4.2 the history of the international monetary system Flashcards
why are capital controls difficult today (recap last class)
rewatch …. beginning class
central bank needs to limit transactions in current account and
- costs:
- practical: investors will use current account to ??
recap trilemma
if you use independent monetary policy to manipulate the domestic monopoly (through money supply or interest rate, e.g. to fight inflation) = problematic if you have fixed exchange rate: you create pressure on the exchange rate (there’s less money around -> currency will appreciate + more investment), to fix this, you would have to go against what you would do for independent monetary policy
it’s okay to have excahnge rate change if you have financial integration, indepdnent moneatyr policy, bc you don’t want to keep it fixed
a bit of history
- 1870-1914: Gold Standard (fixed) + Open Capital Flows
before: bimetallic: could exchange gold and silver - 1919 –1939: Gold Standard reestablished briefly, but abandoned in the Great Depression
- 1944-1971: Bretton Woods: US-backed fixed (but adjustable) + Low capital flows
wars don’t tend to be good for fixed systems, bc they require coordination - 1971-Today: Floating XR + High capital flows in most developed countries, peg to dollar/Euro in many developing countries
The Puzzle: What Caused The Changes?
pure gold standard in theory
gold is the coinage that is used
country A imports more from country B
->
gold moves from A to B (re-coined/minted)
- less money in A -> lower prices: less money chasing the same amount of products
- more money in B -> higher prices: inflation
-> country B imports more from country A
-> balance is restored
(gold standard = financial integration (capital mobility) + fixed exchange rates, no independent monetary policy)
gold standard - reality with paper money
we didn’t use actual gold as means of exchange
!currency not pegged to another currency (which we see now), but to a metal
gold didn’t actually flow (that would require huge transaction costs and a lot of gold at the bottom of the Atlantic Ocean)
central banks fixed the value of their currency to gold
- e.g. 1 pound sterling = 7.322g of gold
- people could, in theory, exchange their paper money for gold
didn’t happen much as long as people believed in the currency
when imbalances arose, Central Banks intervened by adjusting the money supply and interest rates to counteract imbalances
gold standard -> strict discipline:
Central Bank has to cause deflation in times of deficit to lower prices
lower prices means:
- supply of money down
- if you expect prices to fall in te future, you don’t buy anything today
- more expensive to borrow: bc the value of money increases over time -> don’t consume and produce as much
= bad eco crisis: jobs cut, people don’t eat and kids die
deflation is bad for the domestic audience, but necessary for….
side note: gold standard is inherently deflationary
world supply of gold is fixed
with eco growth, eventually more goods chase (relatively) less money -> prices fall, growth constrained
the gold standard was able to persist pre-WW1 partly bc of new gold discoveries
- supply of gold was keeping up with economic growth
how did the gold standard end?
- breaks down with WW1
- countries re-establish it after the war
exacerbated the great depression in the early 1930s bc… (didn’t hear)
- to maintain the gold standard, ….
countries abandon it again in response to the crisis
people don’t believe that the gold standard can last forever: don’t believe in the value of it
- bank of England fist because it was running out of gold
- chain reaction across the world, rush on gold, other countries abandon the gold standard
post-WW2: why didn’t they go back to the gold standard
gold standard = dependent on policy discipline and deflationary periods
- many countries had become more democratic since C19 + stronger labor unions -> would not accept deflationary periods we saw under the gold standard
when people don’t eat (bc deflation)
- autocracies = let them eat cake, they die
- democracies = politicians voted out of office
- economic theory had changed
Keynesianism: based on observation of high unemployment in Britain 1920s+30s
- alternative to neoclassical economics (the market will fix it)
- governments can/should use monetary and fiscal policy to help the economy out of crises
- expansionary policy
Bretton Woods
1945-1971
= fixed exchange rates + independent monetary policy (give up some capital mobility)
agreement on the post WW2 monetary system
monetary system is a public good: it benefits everyone
coordination necessary + allowed for:
- increased international trade and finance: fixed exchange rates good for trade
- way to manage crises so they didn’t spread
attempt to solve a global problem: how to keep monetary policy autonomy and fixed exchange rates
4 innovations Bretton Woods
- fixed but adjustable XR: US pegged to gold, all other countries were fixed to the dollar
(other central banks had USD in their reserves, US had gold): rules on how to adjust if there was a really big imbalance (-> no day to day changes, but exchange rate could be changed to correct a large imbalance) - capital controls (not total control): allowed gov to impose controls when faced with speculative threats (when people started speculating about the value of the currency bc imbalance) = flexibility in managing domestic economies
- current accounts (no control allowed: free movement of current account)
- capital accounts (controls: countries could impose controls (e.g. exchange restrictions) in times of economic instability or speculative threats) - stabilization fund: provide a fund to help govs avoid controls or devaluation when faced with short-term imbalances
- the IMF: created to monitor state behavior (XR changes) and manage stabilization fund
- loans conditional on policy actions
- made sure governments didn’t undermine system by devaluing for an export advantage
why did the bretton woods system fail?
institutions didn’t work:
- IMF lacked true authority over XR policy: gov. didn’t comply, could still devalue, only lost access to the fund
- govs didn’t like conditionality (decided to not implement some stuff): conditionality required gov to reach agreement with IMF on measures to correct balance of payments deficit
- stabilization fund wasn’t large enough to deal with the new imbalances caused by globalization
*imbalances big bc take-off globalization
another problem = US privileged
country holding currency used as reserve (dollar) has an exorbitant privilege
- Federal Reserve only country that could run Balance of Payment deficits and conduct monetary policy to influence aggregate demand, output and employment
- US monetary policy influenced economies of other countries
if US increases its money supply: lower US interest rates -> downward pressure on the value of the US dollar -> if other central banks maintain their fixed exchange rates, need to buy dollar-denominated (foreign) assets, increasing their money supplies
bretton woods failed bc US unwilling/unable to maintain system: US was spending more than wat was entering the country (it had a deficit in both accounts)
-> dollars > actual gold -> speculators saw it was getting out of control -> confidence in the peg was in question -> investors would rush to sell dollars (heightened by newly dynamic capital markets)
- deficit bc: expansionary macroeconomic policy (more spending Vietnam war + social spending without higher taxes) + US investors invest more abroad + high imports
- deficit = more dollars leaving US than coming in
why speculate?
- I earned 3500$ from selling goods to the US -> have right to 100 ounces of gold from Fort Knox
- if i don’t believe the peg to gold will last, i buy gold -> demand for gold goes up, demand for dollars goes down
- people don’t want to hold dollars, they want to hold gold - if the US has to give up the dollar-gold exchange rate, dollar falls to $50 - 1 ounce (rather than $35) -> I sell all my gold for dollars = $5000
!this is the same with speculation between currencies: you foresee an increase in value = buy, you foresee a decrease in value = sell
!is a self-fulfilling prophecy: demand gold goes up more and more, demand for dollar goes up -> forces devaluation
how could the failure of bretton woods be prevented?
- US would have to constrain US economy: run trade-surpluses, change foreign policy
- adjust the peg to gold (requires coordination, can’t be done unilaterally): other countries would have to agree to revalue their money (states didn’t want this bc then US wouldn’t have to adjust anymore)
- expand economic activity in the rest of the world (many states unwilling to experience inflation): that would increase American exports
none of these options was politically popular
slide 29, don’t get it
the end of bretton woods
- speculations about devaluation of the dollar caused large purchase of gold by investors
- federal reserve sold huge quantities of gold in march 1968
- US president Nixon “closes the gold window” on aug 15 1971: federal reserve no longer honors gold claims bc they were running out = no more gold-US dollar exchange - speculation about devaluation of dollar caused investors to purchase large quantities of foreign currency assets
- coordinated devaluation of the dollar against foreign currencies of about 8% (was not enough)
- speculation about another devaluation occurred: European central banks sold huge quantities of European currencies (trying to end speculation)
- Japan and Europe (esp. Germany) stopped selling their currencies and purchasing of dollars in March 1973, allowing the value of te dollar to fall
end of BW monetary system
*end Bretton Woods -> no longer capital controls on gold, there was free trade -> prices gold rose
book: main cause = adjustment problem: to sustain fixed exchange rates, gov had to accept the costs of balance-of-payments adjustment, they weren’t willing to do so
take aways bretton woods
- fixed exchange rate hard to maintain with increasing capital mobility + democratic demands for domestic monetary policy
- gold standard had been backed by the British, BW had been backed by the US (hegemonic stability theory)
- while it would have been nice to have XR stability,, US was no longer in a position / willing to enforce cooperation
- US acted in a self-interested way, as did other countries (Japan, Europe)
post BW
major economies floated their currency
europe tried to organize a regional monetary cooperation around German policy
- eventually adopted a monetary union (the Euro)
other countries floated or pegged to the USD/European currencies
dollar remains world’s reserve currency
despite floating XR, global imbalances still pose a threat to the global economy
uncooridnated macroeconomic policy still has the potential for large problems
central banks: the problem
democracy -> demand for monetary policy autonomy
with the fall of BW and floating exchange rates, CB were free to use monetary policy domestically
monetary manipulation can lead to runaway inflation
this drags on growth and investment in the long run despite short-run benefits
= time inconsistency problem: govs want price stability in the long run, but boosting employment is tempting to win reelection
upward spiral of inflation: ???
maybe long run relationship between unemployment and inflation is a vertical line (rather than Philip’s curve), it goes back to natural rate of unemployment (that is sustainable without causing more inflation)
- relationship between unemployment and inflation may be wrong: see stagflation 1970s = high unemployment + high inflation
see flashcard on upward spiral of inflation with book info
the problem with central banks - how to fix the time inconsistency problem
time inconsistency problem = govs want price stability in the long run, but in the short run boosting employment (by inflation) is tempting
we can avoid this problem by:
-> adopt a fixed exchange rate = ties your hands to stop using expansionary monetary policy
- many developing countries do this
- democracies don’t do well with fixed XR and free capital flows: domestic price instability + instability to deal with real crises
-> adopt an INDEPENDENT CENTRAL BANK
- appointment for long terms + don’t face electoral pressures
central banks as commitment mechanisms
political independence central banks provides the mechanism to maintain monetary policy autonomy but not tempt politicians (too much) to abuse it (cause inflation to boost employment to gain support)
central banks differ in their independence
- freedom to choose economic objectives to pursue: inflation and/or employment
- freedom to set monetary policy to pursue that objective
- whether the policy can be reversed by politicians in government
from the 90s more and more countries increased CB independence
- Swiss National Bank = no provision whatsoever for the gov to influence monetary policy = highly independent
- Reserve Bank of Australia = highly subordinate = secretary of the Treasury (politician) has final authority on monetary policy decisions and interest rate changes
- Reserve Bank of India = gov appoints governor and board of directors to 4y terms = not constitutionally independent, gov can overrule -> faces political pressures
European Central Bank
- mandate for price stability primarily (inflation)
- each country appoints a governing member
- executive council sets decisions
- appointed to non-renewable 8y terms (longer than gov electoral term = establishes stability)
- appointment by “common accord” of member govs
- can’t be removed by politicians
ECB president = Lagarde
US Federal Reserve
president appoints a Fed Chair every 4y (in non-presidential election years)
- confirmed by the Senate
- can’t be removed
- must “report” to Congress bi-yearly: Congress can’t overrule or anything
now has a dual mandate: low unemployment + stable prices and interest rates
set-up allows it to act in times of crisis + avoid political time inconsistency problems
(Trump hates Fed Chair Powell, but he can’t be removed)
Central Bank of the Republic of Turkey
highly politically subordinate
Erdogan “enemy of interest rates”: (does not believe in modern economy or the influence of exchange rates on inflation)
= fired 3 central bank chiefs
markets no longer trust the lira bc of inflation in country and instability
central banks as commitment mechanisms - does it work?
provides greater certainty over monetary policy -> should lead to decreased inflation and greater growth
evidence:
- more independent CB -> less inflation
- relationship between independent CB and economic growth not so clear, maybe even negative (bc they prioritize limiting inflation and stability)
crypto - future of currencies?
cryptocurrency = decentralized currency based on the “blockchain”
- typically not backed by Central Banks
- some (e.g. Bitcoin) are supposed to be finite in nr = meant to combat inflation
==problem: deflation
is it the future of money?
- medium of exchange = transaction costs computationally expensive + not clear if blockchains can handle if everyone uses it for transactions + huge energy demands
- store of value + unit of account = cryptocurrency too instable/volatile
people’s willingness to use a currency to save and invest depends on trust, which there is not that much for cryptocurrencies
Trump -> crypto will likely be deregulated + become more common asset in mainstream banks’ portfolios
however: can’t fulfill the functions of a government backed currency
upward spiral of inflation (book)
inflation = decline real wage (wage accounted for inflation) -> labor less costly to employ -> unemployment decreases
- philips curve = curviliinear relationship with trade off between inflation and unemployment
inflation short term = nice to get votes bc employment increases
but long term:
reduction real wage -> cheaper labor -> higher demand labor -> decline unemployment -> competition to attract new workers -> higher real wages -> demand for labor falls -> unemployment gradually returns to its natural rate
natural rate of unemployment = rate of unemployment to which the economy will return after a recession or boom
- determined by economy-wide real wage = wage at which all workers who want to work can find employment
- gov can’t use monetary policy to move unemployment below or above the natural rate of unemployment for longer than a short time
trying to keep unemployment below the natural rate for any lengthy period can only be done by continually increasing inflation (accelerationist principle) = modified Philips curve
continued rising inflation = bad: raises uncertainty, reduces investment and eco growth rates -> raise natural rate of unemployment
- data: countries with high inflation have relatively high unemployment rates
*Keynesian strategies are based on Philips curve, not on this upward spiral -> 1980s govs began to doubt Keynesianism -> pursuit of price stability led by Thatcher
book: definitions credible commitment and time-consistency problem
credible commitment = actor needs to convince other actors it intends to truly commit to something
credible commitment can be hard bc time-inconsistency problem
time-inconsistency problem = when the best course of action at a particular moment in time differs from the best course of action in general
- e.g. gov short term wants inflation to increase employment, but long term price stability is better
book
price specie-flow mechanism (gold standard) = money supply (stock of gold) is fixed thus when there is eco growth, there is downward pressure on prices -> exports would rise -> imports would fall -> balance-of-payments surplus -> would pull gold into the state and away from the world -> prices back to initial level
- imposes recurrent bouts of inflation and deflation on the societies linked by gold
Bretton Woods: first time exchange rates explicitly as matter of international cooperation + last time (to date) int’l monetary system based on fixed XR
Bretton Woods implemented not in 1944, but in 1959 bc European govs held small foreign exchange reserves -> allowing residents to convert domestic currency to gold/dollar would produce run on a country’s limited foreign exchange reserves -> US balance-of-payments deficit (Marshall plan etc.) to transfer dollars to Europe -> dollar became primary reserve asset of the system -> dollar glut/overhang (continued balance of payment deficit -> US unable to exchange dollars for gold at $35 an ounce)
liquidity problem: to preserve bretton woods, US would have to run surpluses that pulled dollars back in, but reducing nr of dollars circulating the global econ would reduce liquidy that financed world trade (bc dollar is primary reserve asset) -> risk deflationary spiral, but maintaining dollar overhang would undermine fixed exchange rates
USD exorbitant privilege = US could run persistent balance-of-payments deficits bc it couldn’t run out of foreign exchange reserves as long as other govs were willing to accumulate dollars
- SDR created as reserve asset, never really played a role
