2. Evolution of Financial Instability

Question 1

Why is deflation bad for an economy?

Answer 1

Negative impact on wages.

Reduction in investments – producers might not invest as much if prices are going down.

Deflation causes a reduction in consumption, because people avoid buying something now, because they withhold consuming as they wait for prices to drop even further.

Question 2

What was the implied exchange rate between the USD and Brittish Pound during the era of the gold standard?

Answer 2

1 GBP = 5 USD

Question 3

What are the golden rules for the gold standard?

Answer 3

• Gold was freely convertible between domestic money at the fixed price.
• No restrictions on the export of gold by private citizens or capital across countries.
• Bank-Notes and coins were backed by the availability of gold reserves. Long run money supply therefore determined by availability of gold reserves.
• If convertibility of money and gold is suspended, attempt to restore convertibility as soon as possible at the old fixed price.
• Allow inflation to be determined endogenously by world demand and supply of gold.

Question 4

What are the 5 steps of the auto-correction system or price-specie flow in the Gold Standard era?

Answer 4

1. Trade Deficit
2. Outflow of Gold
3. Reduced money supply and prices
4. Improved Competitiveness
5. New equilibrium

Question 5

Why were small countries with few / low quality metallics less competitive during the gold standard?

Answer 5

The only people who could properly leverage the value of the gold, were the international players who had the technology and the expertise to mine it. And therefore extracted the value.

Question 6

Why did the Gold Standard work?

Answer 6

1. Internal political commitment to converitibility:
   (Weak labor interests)
2. Free trade and free capital mobility:
   (Leading country (Great Britain) recycled surpluses by lending to infrastructure development. AND stable exchange = environment which was conducive to international trade and investment)
3. International cooperation (no forced agreement)

However, the internal balance objective was of secondary importance.

Question 7

What is meant by internal balance?

Answer 7

a country’s internal benefits / goals (social welfare, unemployment rates, etc. ) anything a country is interested in just for itself

Question 8

Why would people be adverse towards deflation?

Answer 8

impact on wages. Reduction in investments – producers might not invest as much if prices are going down. Deflation causes a reduction in consumption, because people avoid buying something now, because they withhold consuming as they wait for prices to drop even further.

Question 9

What happened to the gold standard during WW1

Answer 9

Gold standard was abandoned in conflict areas. Exchange rates fluctuated as countries widely used “predatory” depreciations of their currencies as a means of gaining advantage in the world export market.

USA did not abandon the gold standard.

Question 10

What did the USA get right during WW1 to maintain the Gold Standard?

Answer 10

Greenbacks after the war will be convertible back to gold. Money was trading purely on trust.

Question 11

What were the results of the UK valuing their currency to the original value before WW1?

Answer 11

1. Priced UK exports out of international markets.
2. Labor unrest as wage cuts were resisted.
3. Increased need for foreign loans.
4. Placed pressure on the credibility of the system as a whole

Question 12

What was the result of the USA’s policies and gold standard strategies during WW1

Answer 12

1. USA ran a trade surplus of $20 billion. (US outcompeted through war supplies and loans)
2. 40% of the world’s gold was in the USA.
3. The USA was the world’s creditor.
4. USA traded more widely than any other country

Question 13

Explain the difficulties in reinstating the Gold Standard after WW1

Answer 13

1. Lack of credibility in the system (private investors were hesitant to invest if a country’s reserves were running low, because the government could choose to abandon the gold standard again)
2. The global production of gold reduced to a 2/3 of production prior to war (therefore a decrease in prices)
3. The low investments and decrease in prices lead to pressure for deficit countries

Question 14

Why did the US stock market crash in 1929?

Answer 14

The gold supply lead to a boom in investments, the Fed adopted “antispeculative” interest rates, but it was too late, and the market had to self-correct.

Question 15

What were the consequences of the 1929 US stock market crash?

Answer 15

1. Companies’ value dropped by 90%
2. There is less money available for consumption spending and investment
3. Banking crises increased as people struggled to pay their debts.
4. Many companies went bankrupt, creating record levels of unemployment.
5. People began to hoard gold.
6. Economy collapses in Great Depression.

Question 16

In response to other countries abandoning the gold standard, 0n March 3, 1933, the newly-elected President Roosevelt closed the banks in response to a run on the gold reserves. What was the result when banks reopened?

Answer 16

By the time banks re-opened on March 13, they had turned in all their gold to the Federal Reserve. People could no longer redeem dollars for gold. No one could export gold.

Question 17

Who were the two main roleplayers (economists) in developing the Bretton Woods system?

Answer 17

Harry Dexter White & Keyenes

Question 18

What was the objective of the Bretton Woods System?

Answer 18

An attempt to allow countries greater domestic policy autonomy while still insulating them from excessive exchange rate volatility.

Question 19

What was the objective of the Bretton Woods System?

Answer 19

An attempt to allow countries greater domestic policy autonomy while still insulating them from excessive exchange rate volatility.

Question 20

What were the financial reforms under the Bretton Woods System?

Answer 20

1. Fixed exchange rates against the US dollar

2. Fixed dollar price of gold at $35 per ounce

Question 21

How did the countries manage to peg their currency to the USD during the Bretton Woods System?

Answer 21

If their currency’s value became too low relative to the dollar, they would buy up their currency in foreign exchange markets. This would decrease the supply, which would automatically raise the currency price relative to the dollar.

If their currency became too high, they’d print more of their currency, increasing the supply and automatically lowering its price.

Question 22

Why was the USD used as the pegging currency during Bretton Woods?

Answer 22

The U.S. held three-quarters of the world’s supply of gold. The dollar’s value was set at 1/35 of an ounce of gold, so in a way the world was still on somewhat of a quasi-gold standard.

Question 23

What 3 new institutions were founded regarding the Bretton Woods System?

Answer 23

1. IMF (responsibility for supervising a pool of reserves that could be used to finance temporary imbalances and adjudicating changes to exchange rate parities)
2. World Bank (financial assistance for the reconstruction after World War II)
3. General Agreement on Trade and Tariffs (GATT) (predecessor to the World Trade Organization)

Question 24

What were the assumptions regarding the Bretton Woods System?

Answer 24

1. Temporary credit would be sufficient to transition the world economy from war to peace.
2. Major currencies would be in equal demand roughly.
3. Balance of payments imbalances would be temporary and not structural.

Question 25

What were the practical implications of the Bretton Woods System?

Answer 25

1. Underestimated scale of problem of post-war reconstruction.
2. Dollar shortages.
3. Underestimated the functioning of the Marshall plan (European Recovery Plan: Grants Made to Europe)
4. The USA, not IMF, funded the BW system.

Question 26

Why did Bretton Woods collapse?

Answer 26

1. US military spending doubled from 1960-1970 (Vietnam War).
2. Trade competitiveness declined (rise of Japan and West Germany).
3. US inflation increased from 1.5% in 1965 to 5.5% in 1969.
4. Speculation about a devaluation of the dollar caused countries to buy large quantities of gold. Example of Bank Run. Charles de Gaulle – pioneer in buying up gold from the Fed Reserve

Question 27

Compared to the Bretton Woods period, how can the modern period be characterised?

Answer 27

1. More volatile, global growth
2. Higher inflation and inflation volatility
3. More frequent banking crises, currency crises and external defaults.

Question 28

What are the 3 elements to the impossible triangle?

Answer 28

1. Fixed Exchange Rate
2. Free Capital Flow
3. Sovereign Monetary Policy