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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

slide6
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

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

slide9
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
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
slide24
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

slide25
Fixed Exchange Rate

Eurozone countries

Switzerland

PRC

The Trilemma

Open Capital Flows

Sovereign Monetary Policy

slide26
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
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!!
slide35
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

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
slide40
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
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