WEEK 2 - International Monetary Arrangements

Question 1

What are the differing historical monetary arrangements?

Answer 1

Gold Standard (1880-1914)
Inter-war period (1918-40)
Bretton Woods (1944-70)
Transition Years (1971-73)
Post Bretton Woods (1973-Present)

Question 2

What is the Gold Standard?

Answer 2

Currencies fixed price relative to gold

e. g at the time, one ounce of gold $20.67
- Required commitment from participants to buy/sell gold to anyone at fixed price

Question 3

How did the Gold Standard create an exchange rate?

Answer 3

e.g.
$ fixed to gold
£ fixed to gold
So exchange rate $ per £ also fixed

Suppose
$1 = 1/2 ounce of gold
£1 = 1 ounce of gold
-> S £/$ = 2 (£1=$2)

Question 4

Why use gold?

Answer 4

1. History of gold (Linking back to Mesopotamia)
2. Homogneous Commodity, Easily Storable, Portable and Divisible
3. Relatively fixed supply -> So not many flucuations

Question 5

Why did the Gold Standard see stable levels of inflation?

Answer 5

Supply and Inflation depended on gold mining

- In SR, Price flucuations in LR relatively stable since gold mining infrequent

Question 6

How did the gold standard solve BoP disequilibriums and with it issues of new gold?

Answer 6

TRADE SURPLUS -> NET INFLOW OF GOLD -> MONEY SUPPLY UP -> INFLATION -> RISE IN PRICE -> NX DOWN -> REDUCE SURPLUS

TRADE DEFICIT -> NET OUTFLOW OF GOLD -> MONEY SUPPLY DOWN -> FALL IN PRICE-> NX UP -> REDUCE DEFICIT

Question 7

Why did the GS end?

Answer 7

1ST TIME:

• WWI -> Patriotism among other reasons meant gold lending restricted -> Exchange rates floating
• > Rapid inflation -> Not possible to have GS at old rates

2ND TIME:
- England returned GS at pre-war lvls even though new inflation lvls -> So £ overvalued

£ overvalued = Exports down = Trade Deficits = Gold left country = Loss of confidence and run on gold
1931 -> UK gold inconvertible

• US great depression led to low interest rates and thus run on gold -> Lack of monetary control downward spiral on econ so 1933 US declare gold inconvertible

Question 8

What was the need for the Bretton Woods System (1944-70)?

Answer 8

Need for a system that fixes currencies relative to each other but not to fix to gold (too restrictive)

Question 9

How did the Bretton Woods system work? (pt 1)

Answer 9

Agreed to anchor value to the dollar and then dollar fixed to gold = $1 = 1/35 ounce of gold

• Only central banks could convert dollars to gold
• Pressure for US to not inflate $ too much

Question 10

How did the Bretton Woods System work (PT 2)

Answer 10

• IMF created to smoothe the system
• To create some flexibility to attain external balance while allowing for internal balance and stable exchange

VIA:

1. Loans
2. Devaluations (if a fundamental disequilibrium)

Question 11

How did the loan system work?

Answer 11

Loans based on funds paid for by member countries
Each country had quota, determining contribution and amount to borrow
- Large loans -> With conditionalities (Washington Consensus)

Question 12

What were some new features of the Bretton Woods system?

Answer 12

Currencies allowed to trade amongst themselves

• i.e Trade Franc with £ but not $
• > To facilitate flows of goods and services -> i.e Trade benefits all

Question 13

Why did the Bretton Woods System cause asymmetry in policy?

Answer 13

• Monetary policy useless for all except USA
• Only fiscal policy could be used -> But fiscal policy only impacts internal balance (CIG)
• Only devaluations could target the whole economy and cover external and internal imbalances (CIG(X-M))

-> Infrequent devaluations meant politicians would often run up huge external imbalances focusing only on internal balance for political reasons

Question 14

How is currency fixed in the Bretton Woods system?

Answer 14

SEE GRAPH IN NOTES

Question 15

Why did the system fail?

Answer 15

1. Speculative attacks would cause states to outrun supply of dollars and could no longer match
2. Combination of large BoP deficits in the US and refusal to enact deflationary measures
3. Increased trade meant higher growth rates and with it meant there wasn’t enough gold to match new growth -> Countries would trade on dollar denominated assets with flexible supply
4. Trade Unions -> More income, higher imports etc, growth increase and with it outstripped gold agsin

Question 16

Why was the US response to its deficits such a key reason to its failure

Answer 16

States with surpluses questioning the true value of the dollar to gold.
States like Japan would devalue the Yen to peg to an overvalued dollar.
In fear of run on gold, Nixon suspended convertibility and added a 10% tariff.
This retaliatory policy led to major currencies beginning to float.

Question 17

What is the SDR?

Answer 17

Special Drawing Rights

• > Issued by IMF to try and help support Bretton woods and lack of gold
• > SDR still exists

Question 18

How did the world come to differing monetary arrangements?

Answer 18

• 1975 -> members of IMF meet in France to allow flexible exchange rates but avoid erratic fluctuations
• 1976 -> In Kingston ammend IMF membership to formally endorse flexible BUT no manipulating exchange rates

Question 19

Why is the US still the most dominant reserve currency?

Answer 19

Other countries resist greater roles as could mess with monetary policy

Question 20

What are the cases for Floating Rates?

Answer 20

1. Monetary Policy autonomy:
   Can influence interest rates to great effect
2. Automatic Stabilisation: Automatically adjust to high or low AD and output, keeping output closer to normal lvl and stabilising price in LR
3. Flexible Exchange rate may prevent speculation in some cases
4. Symmetry

Question 21

What is the scale of the differing monetary arrangements?

Answer 21

SEE IN NOTES

Question 22

Who fixes their exchange rates?

Answer 22

SMALL ECONOMY
OPEN ECONOMY
HIGHLY CONCENTRATED TRADE
HARMONIOUS INFLATION RATES (SIMILAR MONETARY TO COUNTRY THEY PEG TO)

Question 23

Who Floats?

Answer 23

LARGE ECONOMY
CLOSED ECONOMY
HIGHLY DIVERSIFIED TRADE
DIVERGENT INFLATION RATES (Remain independent monetary policy)

Question 24

What is a Standard Peg?

Answer 24

Fix Domestic currency with 1 or basket of foreign currencies

Question 25

BENEFITS AND WEAKNESSES

Answer 25

B:
Limit exchange rate flucuations

W:

• Limit ability to use domestic monetary policy
• Attract speculative attacks on currency

Question 26

How to peg?

Answer 26

Suppose Peso fixed to $ at 0.5 = 1 peso
- Increase in demand for US products from Mexico. Supply of Peso up

• CB of Mexico have to intervene to peg rate
  Buy peso to sell dollars -> Dollar reserves go down

SEE GRAPH IN NOTES

Question 27

Speculative attack on peg?

Answer 27

Speculators keep attacking at supply -> Have to keep pegging-> Run out of dollar reserves

SEE GRAPH IN NOTES

Question 28

What is Dollarisation?

Answer 28

Adopt someone else’s currency ($) to use

• Brings in stability both on currency level and on institutional since have to match US monetary institutions now

Question 29

What is a currency board?

Answer 29

Fix exchange rate with other currency with 100% foreign reserve backing in central bank

E.G.
HK if 8 HKD = 1 USD, then 800 bn of HKD in circulation will neeed 100 bn of USD reserves

Question 30

What are Target bands?

Answer 30

Rate allowed to vary within official set bands

• If wanders too far, CB has to intervene
• Comes with more negative of floating and fixed than positives

European ERM is a good example here

Question 31

What is a Optimum Currency Area?

Answer 31

An optimal currency area is wherein a geographical area benefits from economic strength by adopting a single currency, the EU being the best example.

Question 32

What are the 4 conditions for a stable OCA by Mundell?

Answer 32

1. High Labour mobility
2. Capital Mobility and wage flexibility to allow for even distribution of flows of labour and to dampen economic shocks.
3. A currency risk-sharing or fiscal mechanism that shares risk via transferring money from countries with a budget surplus to those with a deficit.
4. Similar business cycles to allow for joint monetary policy