Lecture 2 Flashcards
What was the gold standard?
Currencies directly tied to gold. Countries maintained fixed ER by pegging currency to specific amount of gold. Money supply determined by gold reserves. There was stability in ER and automatic correction of trade imbalances via gold flows. Wasn’t as much econ growth due to limited availability of gold. Vulnerable to deflationary pressures. Gold hoarding during crisis. It collapsed due to post ww1, Europe experienced rapid inflation, couldn’t restore gold standard at old ER. Pound became overvalued. And inconvertible by 1931 due to run on British reserves. 1933 abandoned gold standard in US
What was Bretton woods system?
Established in 1944. Replaced gold standard with fixed but adjustable ER. Currencies were pegged to US dollar, which was pegged to gold. 1oz of gold = $35. Dollar did not have an intrinsic value, other countries could ask for dollar holdings to be transformed into gold. IMF created to oversee it. US under pressure to not inflate currency too much. Countries could devalue or revalue their currency. Vulnerable to economic policy and trade imbalances. Worked well until US ran large chronic BOP deficits, became a concern as other countries had to accumulate more and more dollar reserves to peg ER with dollar. In 1971 Nixon suspended convertibility of dollar into gold.
What was primary purpose of IMF under Bretton wood?
To promote ER stability and promote international monetary cooperation. Ensure countries were pegged to USD. Designed to avoid competitive devaluations. To aid countries with temporary BOP deficits. Countries were to change the pegged value of a currency only when BOP disequilibria were viewed as permanent.
Why did Bretton woods system collapse?
Individual country policies in early 70s demanded more flexibility in ER than was permissible under BW. Lack of flexibility led to ultimate breakdown of agreement. Due to US having persistent trade deficits and inflation, causing confidence in dollar to erode as US printed more dollars. Investors converted dollars to gold depleting gold reserves for US.
Bretton woods vs gold standard?
Gold standard: currencies directly linked to gold. Currency fully backed by gold reserves. Fixed ER maintained rigidly, adjustments were rare. Inflexible due to strict gold backing, couldn’t expand money supply beyond gold reserves. Long term price stability, associated with frequent economic downturns
Bretton woods: pegged to US dollar, convertible at 35$ per ounce. We’re allowed limited adjustment, although had Fixed ER. Gold played secondary role, only US dollar was convertible to gold. Countries could devalue or revalue their currency in cases of fundamental disequilibrium. Adjustments relied on IMF. Countries could borrow from IMF. More flexible as countries not required to hold full gold reserves. Ww2 econ growth but failed under strain of growing imbalances and inflation.
Difference between free float and managed float?
Managed float: Allows ER to be determined primarily by market forces. Gov or Central Bank intervenes to stabilise or influence currencies value. E.g. stabilising ER to avoid excessive short term fluctuations. India and china use this system. Also known as dirty float.
Free float: determined solely by market forces supply and demand without any intervention. Exchange rates fluctuate freely based on factors like trade balances, capital flows, interest rates, and investor sentiment. Reflects true market conditions. Can lead to excessive volatility. US, Euro and Japanese Yen are largely free-floating
Why should a country adopt a fixed ER?
ER stability, particularly helpful for small countries. Attracts foreign investors due to stability. Can manage inflation more. Avoids currency wars. Reduces speculative attacks providing there is sufficient reserves. Improves policy credibility. E.g. HKD pegged to USD to maintain trade competitiveness and monetary stability.
How does gold standard eliminate possibility of continuous BOP disequilibrium?
It has a self correcting nature. If country has trade deficit, outflow of gold, reduces money supply. Prices and wages fall. Domestic goods become comparatively cheaper. Exports increase and imports decrease, correcting deficit. There’s a monetary discipline in gold standard.
Dollarization vs currency board?
Dollarization: country fully adopts another currency and replaces its own. E.g. Ecuador and El Salvador. Country relinquishes control over its monetary policy. No currency reserves required.
Currency board: maintains domestic currency but pegs at a fixed ER to foreign currency. E.g. HKD pegged to USD but maintains a currency. Must have sufficient fx reserves.
How does a flexible ER maintain BOP equilibrium?
Self-Correcting Exchange Rate Adjustments due to Supply and demand. If a deficit, exports cheaper for foreign buyers, imports more expensive. Improves CA deficit. No need for intervention. Has monetary policy independence.
Compare and contrast the monetary union and currency board
Monetary Union: A group of countries adopt a single currency and share a central monetary authority. E.g. Euro. Fixed exchange rate among member countries. No reserves are required to back the shared currency directly. Member countries give up monetary sovereignty to the shared authority. Provides exchange rate stability and eliminates currency fluctuations within the union.
Currency Board: A single country pegs its domestic currency to a foreign currency at a fixed exchange rate and maintains full backing with reserves. E.g. HKD. The domestic currency is retained but is fully backed by the foreign currency. The domestic central bank has no independent monetary policy; money supply is tied to foreign currency reserves. Provides exchange rate stability with the anchor currency but is vulnerable to external shocks.
