CHAPTER 9:
INTERNATIONAL MONETARY
REGIMES IN
HISTORY
WHY IS AN INTERNATIONAL MONETARY SYSTEM NECESSARY?
• An international monetary system means currencies can be converted and facilitates international trade
• Otherwise trade restricted to balanced bilateral trade
– E.g. if Denmark wants 10 billion kroner worth of goods from Norway, but Norway only wants 5 billion kroner of goods from Denmark, then trade is restricted to 5 billion kroner
– Cannot fully realize gains from trade and specialization
• Also means domestic savings = domestic investment
– Foreign investment impossible
HOW DO POLICYMAKERS CHOOSE THE INTERNATIONAL MONETARY REGIME?
• Was long believed that commodity currencies and fixed exchange rates were necessary
• Today fiat currencies and floating exchange rates dominate
• Choice depends on the shifting priorities of policymakers!
• Available choices have been termed the open economy trilemma
THREE DESIRABLE POLICY GOALS
1. Fixed exchange rates
– Less uncertainty for international traders
2. Unrestricted capital mobility
– More trade and foreign investment
3. Monetary autonomy
– Use of interest rate as macroeconomic tool
THE TRILEMMA
• Pick two policy goals, any two but only two!
1. Fixed exchange rates and unrestricted capital mobility
– Monetary policy cannot be used
2. Fixed exchange rates and monetary autonomy
– Capital controls must be imposed
3. Unrestricted capital mobility and monetary autonomy
– Exchange rate uncertainty for international traders
WHY CAN’T YOU COMBINE ALL THREE POLICY GOALS?
• With unrestricted capital mobility and fixed exchange rates monetary policy is limited!
• Why? Arbitrage
• An attempt to e.g. lower interest rates lowers the return to domestic capital
• Assets will move out of the country
• Downward pressure on the exchange rate
• Central bank must raise interest rates again!
HISTORY OF INTERNATIONAL MONETARY REGIMES IN A NUTSHELL
• From second half of 19th century to First World War
– Fixed exchange rates and unrestricted capital mobility – International Gold Standard
• From Second World War until 1970s
– Fixed exchange rates and capital controls – Bretton Woods System
• From 1970s until today
– Floating exchange rates and unrestricted capital mobility – Post-Bretton Woods System
THE OPEN ECONOMY TRILEMMA
THE INTERNATIONAL GOLD STANDARD C. 1870-1914
• Gold used as money since ancient times
• Gold Standard as an institution has origins in Britain’s Resumption Act of 1819
• Spread through Europe, replacing bimetallism, based on gold and silver
• Implied fixed exchange rate, and some countries also introduced monetary unions
– Latin Monetary Union of 1865
– Scandinavian Monetary Union of 1875
‘RULES OF THE GAME’ OF THE
INTERNATIONAL GOLD STANDARD
• Most important rules:
1. The currency should be freely convertible to gold at a set price or ‘mint parity’
2. There should be no barriers to capital and gold flows between countries
3. Money should be convertible on request to gold, and thus backed by gold reserves
WHY WAS THE GOLD STANDARD A FIXED EXCHANGE RATE SYSTEM?
• E.g. US mint parity $20.646 / ounce; UK £4.252 / ounce
• Exchange rate must be 20.646 / 4.252 = $4.856/£
• Any other exchange rate gives the possibility of arbitrage (given rules 1-3)
• Currency traders would be able to convert the cheap currency to gold, exchange the gold for the expensive currency and make a profit on the forex markets
• In reality small deviations possible due to gold points
© Paul Sharp and Cambridge University Press
DEVIATIONS FROM THE ‘RULES OF THE GAME’
• Most governments took a laissez faire attitude towards economic policy
• 1752: Hume described price-specie-flow mechanism
– Gold standard automatically ensures balance of payments
equilibrium: if one country has a current account deficit, it will lose gold, forcing prices to decrease, causing exports to increase and restoring equilibrium
• In practice: central banks more concerned about losing gold than gaining it, so sterilized gold inflows
– I.e. did not increase the money supply
SO WHY DID THE GOLD STANDARD LAST SO LONG?
• Commitment: Deviations from parity followed by return to original parity
• Confidence: People believed exchange rates would remain fixed, so speculation was stabilizing
• Symmetry: No one country had an overwhelming influence on the price level
DETERMINANTS OF THE PRICE LEVEL UNDER THE GOLD STANDARD
• Global money supply determined by supply of gold
– Inflation rates uniform among members
• Prices fluctuated over shorter periods due to demand and supply of gold, e.g. stochastic shocks to gold production
– E.g. long deflation period 1875-95 after many countries joined the gold standard
– Then inflation after a new method of extracting gold from ore was discovered
• Especially deflation is damaging!
THE INTERWAR YEARS
• Gold standard suspended during First World War, governments financed war expenditure and
reconstruction by issuing bonds and printing money inflation
• To restore gold standard, deflation was necessary
• For some countries impossible, e.g. Germany
experienced hyperinflation of 3.25 million % / month!
• UK restored parity in 1925, France devalued to 25% of pre-war parity
THE GOLD STANDARD AND THE GREAT DEPRESSION
• By 1929 US trying to slow overheated economy through monetary contraction, France ending an inflationary
period with return to gold, both sterilizing inflows
– US and France ended up holding 70% of world supply of gold – massive deflation needed in other countries
• Then Wall Street Crash of 1929 and Great Depression
– Banks failed because liquidity not available when countries were trying to protect their gold reserves
– UK forced off gold in 1931, US 1933, France 1936
HOW DID THE GOLD STANDARD
PROLONG THE GREAT DEPRESSION?
• Countries which left the gold standard early could devalue their currencies, avoid deflation
• Devaluation meant that exports became more competitive
• Inflation reduced product wages and real interest rates
• Monetary policy became available to policymakers
• Many now believe the gold standard prolonged the Great Depression for those countries which left later
CONTRASTING FORTUNES: GDP/CAPITA
OF FRANCE AND THE UK 1920-39
THE BRETTON WOODS SYSTEM
• Reaction to the Great Depression was disastrous:
protectionism increased, capital flows restricted,
countries became more autarkic, world trade declined, fascism emerged
• In 1944 in Bretton Woods, 44 countries signed Articles of Agreement of the International Monetary Fund
• Designed a system with fixed exchange rates, but with more monetary policy flexibility
– capital controls
DOLLAR EXCHANGE STANDARD
• The dollar was fixed against the price of gold: $35 / ounce
• Member countries held reserves in gold or dollar assets.
Could sell dollars to the Federal Reserve for gold at the official price
• All currencies fixed in value against the dollar, giving N-1 exchange rates
FLEXIBILITY UNDER THE BRETTON WOODS SYSTEM
• Capital controls: convertibility only required on the current account and not the capital account
– Interwar experience led many to believe that speculation was the cause of instability
• IMF controlled pool of currencies which could be used to stabilize countries experiencing current account
deficits (with supervision)
• If ‘fundamental disequilibrium’ (not defined) countries could de- or revalue their exchange rates
DOWNFALL OF THE BRETTON WOODS SYSTEM
• Could avoid capital restrictions by speculating on the current account: ‘leads’ and ‘lags’
• If thought country in ‘fundamental disequilibrium’ they would speculate against the fixed exchange rate
• All countries forced to maintain exchange rate, but not the US. With expansion of welfare spending and the Vietnam War, inflation took off. Lack of symmetry
– Other countries not prepared to import inflation, and US could not maintain value of dollar against gold
THE WORLD OF FLOATING EXCHANGE RATES
• Emerged by accident, fixed exchange rates had always been considered to be necessary
• Prices diverged after Bretton Woods collapse, countries lost interest since floating exchange rates proved to be compatible with increasing world trade
• Emergence of regional fixed exchange rates systems, but usually short lived
• After collapse of Exchange Rate Mechanism in 1992, EU implemented common currency: the euro
THE OPTIMAL CURRENCY AREA CRITERIA
• OCA criteria give conditions under which countries might agree to form a currency union
– Q: When does it make sense to have a common monetary policy?
– A: When asymmetric shocks are less likely
• Economic criteria: Labour mobility, similar structure of trade, openness to trade
• Political criteria: Countries should put common interests before national interests fiscal transfers given shocks
THE EUROZONE CRISIS IN THE LIGHT OF THE HISTORICAL EXPERIENCE
• Note the primacy of political motives
• European Economic and Monetary Union (EMU) differs from previous monetary unions since combines a single currency with a single central bank: the ECB
• 2007/8 financial crisis was an asymmetric shock
– How could the ECB set monetary policy for countries in very different economic situations?
– Badly affected countries forced to implement austerity measures, need deflation (compare to Great Depression)
THE EUROZONE CRISIS IN FIGURES: AN
OPTIMAL CURRENCY AREA?
EXCHANGE RATE SYSTEMS
SUMMARY
• A gradual realization that fixed exchange rates were not necessary for a well-functioning world economy
• The rise of domestic policy goals made monetary policy more desirable
• Globalization made capital controls difficult to implement
• In modern times, fixed exchange rates are made to be broken!
