Feb Lesson 2 By John Kennes International Monetary Economics

Feb Most students will not have previously been facing the question of what is an international monetary system, and yet it is the underlying issue behind the adoption of a single currency. It is a collective decision, distinct from the individual choice of an exchange rate regime, presented in Chapter 11. The evolution of International monetary systems

Feb Monetary union is the controversial end of a long process. History helps understand. Since paper money was invented, Europe’s monetary history has been agitated. Each bad episode carries important lessons. Before paper money, Europe was a de facto monetary union. Understand how it worked helps understand how the new union works. Why study history?

Feb The workings of the gold standard are described by David Hume’s price-specie mechanism Depends on (i) long-run neutrality of money and (ii) the effect of money on interest rates Money and the balance of payments are linked by trade flows Hume’s mechanism implies an automatic change in the money stock to achieve balance of payments equilibrium Figure 10.1 How did the Gold Standard work?

Hume’s price-specie mechanism

Feb Money determines the price level in the long-run. The price level affects the trade balance –If domestic prices are relatively high (low), we have a deficit (surplus) Trade balance is achieved when the stock of money is M 1 Hume’s mechanism: Return to balance is automatic –If we start with deficit (point A, high money stock M ), money flows out until we get back to balance Much the same story applies to the financial account –If the domestic interest rate is high (low), capital flows in (out) and the return to balance is automatic The balance of payments adds the current and financial accounts Hume’s price-specie mechanism

Feb Using Figure 10-1, work out graphically what happens following an initial balance of payments surplus. Why is the capital outflow, prompted by lower interest rates, only partially offsetting financing the current account surplus? Why is there automatic monetary relaxation despite capital outflows? Hume’s price-specie mechanism example

Feb Using Figure 10-1, work out graphically what happens following an initial balance of payments surplus. Why is the capital outflow, prompted by lower interest rates, only partially offsetting financing the current account surplus? Why is there automatic monetary relaxation despite capital outflows? In Figure 10-1, in the rightmost graph we move from point C to point A as the money stock increases, the price level rises and the interest rate declines. Hume’s price-specie mechanism example

Feb Money starts circulating widely Yet the authorities attempt to continue on with the gold standard but –No agreement on how to set exchange rate between paper currencies –An imbalanced starting point with war legacies High inflation High public debts The interwar period

Feb The British Case: A refusal to devalue an overvalued currency brings economic decline 2.The French Case: Devaluation, undervaluation and beggar-thy- neighbor policies, until others retaliate and currency becomes overvalued 3.The German Case: Hyperinflation, devaluation and finally, evading the choice of an appropriate exchange rate by resorting to ever widening non-market controls The interwar period: Case studies

Feb We need a system, one way or another 2.The gold standard – monetary unions – delivers automatic return to equilibrium, but at the cost of booms and Recessions 3.No agreement leads to misalignments, competitive devaluations and trade wars 4.Agreements require “rules of the game”, including a conductor Lessons so far

Feb An overriding desire for exchange rate stability –Initially provided by the Bretton Woods system –The US dollar as anchor and the IMF as conductor Once Bretton Woods collapsed, the Europeans were left on their own –The timid Snake arrangement –The European Monetary System –The monetary union European Postwar Arrangements

The Bretton Woods System Collapse

Feb Agreeing on stabilizing intra-European bilateral parities No enforcement mechanism: too fragile to survive The Snake Arrangement

The European Snake

Feb Complements bilateral exchange rate commitment with a support mechanism. Allows for prompt realignments to avoid misalignments. Emergence of the Deutschemark as the system’s anchor. The EMS: Super Snake

1.Most European countries saw (nominal, they thought, but actually real) exchange rate stability as a pre-condition for trade integration, itself seen by post-war political leaders as the way to end wars. Observation 1

2.Once the dollar standard stopped playing its anchoring role, Europeans switched to the search for their own system, preparing the ground for the monetary union, probably unwittingly. Observation 2

3.Without a common disciplinary device, inflation rates diverged widely, calling for realignments that became increasingly difficult to manage as capital mobility increased. Hence the search for a system that would rule out inflation differentials. The EMS could not do that for political reasons (it had first to be symmetric and next the Bundesbank’s dominance was not sustainable). Observation 3

Feb Some Questions

Feb The excess money supply in the US leaked out to the rest of the world, reducing the dollar’s anchoring role. Different balance of payment surpluses led to different inflation rates. Why did fiscal and monetary indiscipline in the US lead to the collapse of the Bretton Woods system?

Feb The excess money supply in the US leaked out to the rest of the world, reducing the dollar’s anchoring role. Different balance of payment surpluses led to different inflation rates. Why did fiscal and monetary indiscipline in the US lead to the collapse of the Bretton Woods system?

Feb They required realignments that were increasingly foreseen. Why did growing inflation differentials create a problem for exchange rate stability in Europe?

Feb Facing a partner’s competitive devaluation, a country can either devalue even more or raise tariffs. Since it is impossible that everyone devalues vis a vis everyone else, competitive devaluations become self-defeating. During the interwar era, misalignments led to competitive devaluations, which then prompter a tariff war. Explain the links from one step to the next.

Feb Money is created by the Eurosystem and disseminated throughout the area. Countries with balance of payments deficits will lose money base. How can the Hume mechanism be applied to the flows of euros within the euro area?

Lessons from History