Microsoft PowerPoint – C19_ECON7520_week7
Chapter 19
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International Monetary System
: An Historical Overview
Instructor:
Learning Objectives (1 of 3)
19.1 Explain how the goals of internal and external balance
motivate economic policy makers in open economies.
19.2 Understand the monetary trilemma that policy makers
in open economies inevitably face and how alternative
international monetary systems address the trilemma in
different ways.
Learning Objectives (2 of 3)
19.3 Describe the structure of the international gold standard
that linked countries’ exchange rates and policies prior
to World War I and the role of the Great Depression of
the 1930s in ending efforts to restore the pre-1914 world
monetary order.
19.4 Discuss how the post–World War II Bretton Woods
system of globally fixed exchange rates was designed to
combine exchange rate stability with limited autonomy of
national macroeconomic policies.
Learning Objectives (3 of 3)
19.5 Explain how the Bretton Woods system collapsed in
1973 and why many economists at the time favored an
international financial system such as the current one based
on floating dollar exchange rates.
19.6 Summarize how the monetary and fiscal policies of a
large country such as the United States are transmitted
abroad under floating exchange rates.
19.7 Discuss how the world economy has performed in
recent years and what lessons the post-1973 experience
teaches about the need for international policy coordination.
Preview (1 of 2)
• Goals of macroeconomic policies—internal and external
• Gold standard era 1870–1914
• International monetary system during interwar period
• Bretton Woods system of fixed exchange rates 1944–1973
Preview (2 of 2)
• Collapse of the Bretton Woods system
• Arguments for floating exchange rates
• Macroeconomic interdependence under a floating
exchange rate
• Foreign exchange markets since 1973
Macroeconomic Policy Goals (1 of 3)
• Internal balance describes the macroeconomic goals of
producing at potential output (at “full employment”) and of
price stability (low inflation).
– An unsustainable use of resources (overemployment)
tends to increase prices; an ineffective use of resources
(underemployment) tends to decrease prices.
• Volatile aggregate demand and output tend to create
volatile prices.
– Price-level movements reduce economy’s efficiency by
making the real value of the monetary unit less certain
and thus a less useful guide for economic decisions.
Macroeconomic Policy Goals (2 of 3)
• External balance is achieved when a current account is
– neither so deeply in deficit that the country may be
unable to repay its foreign debts,
– nor so strongly in surplus that foreigners are put in
that position.
▪ For example, pressure on Japan in the 1980s and
China in the 2000s.
• An intertemporal budget constraint limits each
country’s spending over time to levels that it can repay
(with interest).
Macroeconomic Policy Goals (3 of 3)
• When countries begin to have trouble meeting their
payments on past foreign loans, foreign creditors become
reluctant to lend them new funds and may even demand
immediate repayment of the earlier loans.
• Such an event is called a sudden stop in foreign lending.
• In such cases, the home government may have to take
severe action to reduce the country’s desired borrowing
from foreigners to feasible levels as well as to repay
maturing loans that foreigners are unwilling to renew.
Can A Country Borrow Forever? The
• has run current account deficits every year for as
far back as official statistics have been recorded.
• Lenders continue to extend credit and do not seem worried
about whether they will be repaid.
• Appears that a country can borrow year after year without going
broke, as long as does not borrow too much.
• By holding net exports to GDP constant at the right value, a
country (like ) with initial net foreign debt will
perpetually run deficits in its current account while still
maintaining a constant ratio of net foreign liabilities to national
’s Net Exports, Current Account, and Net
International Investment Position, 1992–2019
has consistently had a current account deficit for decades, yet its
net foreign liabilities have averaged about 70 percent of GDP and have been
falling in recent years.
Source: Statistics .
The Open-Economy Trilemma (1 of 2)
• A country that fixes its currency’s exchange rate while allowing
free international capital movements gives up control over
domestic monetary policy.
• A country that fixes its exchange rate can have control over
domestic monetary policy if it restricts international
financial flows so that interest parity *R R need not hold.
• Or a country can allow international capital to flow freely and
have control over domestic monetary policy if it allows the
exchange rate to float.
The Open-Economy Trilemma (2 of 2)
• Impossible for a country to achieve more than two items
from the following list:
1. Exchange rate stability.
2. Monetary policy oriented toward domestic goals.
3. Freedom of international capital movements.
Figure 19.1 The Monetary Trilemma for Open
The vertices of the triangle show three features that policy makers in open
economies would prefer their monetary system to achieve. Unfortunately, at
most two can coexist. Each of the three policy regime labels along the triangle’s
edges (floating exchange rate, fixed exchange rate, financial controls) is
consistent with the two goals that it lies between in the diagram.
Macroeconomic Policy under the Gold Standard
• The gold standard from 1870 to 1914 and after 1918 had
mechanisms that prevented flows of gold reserves (the
balance of payments) from becoming too positive or too
– Prices tended to adjust according the amount of gold
circulating in an economy, which had effects on the
flows of goods and services: the current account.
– Central banks influenced financial asset flows, so that
the non-reserve part of the financial account matched
the current account in order to reduce gold outflows
or inflows.
Macroeconomic Policy under the Gold
Standard (1 of 5)
• Price-specie-flow mechanism is the adjustment of prices as gold
(“specie”) flows into or out of a country, causing an adjustment in the
flow of goods.
– An inflow of gold tends to inflate prices.
– An outflow of gold tends to deflate prices.
– If a domestic country has a current account surplus in excess of
the non-reserve financial account, gold earned from exports
flows into the country—raising prices in that country and
lowering prices in foreign countries.
▪ Goods from the domestic country become expensive and
goods from foreign countries become cheap, reducing the
current account surplus of the domestic country and the
deficits of the foreign countries.
Macroeconomic Policy under the Gold
Standard (2 of 5)
• Thus, price-specie-flow mechanism of the gold standard
could automatically reduce current account surpluses and
deficits, achieving a measure of external balance for all
countries.
Macroeconomic Policy under the Gold
Standard (3 of 5)
• The Rules of the Game under the gold standard refer to another
adjustment process that was theoretically carried out by central
– The selling of domestic assets to acquire money when gold
exited the country as payments for imports. This decreased the
money supply and increased interest rates, attracting financial
inflows to match a current account deficit.
▪ This reversed or reduced gold outflows.
– The buying of domestic assets when gold enters the country as
income from exports. This increased the money supply and
decreased interest rates, reducing financial inflows to match the
current account.
▪ This reversed or reduced gold inflows.
Macroeconomic Policy under the Gold
Standard (4 of 5)
• Banks with decreasing gold reserves had a strong
incentive to practice the rules of the game: they could not
redeem currency without sufficient gold.
• Banks with increasing gold reserves had a weak
incentive to practice the rules of the game: gold did not
earn interest, but domestic assets did.
• In practice, central banks with increasing gold reserves
seldom followed the rules.
• And central banks often sterilized gold flows, trying to
prevent any effect on money supplies and prices.
Macroeconomic Policy under the Gold
Standard (5 of 5)
• The gold standard’s record for internal balance was mixed.
– The United States suffered from deflation, recessions,
and financial instability during the 1870s, 1880s, and
1890s while trying to adhere to a gold standard.
– The U.S. unemployment rate was 6.8% on average
from 1890 to 1913, but it was less than 5.7% on
average from 1946 to 1992.
Interwar Years: 1918–1939
• The gold standard was stopped in 1914 due to war, but after
1918 it was attempted again.
– The United States reinstated the gold standard from 1919
to 1933 at $20.67 per ounce and from 1934 to 1944 at
$35.00 per ounce (a devaluation of the dollar).
– The United Kingdom reinstated the gold standard from
1925 to 1931.
• But countries that adhered to the gold standard for the longest
time, without devaluing their currencies, suffered most from
reduced output and employment during the 1930s.
Bretton Woods System: 1944–1973
• In July 1944, 44 countries met in Bretton Woods, NH, to
design the Bretton Woods system:
– a fixed exchange rate against the U.S. dollar and a
fixed dollar price of gold ($35 per ounce).
• They also established other institutions:
1. The International Monetary Fund
2. The World Bank
3. General Agreement on Trade and Tariffs (GATT), the
predecessor to the World Trade Organization (WTO).
International Monetary Fund (1 of 2)
• The IMF was constructed to lend to countries with persistent
balance of payments deficits (or current account deficits), and
to approve of devaluations.
– Loans were made from a fund paid for by members in gold
and currencies.
– Each country had a quota, which determined its
contribution to the fund and the maximum amount it could
– Large loans were made conditional on the supervision of
domestic policies by the IMF: IMF conditionality.
– Devaluations could occur if the IMF determined that the
economy was experiencing a “fundamental disequilibrium.”
International Monetary Fund (2 of 2)
• Due to borrowing and occasional devaluations, the IMF
was believed to give countries enough flexibility to attain
an external balance, yet allow them to maintain an
internal balance and stable exchange rates.
– The volatility of exchange rates during 1918–1939,
caused by devaluations and the vagaries of the gold
standard, was viewed as a source of economic
instability.
Bretton Woods System (1 of 2)
• In order to avoid sudden changes in the financial account
(possibly causing a balance of payments crisis), countries
in the Bretton Woods system often prevented flows of
financial assets across countries.
• Yet they encouraged flows of goods and services
because of the view that trade benefits all economies.
– Currencies were gradually made convertible
(exchangeable) between member countries to
encourage trade in goods and services valued in
different currencies.
Bretton Woods System (2 of 2)
• Under a system of fixed exchange rates, all countries but
the United States had ineffective monetary policies for
internal balance.
• The principal tool for internal balance was fiscal policy
(government purchases or taxes).
• The principal tools for external balance were borrowing
from the IMF, restrictions on financial asset flows, and
infrequent changes in exchange rates.
Policies for Internal and External Balance (1 of 4)
• Suppose internal balance in the short run occurs when production
is at potential output or when “full employment” equals aggregate
f EPY C I G CA A
• An increase in government purchases (or a decrease in taxes)
increases aggregate demand and output above its full employment
• To restore internal balance in the short run, a revaluation (a fall in E)
must occur.
Policies for Internal and External Balance (2 of 4)
• Suppose external balance in the short run occurs when the current
account achieves some value X:
• An increase in government purchases (or a decrease in taxes)
increases aggregate demand, output and income, decreasing the
current account.
• To restore external balance in the short run, a devaluation (a rise in E)
must occur.
Figure 19.2 Internal Balance (II), External Balance
(XX), and the “Four Zones of Economic Discomfort”
The diagram shows what different levels of the exchange rate, E, and overall
domestic spending, A, imply for employment and the current account. Along II,
output is at its full-employment level, .fY Along XX, the current account
is at its target level, X.
Figure 19.3 Policies to Bring about Internal and
External Balance
Unless the currency is devalued and the level of domestic spending rises, internal and
external balance (point 1) cannot be reached. Acting alone, a change in fiscal policy, for
example, enables the economy to attain either internal balance (point 3) or external
balance (point 4), but only at the cost of increasing the economy’s distance from the goal
that is sacrificed.
Policies for Internal and External Balance (3 of 4)
• But under the fixed exchange rates of the Bretton Woods
system, devaluations were supposed to be infrequent,
and fiscal policy was supposed to be the main policy tool
to achieve both internal and external balance.
• But in general, fiscal policy cannot attain both internal
balance and external balance at the same time.
• A devaluation, however, can attain both internal balance
and external balance at the same time.
Policies for Internal and External Balance (4 of 4)
• Under the Bretton Woods system, policy makers
generally used fiscal policy to try to achieve internal
balance for political reasons.
• Thus, an inability to adjust exchange rates
left countries facing external imbalances
over time.
– Infrequent devaluations or revaluations helped
restore external and internal balance, but
speculators also tried to anticipate them, which
could cause greater internal or external
imbalances.
U.S. External Balance Problems under
Bretton Woods (1 of 3)
• The collapse of the Bretton Woods system was caused
primarily by imbalances of the United States during the
1960s and 1970s.
– The U.S. current account surplus became a deficit in
– Rapidly increasing government purchases increased
aggregate demand and output, as well as prices.
– Rising prices and a growing money supply caused the
U.S. dollar to become overvalued in terms of gold and
in terms of foreign currencies.
U.S. External Balance Problems under
Bretton Woods (2 of 3)
• Another problem was that as foreign economies grew, their
need for official international reserves to maintain fixed
exchange rates grew as well.
• But this rate of growth was faster than the growth rate of the
gold reserves that central banks held.
– Supply of gold from new discoveries was growing slowly.
– Holding dollar-denominated assets was the alternative.
• At some point, dollar-denominated assets held by foreign
central banks would be greater than the amount of gold held
by the Federal Reserve.
U.S. External Balance Problems under
Bretton Woods (3 of 3)
• The Federal Reserve would eventually not have enough
gold: foreigners would lose confidence in the ability of
the Federal Reserve to maintain the fixed price of gold at
$35/ounce, and therefore would rush to redeem their
dollar assets before the gold ran out.
– This problem is similar to what any central bank may
face when it tries to maintain a fixed exchange rate.
– If markets perceive that the central bank does not
have enough official international reserve assets to
maintain a fixed rate, a balance of payments crisis is
inevitable.
Collapse of the Bretton Woods System (1 of 5)
• The United States was not willing to reduce government
purchases or increase taxes significantly, nor reduce money
supply growth.
• These policies would have reduced aggregate demand, output,
and inflation and increased unemployment.
– The United States could have attained some semblance of
external balance at a cost of a slower economy.
• A devaluation, however, could have avoided the costs of low
output and high unemployment and still have attained external
balance (an increased current account and official international
reserves).
Collapse of the Bretton Woods System (2 of 5)
• The imbalances of the United States , in turn, caused
speculation about the value of the U.S. dollar, which
caused imbalances for other countries and made the
system of fixed exchange rates harder to maintain.
– Financial markets had the perception that the
U.S. economy was experiencing a “fundamental
disequilibrium” and that a devaluation would
be necessary.
Collapse of the Bretton Woods System (3 of 5)
• First, speculation about a devaluation of the dollar caused
investors to buy large quantities of gold.
– The Federal Reserve sold large quantities of gold in March
1968, but closed markets afterwards.
– Thereafter, individuals and private institutions were no
longer allowed to redeem gold from the Federal Reserve or
other central banks.
– The Federal Reserve would sell only to other central banks
at $35/ounce.
– But even this arrangement did not hold: the United States
devalued its dollar in terms of gold in December 1971 to
$38/ounce.
Collapse of the Bretton Woods System (4 of 5)
• Second, speculation about a devaluation of the dollar in terms
of other currencies caused investors to buy large quantities of
foreign currency assets.
– A coordinated devaluation of the dollar against foreign
currencies of about 8% occurred in December 1971.
– Speculation about another devaluation occurred: European
central banks sold huge quantities of European currencies
in early February 1973, but closed markets afterward.
– Central banks in Japan and Europe stopped selling their
currencies and stopped purchasing of dollars in March
1973, and allowed demand and supply of currencies to
push the value of the dollar downward.
Collapse of the Bretton Woods System (5 of 5)
• The Bretton Woods system collapsed in 1973 because
central banks were unwilling to continue to buy
overvalued dollar-denominated assets and to sell
undervalued foreign currency–denominated assets.
• In 1973, central banks thought they would temporarily
stop trading in the foreign exchange market and would
let exchange rates adjust to supply and demand, and
then would reimpose fixed exchange rates soon.
• But no new global system of fixed rates was started
Table 19.1 Inflation Rates in Industrial Countries,
1966–1972 (Percent Per Year)
Country 1966 1967 1968 1969 1970 1971 1972
Britain 3.6 2.6 4.6 5.2 6.5 9.7 6.9
France 2.8 2.8 4.4 6.5 5.3 5.5 6.2
Germany 3.4 1.4 2.9 1.9 3.4 5.3 5.5
Italy 2.1 2.1 1.2 2.8 5.1 5.2 5.3
2.9 3.1 4.2 5.5 5.7 4.4 3.2
Source: Organization for Economic Cooperation and Development. Main Economic Indicators:
Historical Statistics, 1964–1983. Paris: OECD, 1984. Figures are percentage increases in each
year’s average consumer price index over that of the previous year.
Figure 19.4 Effect on Internal and External Balance of a
Rise in the Foreign Price Level, P*
After P* rises, point 1 is in zone 1 (overemployment and an excessive surplus).
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