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International Monetary Exchange in Theory. Lecture 11 – Thursday, 15 October 2009 J A Morrison. Satirical Cartoon of John Law’s Mississippi Scheme (Paris, 1720). Admin. Papers back Soon—Friday? Online Discussion: Another post by 29 Oct. We’re at another turning point in the course….

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international monetary exchange in theory

International Monetary Exchange in Theory

Lecture 11 – Thursday, 15 October 2009J A Morrison

Satirical Cartoon of John Law’s Mississippi Scheme (Paris, 1720)

  • Papers back Soon—Friday?
  • Online Discussion: Another post by 29 Oct
ps 0304 int l pol econ
PS 0304 Int’l Pol Econ

  • Unit 1: Studying the Global Economy
    • Topic 1: Introductory
    • Topic 2: Perspectives on IPE
    • Topic 3: Explaining Foreign Economic Policy
  • Unit 2: Trading Goods & Services
    • Topic 4: Trade in Theory
    • Topic 5: Trade in Practice
  • Unit 3: The International Monetary System
    • Topic 6: The IMS in Theory
    • Topic 7: The IMS in Practice
  • Unit 4: Migration
  • Unit 6: Special Topics in IPE

international monetary exchange in theory1
International Monetary Exchange in Theory
  • Introductory: Money is Hard
  • The Basics of Monetary Exchange
  • The International Connection
  • Managing the Monetary System
international monetary exchange in theory2
International Monetary Exchange in Theory
  • Introductory: Money is Hard
  • The Basics of Monetary Exchange
  • The International Connection
  • Managing the Monetary System

Before we launch into the specifics of international monetary exchange, let’s step back to consider international monetary exchange in the context of international trade.How does money compare to trade?

Simply put, money is hard…Money is hard for us—the academicians—to understand.And it is hard for policymakers to control.
money is hard for us
Money is Hard for Us
  • Less familiar than trade
  • More abstract than trade & migration
  • Money has changed more over time
    • Variation in policies: fixed versus flexible
      •  akin to change in trade policy: liberal versus managed
    • But money itself might be different: commodity currency is governed by different rules than is fiat currency
money is hard for policymakers
Money is Hard for Policymakers
  • More difficult to understand
  • Imprecise, blunt instruments
  • Money is more mobile  more difficult to control
  • Severe market constraints: attacks, competition, counterfeiting, contagion, &c.
So, the international monetary system is more difficult for us to control than is the trade regime.But, arguably, the stakes are higher…
money matters
Money Matters
  • The downside risk is greater
    • Collapse of trade: ouch!
    • Currency collapse  catastrophic!
  • All interests are affected
    • Some groups rely relatively little on trade
    • Everyone uses money  tighter coupling with macroeconomic effects
  • Damage is harder to repair
    • Violating a trade agreement causes upset
    • States spend decades trying to repair reputations after currency disorders

Here’s our plan…We’ll proceed as we did for trade: first theory, then empirics. Be prepared that money will be challenging. I’ll do my best to unpack the key terms and concepts. But you might have to turn things up a notch. (Good thing you’ve caught up on rest!)

international monetary exchange in theory3
International Monetary Exchange in Theory
  • Introductory: Money is Hard
  • The Basics of Monetary Exchange
  • The International Connection
  • Managing the Monetary System
ii basics of monetary exchange
  • Background on Money
  • Monetary Systems

It’s easy to understand why we trade goods & services: the benefits of specialization are readily apparent.Understanding the invention and use of money, however, is less immediately accessible.

1 medium of exchange
(1) Medium of Exchange
  • Money resolves “double coincidence of wants problem”
  •  What are the chances that you’ll encounter someone who has what you want and wants what you have?
  • Hint: < Finding True Love

Money evolves as a means to resolve this problem. Individuals accept a common good with certain characteristics (high value to bulk ratio, divisible, durable, uniform in quality) that becomes the common medium of exchange.

2 store of value
(2) Store of Value
  • Money allows individuals to convert perishables into more durable goods
  • This allows:
    • Storing value between transactions
    • Saving by hoarding cash
3 unit of account
(3) Unit of Account
  • Money provides a standard relationship between various g&s in the economy
  •  Using a standard unit simplifies accounting and transactions immensely
ii basics of monetary exchange1
  • Background on Money
  • Monetary Systems

Across history, nations have chosen a wide variety of materials to serve as money. The ancient Greeks used cattle, some Native Americans used wampum, and the early Chinese used cowry shells.Today, most countries use “paper” currency, which is usually made from cotton and/or linen.

the values of money
The Values of Money
  • Intrinsic Value: market value of the currency’s constituent material when used for non-monetary purposes
    • E.g. gold coin sold as material for jewelry
  • Exchange Value: market value of the currency when used as currency in trade
    • E.g. gold coin used to purchase jewelry
  • Extrinsic/Nominal Value: “official” value and/or units
    • E.g. “1 shilling,” “1 dollar”
Monetary systems can be grouped along a continuum according to the gap between the intrinsic and the exchange values of the currency.

(Here, we’ll treat “backed” or “representative” currencies as commodity money since they can, by definition, be traded with the government for a commodity of high value.)

  • Historical Origin: charge at mint to convert raw material into currency
    • Also called “brassage” or “coinage”
  • Modern Usage: “the excess of the nominal value of a currency over its cost of production” (Cohen, Future of Money, 18)
  • Implications:
    • Revenue source for state
    • Creates incentive to counterfeit—(the unauthorized creation of currency)
seigniorage and monetary systems
Seigniorage and Monetary Systems
  • Commodity Money
    • High seigniorage might be viewed as revenue source (e.g. France)
    • Low or no seigniorage would subsidize exports and encourage capital inflows (e.g. Britain)
  • Fiat Money
    • Seigniorage is necessarily high; seigniorage creates the difference of value between intrinsic and exchange values
Jerry Cohen and I have an on-going debate about whether the difference between monetary systems is one of type or of degree…
me difference of degree
Me: Difference of Degree
  • Seigniorage is very large for fiat money
  • Fiat money still has intrinsic value—it’s just small!
  • Consider what happens when the exchange value drops below the “intrinsic value”…

Woman burning money instead of firewood (Germany, 1923)

jerry difference of type
Jerry: Difference of Type
  • Fiat money has essentially no intrinsic value
  • Difference is so significant that it must be treated as one of type

The historical trend is clearly away from commodity money and toward fiat money. Policymakers generally prefer fiat money because (1) they gain increased revenue from seigniorage; and (2) the market imposes fewer constraints on monetary policy when using fiat money.But the power to “print” money is frequently abused. Some economists, like FA Hayek, appreciated the discipline imposed by commodity money systems.

international monetary exchange in theory4
International Monetary Exchange in Theory
  • Introductory: Money is Hard
  • The Basics of Monetary Exchange
  • The International Connection
  • Managing the Monetary System
iii the international connection
  • The Nth Currency
  • Exchange Rate Regimes
  • The Balance of Payments

The same logic that impels the development of a common medium of exchange within economies impels the adoption of international media of exchange between economies.Such a currency is sometimes called the Nth Currency.


Gold & silver previously performed this role. After WWII, the US dollar was the preeminent Nth Currency. Today, the dollar faces competition from the Euro, the Yen, and the Renminbi.


“The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency…Looking forward, there will increasingly be other options to the dollar.”-- World Bank President Robert B. Zoellick (26 Sept 2009)(Source: NYT 28 Sept 2009)

Why would foreign states move away from holding the dollar in reserve and using the dollar in international exchanges?
the dollar s declining role
The Dollar’s Declining Role
  • Medium of Exchange
    • US share of total GATT/WTO Member GDP
      • 1948: ~65%
      • 2001: ~38%

(Source: Barton, et al, p 13)

  • Store of Value
    • Market price of gold (per ounce) in $US
      • 1945: $35/ounce
      • 14 Oct 2009: $1063/ounce
iii the international connection1
  • The Nth Currency
  • Exchange Rate Regimes
  • The Balance of Payments
An exchange rate(ER) is the specific valuation between domestic currency and a foreign/international currency/commodity.

A state’s exchange rate regime is the set of rules that determine the relationship (including valuation) between domestic currency and foreign or international currencies.


For now, we assume governments enjoy monetary sovereignty, the ability to control the market value of domestic currency, the currency used for transactions in the home market.

how states regulate the value of the currency
How States Regulate the Value of the Currency
  • Intervention in Foreign Exchange (Forex) Market
    • Buy/sell reserves of domestic currency, foreign currency, and/or a key commodity to directly affect market prices
  • Adjust Quantity via Monetary Policy
    • Open Market Operations
    • Fractional Reserve Rate
    • Discount Rate (Interest Rate)
  • By Proclamation and/or Price Controls
    • “What was previously worth $1 shall now be worth $5.”
    • “Grain shall not be sold for less than $5 per bushel.”
    • “One Pound shall not be traded for more or less than $4.86.”
states can regulate the value of the currency vis vis
States can regulate the value of the currency vis-à-vis:
  • Foreign currency(ies)
  • Key commodity(ies)
  • The overall national price level

 Is it possible to fix a currency with respect to several things simultaneously?


 Answer: Not usually.Different parts of the economy grow at different rates. Maintaining stability with respect to one precludes stability with respect to the others.

pick a price any single price
Pick a Price, Any Single Price
  • Assume Different Rates of Growth
    • World supply of gold: 2%
    • US GDP: 3%
    • British GDP: 1%
  • What should be rate of increase of US dollars?
    • Stable gold price: 2%
    • Stable overall price level: 3%
    • Stable ER vis-à-vis pound: 1%

 Stability can only be maintained along one dimension at a time

Exchange rate regimes exist along a continuum: to what extent does the state intervene to maintain a stable exchange rate in the market?
exchange rate regimes
Exchange Rate Regimes

-- We’ll talk here in terms of regimes that are “fixed” and those that are and “flexible/adjustable.”

commodity money and er regimes
Commodity Money and ER Regimes
  • In theory, currency is fixed vis-à-vis the constituent material (e.g. the gold in the gold coin)
  • But state may debase the currency: decrease quantity of metal in specie
  • State may erect restrictions to limit convertibility, thus allowing the exchange value to fluctuate vis-à-vis the intrinsic value
fait money and er regimes
Fait Money and ER Regimes
  • Use of fiat money allows maximum potential flexibility of the exchange rate
  • But states sometimes choose to fix the ER
    • Pegged ER: state intervenes to maintain ER stability in the market
    • Currency Board: state promises to exchange fixed amount of foreign currency for domestic currency

Government intervention sometimes fails to achieve its goal.“Fixed” ER regimes do not always generate stable market ERs. And sometimes states claim to have “flexible” ERs but, in reality, regulate them such that their market values remain stable.

mexico switzerland in the 1990s
Mexico & Switzerland in the 1990s

Grieco & Ikenberry, 62.

iii the international connection2
  • Exchange Rate Regimes
  • The Balance of Payments

Bunsen, I thought we were done with the balance of payments!!!

Well, Dewb, I thought you could use a refresher...


Remember that the balance of payments (BoP) reconciles all of a country’s financial transactions with the world.This includes trade, remittances, investment, loans, &c.

you should also remember that the er regime determines in part how balance in the bop is maintained
You should also remember that the ER regime determines, in part, how balance in the BoP is maintained.
 The ER regime determines whether these adjustments happen through the marketor throughintervention by the monetary authority.
 So, again, note that the regime is determined by what the monetary authority actually does, not what it promises to do.
international monetary exchange in theory5
International Monetary Exchange in Theory
  • Introductory: Money is Hard
  • The Basics of Monetary Exchange
  • The International Connection
  • Managing the Monetary System
next time
Next Time
  • Politics of FEP and international monetary exchange
  • Start on empirics: the gold standard!