the capital account
• Visible commodity trade
• Invisible shipping, TOURISM

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KO Capital Account (your savings)

• Inflows money received from foreign buyers of US
  bonds, stocks, real estate, patents or other
  assets
• Outflows money paid to foreign sellers for
  purchase of foreign bonds, stocks, real estate,
  patents or other assets
• All international asset transactions including
  those made by monetary authorities
• Private foreign investment and public grants and
  loans
• US residents buy German bonds (an outflow)
• German residents buy US assets (an inflow)
• Foreign direct investment (FDI) a factory built
  in Canada
• Long-term portfolio investment (purchases of
  securities and bank loans)
• Short-term purchases of securities
• maturity less than one year

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Relationship Between the Two

• Back to personal finance analogy

• With a surplus in the current account
• transfer to capital account

Should people always have a surplus in their
current account? life cycle theory of savings
Apply to nations?
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Balance of Payments (cont)

• Official Reserve Transactions (ORT)
• Central bank transactions in the form of
  international reserve assets such as gold and
  major currencies changes in foreign bank
  holdings of domestic assets and change in
  domestic central bank holdings of foreign assets
• ORTs result from other transactions
• Talk about this more in the context of exchange
  rates (ERs)

Cat KOt -ORTt
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Current Account Deficits

• When absorption gt output
• Absorption as consumption includes business
  investment and government spending
• Arguments for current account deficit
• Position of major countries
• Structural adjustment programs spring from
  changing the balance between absorption and
  output
• Need to increase output, decrease absorption, or
  both (austerity programs)
• Increase output tax incentives, wage controls,
  improved regulatory system
• Lowering absorption (consumption) raise taxes,
  reduce government transfers, increase interest
  rates

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National Income Accounting

• Y Gross National Product (GNP) total value of
  all final goods and services produced by a
  countrys factors of production

C Consumption purchases by private sector for
current wants

• I Investment part of current output used to
  increase in the capital stock and produce
  more output in future

• G Government purchases goods and services
  purchased by the public sector

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In a closed economy, what is relationship between
these variables?
Y C I G
This equation is true by definition, we call it
an identity
In a closed economy, each item produced is going
to be utilized for something within the country
Y - C - G I S I
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In an open economy
Now goods can flow across national borders, so
the goods produced within the US do not need to
be utilized within the US
Y C I G EX - IM
Exports less imports can roughly be referred to
as the current account
CA EX - IM
Y C I G CA Y - C - G I CA S I CA
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New Way to Compute Current Accounts
Difference between national saving and investment
CA S - I
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US Current Account
Source IMF
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If the current account is in deficit
How is the U.S. paying for its imports in excess
of exports?
It is selling off its assets, the wealth created
by past production.
Example Suppose consumers in the US purchase a
million Toyotas from Japan and give Toyota in
Japan dollars in exchange. Japanese will use some
of these dollars to buy Fords from the US, but
suppose they only want half a million Fords. What
will they do with the remaining dollars? They may
use them to purchase real estate in the US or US
government bonds which are government IOUs. In a
sense, the US is borrowing from rest of world.
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Is the increase in indebtedness bad?
CA S I Y C G - I

• CA negative as consumption high relative to
  output or
• Investment spending is high
• Or increase in government spending

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Understanding the Twin Deficits Hypothesis
Y - C - I - G CA
(Y - T) - C - I - (G - T) CA
Define Yd Y - T disposable income
(Yd - C) (T - G) - I CA
Sp Sg - I CA
Sp Yd - C
Sg T - G
Sp - def - I CA
the government budget deficit def G - T
All else constant, a worsening budget deficit
(def) will lead to a fall in the current account
balance (CA)
Private saving and investment can also change and
potentially cause current account deficits as well
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US Current Account and Components
Source IMF
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Exchange Rates (ER)

• Price of one currency for another currency
• Who has been to Europe? More or less expensive
  than before?
• How are exchange rates determined?
• Interest rates and investment returns demand for
  dollars to purchase US securities and other
  interest bearing investments if interest rates
  higher, greater demand for the dollar and thus
  the dollar appreciates
• So self-correcting and also influenced by policy
• What do the G-8 talk about?
• Why are they volatile?

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History and Types of Exchange Rates

• Gold standard (1870s to 1914) value of money
  fixed in terms of gold
• Dollar 35 and 14.5 per ounce of gold
• so exchange rate was 2.41 per
• Backed by British hegemony
• Sacrifice domestic goals for stability

US dollar () British pound ()
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Inter-War Period Competitive Devaluations

• Britain unable to maintain the gold standard
  exchange regime
• Competitive devaluations
• Shift to floating exchange rates
• Countries did not want to sacrifice domestic
  goals for currency stability

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Bretton Woods Post WWII

• What do you want in an exchange rate regime?
• Stability and autonomy
• Stability if currencies pegged to a leader, or
  tied to a monetary asset (gold) or coordination
  of economic policies by governments
• Currency pegged to gold or the US dollar
• Pegged exchange rates for stability, but also
  some flexibility of adjustment
• Countries could revalue their currency under
  International Monetary Fund (IMF) guidance
• IMF to provide short-term loans for
  balance-of-payment problems and domestic problems
  from exchange-rate volatility
• Support for national control over movement of
  capital
• Why does this seem astonishing now????

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US Dollar as Key

• International Monetary Fund to provide reserves
  for stabilization, but the reserves of dollars
  held by member governments achieved this goal
• Key role of dollar
• facilitated achievement of US political alliance
• its role as a currency of transaction facilitated
  trade

• US right of seiniorage privilege
• print dollars to finance wars
• other countries unhappy about US privilege
• G-8 proposed to combat US hegemonic privilege
  but it ensconced it
• France converting US dollars to put pressure on
  the dollar

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US Dollar as Key (cont)

• But has to pay interest to countries holding
  assets in its currency
• Has to maintain confidence in the currency
• banking system of the country benefits
  economies of scale as reserves and transactions
  in its currency
• US spent a lot of to help allies and great
  society programs
• By Vietnam war could not redeem it all for
  35/oz. and went off gold standard
• US partners persuaded to hold overvalued US
  dollars

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US had its first trade deficit in 1971

• Declining competitiveness
• Could not devalue currency(as its the reserve)
  to reduce trade deficit
• Allowed the US to live beyond its means
• then and NOW

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World Oil Price Chronology 1970-2003
Source U.S. Department of Energy, Energy
Information Administration, March 2004.
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End of Fixed Exchange Rates

• Nixon announced end of fixed exchange rates
  August 15, 1971

Other countries agreed to appreciate their
currencies why didnt they want to?
1976 flexible rates
Belief/hope that flexible rates would give
governments more autonomy
Fear that without being linked to monetary asset
inflation would result
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New Monetary System

• However, capital flows grew dwarfed trade flows
  251

• Increased financial markets led to growth of
  multinational corporations (MNCs)
• Size of capital flows led to exchange-rate
  volatility

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to
1
Trade Flows
Capital Flows
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Floating Rates

• Bretton Woods outlawed floating rates most
  countries violated by 1973 meeting to
  determine what to do
• Free float governments do not intervene in the
  value of their currency
• Managed floating members do intervene to prevent
  excessive fluctuations
• Today
• US, Japan, Canada and some Least Developed
  Countries float
• EU countries manage and coordinate the EURO ()
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
  
• Isolate themselves from irresponsible US policies
  
• Perhaps gain benefits from seiniorage
• Least Developed Countries frequently peg their
  currencies to a key currency or a basket
• Shift to floating rates created a crises of
  purpose for the International Monetary Fund

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Misalignment and Volatility

• Misalignment long run, sustained by government
  policy
• China and its currency undervaluation
• Volatility due to massive flows of capital
• Negative consequences for growth
• Contributed to the new protectionism
• Alternatives found in regional relationships such
  as the EU
• Different than dollarization

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Integration of Global Financial Markets

• A country raises interest rates and attracts
  capital from other countries to benefit from the
  higher rate causes a contraction in economic
  activity in the country from which the capital
  flowed

Reduced capacity for governments to achieve full
employment, which undermines support for
integration in the world economy
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Contributed to Increasing Importance of
Multinational Corporations
Reorganization of business

• Single, globally integrated market for
  international business take-overs acquisitions
  and alliances

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Triangle Exchange Rates, Capital Flowsand
Monetary Policy

• Three variables only twocan be accommodated

• Free capital flows
• Fixed exchange rates
  
  
  
  
  
  
  
  
• Independent monetary policy

Source Economic Report of the President, 2003,
chapter 13
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Triangle Examples (cont)

• US has a flexible exchange rate and free flow of
  capital interests rates set high by US Federal
  Reserve, so inflow of capital, currency
  appreciation
• China pegs exchange rate to US can operate
  independent monetary policy as restrictions on
  capital flows

• Hong Kong has free capital flows and flexible
  exchange rate so cannot adjust interest rates

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Reform the System?

• Adjustment
• Liquidity
• Need reserves to meet balance-of-payment
  difficulties caused by shocks (oil)
• Confidence