4.2 the history of the international monetary system

Question 1

why are capital controls difficult today (recap last class)

Answer 1

rewatch …. beginning class

central bank needs to limit transactions in current account and

• costs:
• practical: investors will use current account to ??

Question 2

recap trilemma

Answer 2

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

Question 3

a bit of history

Answer 3

• 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?

Question 4

pure gold standard in theory

Answer 4

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)

Question 5

gold standard - reality with paper money

Answer 5

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….

Question 6

side note: gold standard is inherently deflationary

Answer 6

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

Question 7

how did the gold standard end?

Answer 7

• 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

Question 8

post-WW2: why didn’t they go back to the gold standard

Answer 8

gold standard = dependent on policy discipline and deflationary periods

1. 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

2. 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

Question 9

Bretton Woods

Answer 9

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

Question 10

4 innovations Bretton Woods

Answer 10

1. 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)
2. 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)
3. stabilization fund: provide a fund to help govs avoid controls or devaluation when faced with short-term imbalances
4. 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

Question 11

why did the bretton woods system fail?

Answer 11

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

Question 12

why speculate?

Answer 12

1. I earned 3500$ from selling goods to the US -> have right to 100 ounces of gold from Fort Knox
2. 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
3. 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

Question 13

how could the failure of bretton woods be prevented?

Answer 13

• 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

Question 14

the end of bretton woods

Answer 14

1. 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
2. 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

Question 15

take aways bretton woods

Answer 15

• 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)

Question 16

post BW

Answer 16

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

Question 17

central banks: the problem

Answer 17

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

Question 18

the problem with central banks - how to fix the time inconsistency problem

Answer 18

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

Question 19

central banks as commitment mechanisms

Answer 19

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

Question 20

European Central Bank

Answer 20

• 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

Question 21

US Federal Reserve

Answer 21

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)

Question 22

Central Bank of the Republic of Turkey

Answer 22

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

Question 23

central banks as commitment mechanisms - does it work?

Answer 23

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)

Question 24

crypto - future of currencies?

Answer 24

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

Question 25

upward spiral of inflation (book)

Answer 25

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

Question 26

book: definitions credible commitment and time-consistency problem

Answer 26

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

Question 27

book

Answer 27

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