The international monetary system contemporary international monetary arrangements
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The International Monetary System: Contemporary International Monetary Arrangements. READING ASSIGNMENT: Oatley – Chapter 11. Plan for today. The rise and fall of Bretton Woods Why fail to address a BoP imbalance under fixed XR – why “beggar-thy-neighbor”? The Trilemma

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The international monetary system contemporary international monetary arrangements

The International Monetary System: Contemporary International Monetary Arrangements

READING ASSIGNMENT: Oatley – Chapter 11


Plan for today

Plan for today

  • The rise and fall of Bretton Woods

  • Why fail to address a BoP imbalance under fixed XR – why “beggar-thy-neighbor”?

  • The Trilemma

  • France vs. Germany in the 1980s

  • How to deal with imbalances: fix vs. float

  • The US $


The rise and fall of bretton woods a puzzle

THE RISE AND FALL OF BRETTON WOODSA puzzle

Degree of global capital mobility

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1971-3

1944

BRETTON WOODS PERIOD


Conclusion

Conclusion:

Cannot maintain (global) fixed exchange rates in the presence of high capital mobility…?


The rise and fall of bretton woods a puzzle1

THE RISE AND FALL OF BRETTON WOODSA puzzle

Degree of global capital mobility

*

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1971-3

1870

1944

BRETTON WOODS PERIOD


The international monetary system contemporary international monetary arrangements

A puzzle:Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19th century?

Fixed exchange rates

+

Open capital flows

Degree of global capital mobility

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870

Interwar period

1971-3

1944


The international monetary system contemporary international monetary arrangements

Why?


Answer democracy

Answer: Democracy

Growing #’s of democracies + LABOR UNIONS!

Few democracies

Fixed exchange rates

+

Open capital flows

Degree of global capital mobility

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870

Interwar period

1971-3

1944


The international monetary system contemporary international monetary arrangements

Why?

  • So, why do fixed exchange rates pose a problem for democracies in the face of highly mobile capital?


Pure gold standard

Pure gold standard

  • Country A imports from Country B

  • Gold moves from A to B (re-coined/minted)

  • Less money in A  lower prices

  • More money in B  higher prices

  •  Country B imports from Country A

  • Balance is restored


With paper money

With paper money

  • Central Banks intervene by adjusting interest rates

  • So gold doesn’t actually flow

  • Gold Standard  strict discipline!


What is discipline

What is “discipline”?

  • What do “lower prices in Country A” mean?

  • Supply of money down

  • More expensive to borrow

  • Jobs cut!

  • People don’t eat!


People don t eat

Under authoritarianism:

Let them eat cake

Under democracy:

Incumbents lose elections

People don’t eat


Hazard rate over time for democracies solid line dictatorships dotted line time in years

Hazard Rate over Time for Democracies (Solid Line) & Dictatorships (Dotted Line) – Time in years


Stylized history

Stylized history

  • Late 19th century:

    • Mobile capital, authoritarian governments

  • Interwar years:

    • Mobile capital + democracy  beggar-thy-neighbor

    • http://www.youtube.com/watch?v=3_ex0sTsb_I&feature=channel

  • Bretton Woods (1944-1971/3):

    • Capital controls + democracy

    • http://www.youtube.com/watch?v=GVytOtfPZe8

  • Post Bretton Woods:

    • Floating exchange rates

    • http://www.youtube.com/watch?v=iRzr1QU6K1o


What were the goals of bretton woods

What were the goals of Bretton Woods?

  • Attempted to establish a system of fixed XR in a world where governments were unwilling to sacrifice employment to address imbalances

  • 4 INNOVATIONS:

    • Some XR flexibility (fixed-but-adjustable “snake”)

    • Capital controls

    • A stabilization fund (held on reserve at the IMF)

    • The International Monetary Fund – authority over XR changes + conditionality attached to loans


Bretton woods failed for several reasons

Bretton Woods failed for several reasons

  • IMF lacked true authority over XR – governments did as they saw fit

  • Governments did not like IMF conditionality

  • The stabilization fund was never large enough to deal with the potentially massive imbalances that come with growing globalized economic integration

  • Straws that broke the BW back:

    • USA: VIETNAM + SOCIAL SPENDING + INTERNATIONAL RESERVE CURRENCY

    •  SPECULATION that the US cannot maintain the fixed convertibility to gold + the French – regularly demanded American gold from the US for the $’s they accumulated

  • http://www.youtube.com/watch?v=iRzr1QU6K1o


Http www youtube com watch v lobe0wxtts8

http://www.youtube.com/watch?v=loBe0WXtts8


The saga continues

The saga continues…

  • The story of the contemporary international monetary system is the story about the search for the elusive ideal balance between domestic economic autonomy and exchange rate stability


The unholy trinity

The Unholy Trinity

  • Fixed Exchange Rate

  • Autonomy of Monetary Policy

  • Capital Mobility

    Mundell-Fleming: Only 2 out of 3 are possible


The point of the unholy trinity you can t have it all

The point of the unholy trinity – you can’t have it all…

  • “The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).”

  • – Paul Krugman http://slate.com/id/36764


The international monetary system contemporary international monetary arrangements

Free Capital Flow

Eurozone countries

Switzerland

PRC

Inconsistent/Unholy

Trinity

Or

“Trilemma”:

a country can only have 2 out of 3 of these

Fixed Exchange Rate

Sovereign Monetary Policy


The international monetary system contemporary international monetary arrangements

Fixed Exchange Rate

Eurozone countries

Switzerland

PRC

The Trilemma

Open Capital Flows

Sovereign Monetary Policy


The international monetary system contemporary international monetary arrangements

Fixed Exchange Rate

Eurozone countries

Switzerland

PRC

The Trilemma

Open Capital Flows

Sovereign Monetary Policy


The european monetary system

The European Monetary System

  • 1979

  • Fixed but adjustable

  • The Bundesbank (Germany) used monetary policy to keep inflation low, and other countries engaged in foreign exchange market intervention to fix their currencies to the German mark


French german fight in 1981 3

French-German fight in 1981-3

  • Mitterand – socialist president – believed German monetary policy was strangling

  • Expansionist monetary policy (e.g., lowered interest rates)

  • French inflation began to rise

  • Called on Germany to lower their interest rates

  • 18 month stand-off… the French backed down


1988 2002 monetary union

1988-2002: Monetary Union

  • 1988: Planning begins

  • Gradually moved towards fixing their currency XR’s (1999 – “permanently” fixed)

  • Jan 2002: The Euro!

  • Why union?

  • High degree of economic openness across Europe 

  • Sacrificed monetary autonomy for XR stability


To fix or to float

To fix or to float?


Trade international capital flows lead to imbalances

Trade & international capital flows lead to imbalances

How do governments deal with these imbalances?

  • Fixed exchange rate  sacrifice monetary policy

    OR:

  • Floating exchange rate uncertainty

    Trade-off between

  • exchange rate stability

    versus

  • domestic price stability with monetary policy autonomy


Why are there imbalances

Why are there imbalances?

  • These days, foreign exchange markets conduct between $1 trillion and $1.5 trillion worth of business… PER DAY!!

  •  Exchange rate volatility!

  •  Exchange rate misalignments


Consequences of xr volatility

Consequences of XR volatility?

  • Uncertainty hurts international transactions?

  • Suppose you work on a profit margin of 5%-9% and the XR changes 5% between the time you ship an export and the time it arrives…

  • But businesses can purchase options to buy a foreign currency 30, 60, or 90 days in the future at today’s XR, thereby insuring themselves against short-term XR volatility

  • Nevertheless, a reduction in investment is one possible consequence of currency misalignments


Fixed xr

Fixed XR

  • A kind of commitment

  • To avoid SPECULATATION governments try to make a credible commitment to a fixed XR

  • If the commitment is not credible, speculation can be disastrous

  • Argentine Currency Board (1991-2002)

    • Pegged the Argentine peso to the U.S. dollar in an attempt to eliminate hyperinflation

    • Credibility? Required legislative vote to change the value of the currency (public discussion undermines the point of a devaluation!)

    • But deficit spending ultimately undermined confidence

    • And tied hands prevented the government from acting

    • Run on the currency in 2002  disaster!!


The international monetary system contemporary international monetary arrangements

Free Capital Flow

USA

PRC

Inconsistent/Unholy

Trinity

Or

“Trilemma”:

a country can only have 2 out of 3 of these

Fixed Exchange Rate

Sovereign Monetary Policy


Why is the us dollar special

Why is the US dollar special?


Overvaluation of the dollar

Overvaluation of the Dollar

  • International reserve currency

  • Early 1980s: Reagan’s fiscal expansion – cut taxes, increased spending 

  • Current account deficit 

  • Increased interest rates and capital inflows (from, e.g., Japan)

  • Value of the dollar goes up!

  • Plaza Accord (fall 1985): G5 agreed to reduce the value of the dollar against the yen & mark by 10-12% – sell dollars if it appeared the value was going to increase

  • By early 1987, dollar had depreciated 40%


Similar situation today

Similar situation today

  • US twin deficits: fiscal & current account

  • Japan, Europe, China, current account surpluses 

  • Finance the American deficit

    • US absorbs about 6% of the world’s savings

  • US international investment position:

    • foreign-owned assets in 2007: $17.8 trillion

    • US residents’ foreign assets in 2007: $15.4 trillion

    • international investment position: –$2.4 trillion


What s the worry

What’s the worry?

  • Catastrophe!

  • Doubts about the solvency of American financial institutions & American assets

  • Foreign lenders reluctant to continue to accumulate dollar-denominated assets

  • Trigger massive sales of current holdings?

  • http://www.youtube.com/watch?v=qu2uJWSZkck


The international monetary system contemporary international monetary arrangements

Hope?

  • Cooperation amongst G5?

    • (G5??? p255... China?)

  • US needs to reduce its budget deficit

  • Countries with surpluses need to expand demand in their own countries

  • Macroeconomic coordination along these lines would reduce American imports & expand consumption in surplus countries

  • Cooperation could also guide a gradual decline of the $, rather than a fast catastrophic drop

  • Problem for China: adjustment moving from the US market to the domestic market would create economic dislocation, winners & losers…  political instability?

  • This is a reality that the Chinese government must deal with and therefore the American government must also!

  • But a catastrophic drop would hurt the export-oriented sectors of all countries with current account surpluses with the US!


Take aways

Take aways

  • Democracy  Fall of the gold standard

  • Fall of Bretton Woods replaced with floating XR

  • The Trilemma

  • France vs. Germany in the 1980s

  • Floating XR allows for flexibility in monetary policy

  • China-US problem – we have incompatible solutions to our trilemmas


The international monetary system contemporary international monetary arrangements

Thank you


The international monetary system contemporary international monetary arrangements

Source: http://www.fas.org/sgp/crs/row/RS22860.pdf


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