1. Lecture 9:International monetary regimes in history
This power point presentations have been revised by Paul Sharp (Ph.D. student)
on the basis of my slides

2. Last time
We looked at some similarities and differences between the world before WW1 and the world today.
We saw why many economists believe that there are “gains from trade”.
We discussed the importance of trade policy by showing the impact of extreme protectionism on the interwar period.
This time: We turn to monetary policy.
How have international monetary regimes evolved through history?
How did they work?
How well did they work?
Again, we will see the importance of getting economic policy “right”.

3. First, some important definitions and concepts (Mankiw chapters 29-31)
Commodity vs. fiat money, see lecture 4
Fixed vs. floating exchange rates
If Danmark’s Nationalbank has decided to keep the Danish kroner per US$ at a constant rate, say 5 kroner per US$ then it is a fixed exchange rate.This was the case in the Bretton Woods system after WWII.
In the Gold standard currencies had legally determined gold content. and exchange rates were anchored by relative gold content of the currencies.
If Sweden decides to let its exchange rate to the US$ be determined in the foreign currency markets then it is a floating exchange rate. It changes a little from day to day and can change a lot from year to year.
Dk has now pegged( approximately fixed) its exchange rate to the Euro while the Swedish krona floats. .

4. Real exchange rate
Real exchange rate = Nominal exchange rate *US price level/Denmark’s price level
for example (5 * 100)/500 = 1
Nominal exchange rate is domestic currency per 1 US$
At this nominal exchange rate purchasing power parity (PPP) is established
PPP means that at the prevailing nominal exchange rate 500 Dkr buys the same basket of goods in DK as it does in the US, since 500 Dkr is exchanged for 100US$, which is the price in US for the same basket of goods

5. Undervalued or overvalued?
Assume that the Danish price level increases to 600 while the price level in US and the nominal exchange rate are constant
RER = (5*100)/600 = 0.83
The DKR buys more goods in US than in Denmark; Imports from US increases. DK exports fall. DKR is overvalued, relative to PPP
Assume that the Danish price level falls to 400 while the price level in US and the nominal exchange rate are constant
RER = (5*100)/ 400 = Now the Dkr buys less goods in the US than in Denmark, US exports fall, DK exports increase. The DKR is undervalued.

6. Adjustments
In a fixed exchange rate regime an economy that has experienced an isolated inflationary shock will see its RER appreciate and export (import) demand will fall (increase); employment falls, money supply is supposed to fall bringing about deflation. Eventually PPP is restored.
In a floating exchange rate regime an isolated inflationary shock leads to a depreciation of the nominal exchange rate, for example
RER = (4.17*120)/500 = 1

7. Effects on price levels of fixed and floating regimes

8. The recent history of international monetary regimes in a nutshell
Earlier Often bimetallism, gold and silver
ca Fixed: International Gold Standard
World War 1 - Gold standard suspended
Movement toward returning to gold
Fixed: International Gold Standard
Managed floating
World War 2
Gradual return to fixed rates
Fixed-but-adjustable: Bretton Woods dollar exchange standard
1973-present Regionally fixed, globally floating

9. The importance of an international monetary order
A foreign exchange market allows exchange rates to be determined and a global capital market to form.
Allows current account deficits to be financed.
With no foreign exchange market trade tends to be balanced bilateral trade – tends to reduce trade.
E.g. if Denmark wants 10 billion kroner of goods from Norway and Norway only wants 5 billion kroner of goods from Denmark, then Denmark can only import 5 billion kroner of goods.
Think of two people trading without money!
Foreign exchange markets also provide opportunity for international lending, so savings not constrained by investment demand.

10. To float or to fix?
Historically, it was believed that a fixed exchange rate was essential for a well-functioning international monetary order.
There are many examples in history of fixed exchange rates.
Prior to the first world war, there was an almost universal long-lasting fixed exchange rate system.
Since the first world war various unsuccessful attempts have been made to resurrect this.
Today, the most important currencies are floating.
An important exception is Denmark. The kroner is pegged to the euro.
Why have fixed exchange rates been so unstable and short-lived after 1913?

11. (Simplified) macroeconomic policy goals
Policymakers can often be thought of as aiming for both internal balance and external balance.
Internal balance: Full employment of resources; price level stability.
External balance: Current account should be neither too far in deficit nor too far in surplus.
The choice of exchange rate regime impacts on these aims.
We can use these definitions to analyze the successes and failures of historical monetary regimes.

12. Why internal balance? Full employment
Underemployment of resources: Waste.
Overemployment of resources: Less leisure for workers, more breakdowns for machines.
Price level stability
Price level instability can be caused by over- and underemployment or by expectations of price changes.
Unexpected price level changes cause redistribution between creditors and debtors.

13. Why external balance? Remember: Y = C + I + G + NX, so NX = S – I
So a current account deficit means that the country is borrowing from the rest of the world to finance investment. Not necessarily bad if the investment is profitable after paying the interest on the loans.
Current account surplus can be OK if investment is more profitable abroad.
But excessive current account deficits can result in a lending crisis, if creditors do not believe that their interest payments can be met.
Excessive current account surpluses can mean that too little is being invested domestically and may be internationally unpopular, e.g. leading to tariffs.

14. The International Gold Standard ca. 1870-1914
Gold has been used as money (medium of exchange, unit of account and store of value) since ancient times.
1819 UK Resumption Act:
Resumed (after Napoleonic Wars) and institutionalized the practice of exchanging currency notes for gold on demand at a fixed rate.
Repealed restrictions on export of gold.
Britain becomes leading economic power.
Other countries followed Britain’s lead, e.g. US in 1870s.
Previously bimetallic systems were popular (silver and gold).
London became centre of international monetary system.

15. Attempts at currency unions
Some countries tried to take the gold standard further and form monetary unions:
1865 Latin Monetary Union
1875 Scandinavian Monetary Union
etc.
If we do nothing, what then? Why, we shall be left out in the cold. Before long, all Europe, save England, will have one money, and England be left standing with another money.
– The Economist, 1860

16. Working of the pre-WW1 gold standard
No formal rules, but the following were usually observed:
Currency freely convertible to gold at a set price or “mint parity”.
Free flow of gold between countries.
Money supply expected to vary positively with gold reserves in national bank.
If losing gold in liquidity crisis, raise interest rates.
Temporary suspension should be followed by restoration of mint parity as soon as possible.
Prices determined by demand for and supply of gold.

17. Why was the gold standard a fixed exchange rate system?
Example:
US mint parity: $ / ounce.
UK mint parity: £4.252 / ounce.
Exchange rate must be / = $4.856 / £
Reason: Any other exchange rate gives possibility of arbitrage.
E.g. Use rules 1-3 to see that $1/£ gives possibility of:
Presenting £1 to Bank of England. Get 1/4.252=0.23 ounces of gold.
Presenting gold to US Treasury. Get 0.23*$ = $4.85
Exchange dollars on foreign exchange market for £4.85!
Flow of gold to US leads to increase in $ supply, decrease in £ supply. The £ strengthens on the foreign exchange market.

18. How fixed was it?
In reality small deviations within the so-called “gold points” were possible due to transport/transaction costs.
Transporting gold between countries is not costless.
Arbitrage will only take place as long as the gains from doing so outweigh the costs.
I.e. as long as one of the following:
(1) Get less dollars for a pound on the foreign exchange market than by using gold. (SER is spot exchange rate: $/£)
(2) Get less pounds for a dollar on the foreign exchange market than by using gold.

19. Illustration of gold arbitrage

20. Let’s speculate!
Currency traders London are unhappy with the fact that the number of dollars they get for a pound note is much below the mint parity at 4.856
Assume the SER is US$ per £ 1.
Buy 1 ounce of gold in London at the official price and ship it to New York at the cost of 0.12 US$.
Present the gold in NY and you will receive US$ but you have to deduct the transport cost so your net dollar holdings will be
The gold arbitrage exchange rate will be your net holding of US$ divided by the price in £ for 1 ounce of gold, that is /4.252=
There is an arbitrage profit of =0.04US$ per ounce of gold shipped.

21. Gold arbitrage and interest rate adjustments
If there was an outflow of gold the National Bank was expected to raise interest rates and shrink the money supply.
If the public buys gold from the National Bank in order to do arbitrage the domestic money supply falls unless the National Bank sterilizes the gold flow by buying domestic assets.
Rules of the game prescribed: if the National Bank loses foreign assets (gold) sell domestic assets.

22. External balance under the Gold Standard
Central banks should be neither gaining nor losing too much gold from abroad.
I.e. avoid sharp fluctuations in balance of payments. Surplus or deficit financed by gold shipments between central banks.
Many governments took a laissez-faire attitude, i.e. Britain’s surplus was 5.2% of GNP on average!
Price-specie-flow mechanism (Hume, 1752). Automatically ensured balance of payments equilibrium.
If gold is flowing to Britain, money supply increases and then British prices are rising, and foreign prices are falling.
Increases British demand for foreign goods and decreases foreign demand for British goods.
So gold flows out again! Equilibrium restored.
Reinforced by central bank practice of raising interest rates if losing gold, lowering rates when there is a gold inflow: “Rules of the game”.

23. Violations of rules of the game
In practise, central banks were more worried about gold losses than gold gains.
Continental Europe:
Even when not under pressure, sterilized gold inflows, so money supply did not increase, gave excess gold reserves.
Bank of England:
Active interest rate policy to stem anticipated gold losses.
Reason: If pound weakened, investors withdrew bank deposits, converted pounds to gold and exported it.
If there was a loss of gold Bank of England should actively reduce money supply (by selling domestic assets).
Bank did often violate this rule
If critical, could rely on loans from other central banks.

24. So why did the system survive so long?
Commitment – Deviations from the gold standard would be followed by a return to the original parity.
Confidence – People believed that rates would remain fixed, so speculation was equilibrating.
Symmetry – All national price levels dictated by gold demand/supply. No one country had overwhelming influence on price level.

25. Internal balance under the gold standard
Economic policy subordinate to external objectives.
Gold standard ensured price stability over longer periods.
For shorter periods there was inflation or deflation depending on the worldwide demand and supply of gold.
Internal policy objectives (e.g. combating unemployment) not considered important before WW1.

26. World War 1 and after (1914-1918-1925)
Gold standard suspended.
Expenditures financed by printing money.
Inflation!
After the war: some governments financed reconstruction by printing more money!
e.g. German hyperinflation, reached 3.25 million percent per month!
Money was useful for lighting the stove…

27. Return to gold 1919 US returns to gold.
Pre-WW1 seen as a golden age. Return to gold a priority.
But inflation increased at different rates in different countries during the war.
Restoring gold standard at original parities would mean deflation.
Deflation can be painful for economies since nominal wages do not normally fall easily, labour becomes relatively expensive and output declines and unemployment increases.
But now internal objectives were much more important: spread of democracy, powerful trade unions. (Socialism, communism on the rise.

28. Deflationary vs. inflationary countries
Some countries return to gold at the pre-war parity.
E.g UK returns to gold at pre-war price:
UK wanted to restore confidence in the gold standard and its ability to manage the system.
Required deflation – contractionary monetary policy.
Led to severe unemployment.
Other countries reduced the mint parity.
E.g. France rejoined at 20% of pre-war level.

29. Industrial growth in deflationary and inflationary nations in Europe in the 1920’s.

30. 1929 Wall Street Crash and the Great Depression
US trying to slow overheated economy through monetary contraction.
France ending inflationary period with return to gold.
France and US sterilizing gold inflows and absorbing world’s gold (reached 70% of world supply!).
Other countries forced to restrict money supply.
This worldwide monetary contraction and the Wall Street Crash led to the Depression.
1931 UK losing reserves and forced off gold.
Other countries follow e.g. Scandinavia.
France leaves last in 1936.

31. What was the impact of the gold standard?
The Great Depression had worldwide impact.
Wall Street crash, unemployment and bank failures.
Recent research suggests that the gold standard played a large part in prolonging and worsening the Depression.
Bank failures worsened because countries refused to provide liquidity since they needed to protect their gold reserves.
Countries (such as the UK) which left the gold standard early enjoyed faster recovery than countries like France, which did not.
Devaluation meant that
industry became more competitive.
real wages and real interest rates declined
monetary policy could be used.

32. Changes in exchange rates and industrial growth, the 1930s.

33. Reaction to the Great Depression
Countries gradually left the gold standard.
Beggar-thy-neighbour policies (such as the US Smoot-Hawley tariff) were implemented.
Restrictions on capital flows were implemented to offset reserve movements caused by uncertainty.
Countries became more autarkic.
Avoided external imbalance…
…at a terrible cost to the world economy.
World trade declined.
Fascism in Europe.
The progress of the nineteenth century was put back almost to square one.

35. Bretton Woods and the International Monetary Fund (IMF)
July 1944: 44 countries sign Articles of Agreement of IMF.
Hoped to design system that would allow both internal and external balance without trade restrictions.
Result of interwar experience. Floating exchange rates seen to be cause of instability and harmful to trade.
BW system was a gold exchange standard:
Fixed dollar price of gold: $35 an ounce.
Member countries hold reserves in gold or dollar assets as buffer stocks, and no link to money supply.
National banks had right to sell dollars to Federal Reserve for gold at official price. Meant to discipline US.
Currencies fixed to dollar in a narrow band: N-1 exchange rates to US$.
So countries responsible for maintaining exchange rate, US responsible for maintaining dollar price of gold.
Some flexibility allowed.

36. Flexibility
IMF lending facilities: Pool of gold and currencies from member countries could be used to lend to members who were experiencing current account deficits, but where contractionary policy would lead to unemployment. Members who borrowed from the IMF would be supervised by the IMF.
Adjustable parities: If balance of payments in “fundamental disequilibrium” (not defined!). Allowed devaluation against dollar if countries suffered permanent adverse international shifts in the demand for their products. Not available to Nth currency, the dollar.

37. Convertibility
IMF articles of agreement urged convertibility as soon as possible. (Important efficiency implications)
Only required convertibility on current account (goods and services) not capital account (financial assets).
Interwar experience led to belief that private capital movements and speculation led to instability.
US & Canadian dollars convertible from 1945.
US dollar becomes key international currency.

38. Why the restriction on capital mobility?
An expansionary monetary policy results in a tendency towards depreciation of the domestic currency.
Since exchange rate adjustments were permitted currency traders would speculate in a devaluation and sell the domestic currency
To stop speculation the central bank is forced to restrict monetary supply.
The monetary policy instrument is thus unavailable when exchange rates are fixed and free capital mobility.
However, limiting capital flows limits arbitrage and speculation, and expansionary monetary policy is again possible, at least in the short run.

39. External balance under Bretton Woods
First decade of Bretton Woods: Reconstruction after war.
Dollars needed to finance reconstruction: “dollar shortage”.
Helped by Marshall Plan in 1948.
Current account deficits limited by difficulty of obtaining foreign credit.
Convertibility restored in 1958.
Although still capital restrictions, was possible to borrow from abroad by delaying payments for goods and vice versa. “Leads” and “lags”.
Much more financial integration. Gave possibility of speculation.

40. Special Drawing Rights
Introduced in late 1960s.
1 SDR = 1 USD
Allocated in proportion to subscription to IMF.
Could be used to settle current account imbalances.
A country in deficit could deposit SDRs in a surplus country in return for foreign currency.
Allowed for greater international liquidity, but in practise the main provider of foreign reserves was the US.
US has almost permanent deficit due to heavy investment abroad (paid for with dollar assets).
Most countries were happy to hold dollar assets, since they gave interest (which gold does not).
An exception was - of course - France!

41. Speculative problems
If countries had large and persistent current account deficits, then they might be suspected of being in “fundamental disequilibrium”.
Prompted destabilizing speculation.
Bretton Woods lacked the credibility of the pre-WW1 gold standard.
UK devalued in 1967.
France devalued in 1957, 1958 and 1969.

42. Triffin credibility problem
By 1960s the Federal Reserve gold stock was a small fraction of US international liabilities.
Triffin suggested that a credibility problem destroyed the Bretton Woods system, as foreigners worried that the dollar was not “as good as gold”.
Dilemma:
If US does not have balance of payments deficit, then there will not be sufficient international liquidity, which might lead to a recession.
If US does have balance of payments deficit, then the gold convertibility and credibility vanishes, destroying the system.
But this was not what destroyed the Bretton Woods system!

43. The N-1 problem
The Bretton Woods system was asymmetrical (unlike the gold standard).
Only the US had the freedom to set its interest rate / use monetary policy.
All other countries had to use monetary policy to keep their currencies tied to the dollar.
They could in principle discipline the US, but they needed the dollar reserves to finance fast expanding trade!
Remember: if the domestic currency is fixed to the dollar, then domestic prices will move with US prices.

44. Inflation in the US forced on Europe
In the 1960s Democratic administrations
expanded welfare spending: the “Great Society”.
got involved in the Vietnam war.
Led to budget deficits and expansionary monetary policy.
Inflation doubled.
European governments had other inflation targets, but were forced to import US monetary policy.
German solution was to revalue: in 1961 and 1969.
US inflation made the dollar overvalued and devalued against gold in 1971.
But inflation continued, and gold convertibility was abandoned in 1973.

45. 1970s to today
Initially floating exchange rates seen as a temporary measure.
However, no new worldwide fixed exchange rate system seems likely.
There have been and are regional attempts at regional cooperation, e.g. European ERM which collapsed in 1992.
Recently, the problems of fixed exchange rates have been sought avoided by abolishing exchange rates altogether: the euro.
There is now little interest in an international fixed exchange rate system, since floating exchange rates have shown themselves to be compatible with free capital flows and trade.

46. The open economy trilemma

47. A summary: Fixed exchange rates are made to be broken!
Prior to WW1 governments emphasized external balance at the expense of internal balance. The gold standard thus combined free capital mobility and a fixed exchange rate, whilst leaving little room for monetary policy.
After WW1 governments desired a return to the stability of the Gold Standard, but could no longer ignore internal objectives. This led to a collapse in the gold standard.
After WW2 governments desired fixed rates with the flexibility to use monetary policy to reach internal balance. The Bretton Woods system thus required capital controls.
Increasing trade and economic integration meant that capital controls were no-longer feasible and the Bretton Woods system collapsed.
From the 1970s the goal of fixed exchange rates has been dropped.

48. References
For an (excellent and brief) description of monetary regimes in history, and the macro theory of fixed exchange rates, see:
Krugman, P.R. & Obstfeld, M. (2003) International Economics:
Theory and Policy.
For more basic macro see:
Mankiw, N.G. (2004) Principles of Economics.
And of course the following is compulsory reading!
Persson, K.G. & Sharp, P.R. A Note on International Monetary Regimes in History. Available on the course homepage: