The international monetary system

Chapter 18 The International Monetary System, 1870-1973

The interdependence of open national economies has made it more difficult for governments to achieve full employment and price stability. The channels of interdependence depend on the monetary and exchange rate arrangements. This chapter examines the evolution of the international monetary system and how it influenced macroeconomic policy.

Macroeconomic Policy Goals

In an Open Economy In open economies, policymakers are motivated by two goals:  Internal balance: It requires the full employment of a country’s resources and domestic price level stability. External balance: It is attained when a country’s current account is neither so deeply in deficit nor so strongly in surplus.

Internal Balance: Full Employment and Price-Level Stability Under-and over employment lead to price level movements that reduce the economy’s efficiency. To avoid price-level instability, the government must: Prevent substantial movements in aggregate demand relative to its full-employment level. Ensure that the domestic money supply does not grow too quickly or too slowly.

External Balance: The Optimal Level of the Current Account. External balance has no full employment or stable prices to apply to an economy’s external transactions. An economy’s trade can cause macroeconomic problems depending on several factors: The economy’s particular circumstances, Conditions in the outside world, The institutional arrangements governing its economic relations with foreign countries.

Problems with Excessive Current Account Deficits:

They sometimes represent temporarily high consumption resulting from misguided government policies.

They can undermine foreign investors’ confidence and contribute to a lending crisis

Problems with Excessive Current Account Surpluses:

They imply lower investment in domestic plant and equipment.

They can create potential problems for creditors to collect their money.

They may be inconvenient for political reasons.

Several factors might lead policymakers to prefer that domestic saving be devoted to higher levels of domestic investment and lower levels of foreign investment: It may be easier to tax, It may reduce domestic unemployment, It can have beneficial technological spillover effects.

International Macroeconomic Policy Under the Gold Standard, 1870-1914

Origins of the Gold Standard.  The gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of value. The Resumption Act (1819) marks the first adoption of a true gold standard. It simultaneously repealed long-standing restrictions on

the export of gold coins and bullion from Britain. The U.S. Gold Standard Act of 1900 institutionalized the dollar-gold link.

External Balance Under the Gold Standard  Central banks Their primary responsibility was to preserve the official parity between their currency and gold. They adopted policies that pushed the non reserve component of the financial account surplus (or deficit) into line with the total current plus capital account deficit (or surplus). A country is in balance of payments equilibrium when the sum of its current, capital, and non reserve financial accounts equals zero. Many governments took a laissez-faire attitude toward the current account.

The Price-Specie-Flow Mechanism The most important powerful automatic mechanismthat contributes to the simultaneous achievement ofbalance of payments equilibrium by all countriesThe flows of gold accompanying deficits and surplusescause price changes that reduce current accountimbalances and return all countries to external balance.

The Gold Standard “Rules of the Game”: Myth and Reality. The practices of selling (or buying) domestic assets inthe face of a deficit (or surplus).The efficiency of the automatic adjustment processesinherent in the gold standard increased by these rules.In practice, there was little incentive for countries withexpanding gold reserves to follow these rules. Countries often reversed the rules and sterilized gold flows.

Internal Balance Under the Gold Standard. The gold standard system’s performance inmaintaining internal balance was mixed.Example: The U.S. unemployment rate averaged 6.8%between 1890 and 1913, but it averaged under 5.7%between 1946 and 1992.

The Interwar Years, 1918-1939

With the eruption of WWI in 1914, the gold standard was suspended. The interwar years were marked by severe economic instability. The reparation payments led to episodes of hyperinflation in Europe.  The German Hyperinflation.  Germany’s price index rose from a level of 262 in January 1919 to a level of 126,160,000,000,000 in December 1923 (a factor of 481.5 billion).

The Fleeting Return to Gold.  1919=>U.S. returned to gold. 1922=>A group of countries (Britain, France, Italy, and Japan) agreed on a program calling for a general return to the gold standard and cooperation among central banks in attaining external and internal objectives. 1925=>Britain returned to the gold standard. 1929=>The Great Depression was followed by bank failures throughout the world. 1931=> Britain was forced off gold when foreign holders of pounds lost confidence in Britain’s commitment to maintain its currency’s value.

International Economic Disintegration. Many countries suffered during the Great Depression Major economic harm was done by restrictions oninternational trade and payments.These beggar-thy-neighbor policies provoked foreignretaliation and led to the disintegration of the worldeconomy.All countries’ situations could have been betteredthrough international cooperation.

The Bretton Woods System and the International Monetary Fund

International Monetary Fund (IMF) In July 1944, 44 representing countries met in Bretton

Woods, New Hampshire to set up a system of fixed exchange rates. All currencies had fixed exchange rates against the U.S. dollar and an unvarying dollar price of gold ($35 an ounce). It intended to provide lending to countries with current account deficits. It called for currency convertibility.

Goals and Structure of the IMF. The IMF agreement tried to incorporate sufficientflexibility to allow countries to attain external balancewithout sacrificing internal objectives or fixedexchange rates. Two major features of the IMF Articles of Agreementhelped promote this flexibility in external adjustment:IMF lending facilities, IMF conditionality is the name for the surveillance over thepolicies of member counties who are heavy borrowers of Fundresources., Adjustable parities

Convertibility. Convertible currency is a currency that may be freely exchanged for foreigncurrencies.Example: The U.S. and Canadian dollars became convertiblein 1945. A Canadian resident who acquired U.S. dollars coulduse them to make purchases in the U.S. or could sell them tothe Bank of Canada.

The IMF articles called for convertibility on current account transactions only.

The Changing Meaning of External Balance. The “Dollar shortage” period (first decade of theBretton Woods system)

The main external problem was to acquire enough dollars to finance necessary purchases from the U.S.  Marshall Plan (1948) A program of dollar grants from the U.S. to European countries.  It helped limit the severity of dollar shortage.

Speculative Capital Flows and Crises Current account deficits and surpluses took on addedsignificance under the new conditions of increasedprivate capital mobility.Countries with a large current account deficit might besuspected of being in “fundamental disequilibrium”underthe IMF Articles of Agreement.  Countries with large current account surpluses might be viewed by the market as candidates for revaluation. To describe the problem an individual country (other than the U.S.) faced in pursuing internal and external balance under the Bretton Woods system of fixed exchange rates, assume that: R = R*.

Collapse of the Bretton Woods System

The U.S. was not willing to reduce government purchases or increase taxes significantly, nor reduce money supply growth. These policies would have reduced aggregate demand, output and inflation, and increased unemployment. The U.S. could have attained some semblance of external balance at a cost of a slower economy. A devaluation, however, could have avoided the costs of low output and high unemployment and still have attained external balance (an increased current account and official international reserves). The imbalances of the U.S., in turn, caused speculation about the value of the U.S. dollar, which caused imbalances for other countries and made the system of fixed exchange rates harder to maintain. Financial markets had the perception that the U.S. economy was experiencing a “fundamental equilibrium” and that a devaluation would  be necessary. First, speculation about a devaluation of the dollar caused investors to buy large quantities of gold. The Federal Reserve sold large quantities of gold in March 1968, but closed markets afterwards. Thereafter, individuals and private institutions were no longer allowed to redeem gold from the Federal Reserve or other
central banks. The Federal Reserve would sell only to other central banks at $35/ounce.  But even this arrangement did not hold: the U.S. devalued its dollar in terms of gold in December 1971 to $38/ounce. Second, speculation about a devaluation of the dollar in terms of other currencies caused investors to buy large quantities of foreign currency assets. A coordinated devaluation of the dollar against foreign currencies of about 8% occurred in December 1971. Speculation about another devaluation occurred: European central banks sold huge quantities of European currencies in early February 1973, but closed markets afterwards.  Central banks in Japan and Europe stopped selling their currencies and stopped purchasing of dollars in March 1973, and allowed demand and supply of currencies to push the value of the dollar downward.

International Effects of U.S. Macroeconomic Policies

Recall from chapter 17, that the monetary policy of the country which owns the reserve currency is able to influence other economies in a reserve currency system.In fact, the acceleration of inflation that occurred in the U.S. in the late 1960s also occurred internationally during that period. Evidence shows that money supply growth rates in other countries even exceeded the rate in the U.S. This could be due to the effect of speculation in the foreign exchange markets. Central banks were forced to buy large quantities of dollars to maintain fixed exchange rates, which increased their money supplies at a more rapid rate than occurred in the U.S.

In summary, in an open economy, policymakers try to maintain internal and external balance.  The gold standard system contains a powerful automatic mechanism for assuring external balance, the price-specie-flow mechanism. Attempts to return to the prewar gold standard after 1918 were unsuccessful. As the world economy moved into general depression after 1929, the restored gold standard fell apart and international economic integration weakened. The architects of the IMF hoped to design a fixed exchange rate system that would encourage growth in international trade. To reach internal and external balance at the same time, expenditure-switching as well as expenditure changing policies were needed.  The United States faced a unique external balance problem, the confidence problem. U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early 1973.