1. Chapter 7 THE INTERNATIONAL MONETORY SYSTEM 1870-1973

2. THE INTERNATIONAL MONETORY 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.

3. THE INTERNATIONAL MONETORY SYSTEM 1870-1973
This chapter examines how the international monetary system influenced macroeconomic policy-making and performance during three period:
The interwar period ( )
The gold standard era( )
The post-World War II years ( )

4. THE INTERNATIONAL MONETORY SYSTEM 1870-1973
Gold Standard era
1870
1914
1918
1939
Interwar Years
1946
1973
Under the Bretton Woods System

5. Macroeconomic Policy Goals In an Open Economy
Internal Balance:Full Employment and Price-Level Stability
When a country’s productive resources are fully employed and its price level is stable,the country is in internal balance.
External Balance:The Optimal Level of the Current Account
Because of the existence of intertemporal trade,it’s difficult to make a exact current account balance.So the external balance goal is The Optimal Level of the CA.

6. Internal Balance: Full Employment and Price-Level Stability
A country is in internal balance when its resources are fully employed and there is price level stability.
Under-and over-employment lead to price level movements that reduce the economy’s efficiency.
One particularly disruptive effect of an unstable price level is its effect on the real value of loan contracts.
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.

7. 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

8. Macroeconomic Policy Goals In an Open Economy
Problems with Excessive Current Account Deficits.
A large CA deficit can undermine foreign investors’ confidence and contribute to a lending crisis.
Problems with Excessive Current Account Surpluses
The total domestic saving ,S, is divided between foreign asset accumulation,CA,and domestic investment I, S=CA +I . So for a given level of national saving,an increased CA surplus implies lower investment in domestic plant and equipment. (S , CA , I )

9. 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 .
External Balance Under the Gold Standard
A situation in which the central bank was neither gaining gold from abroad nor losing gold to foreigners at too rapid a rate.
The Price-Specie-Flow Mechanism
Internal Balance Under the Gold Standard

10. The The Price-Specie-Flow Mechanism
David Hume ,the Scottish philosopher, in 1752 described the The Price-Specie-Flow Mechanismas follows:
It is to say that in the Gold Standard era the economy can achieve balance automatically. Ms P P*
export
import CA
National price
level
Foreign price
level

11. The The Price-Specie-Flow Mechanism
The price-specie-flow mechanism described by David Hume shows how the gold standard could ensure convergence to external balance. This model is based upon three equations:
The balance sheet of the central bank. At the most simple level, this is just gold holdings equals the money supply: G = M.
The quantity theory. With velocity and output assumed constant and both normalized to 1, this yields the simple equation M = P.
A balance of payments equation where the current account is a function of the real exchange rate and there are no private capital flows: CA = f(E·P*/P)

12. The The Price-Specie-Flow Mechanism
These equations can be combined in a figure like the one below.
The 45 line represents the quantity theory and the vertical line is the price level where the real exchange rate results in a balanced current account.
The economy moves along the 45 line back towards the equilibrium point 0 whenever it is out of equilibrium.
For example, the loss of four-fifths of a country's gold would put that country at point a with lower prices and a lower money supply.
The resulting real exchange rate depreciation causes a current account surplus which restores money balances as the country proceeds up the 45 line from a to 0.

13. International Macroeconomic Policy Under the Gold Standard 1870-1914
The Gold Standard “Rules of the Game”: Myth and Reality
The practices of selling (or buying) domestic assets in the face of a deficit (or surplus).
The efficiency of the automatic adjustment processes inherent in the gold standard increased by these rules.
In practice, there was little incentive for countries with expanding 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 in maintaining 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.

14. THE INTERWAR YEARS
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 billion).

15. THE INTERWAR YEARS 1918-1939 The Fleeting Return to Gold
U.S. returned to gold
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.
Britain returned to the gold standard
The Great Depression was followed by bank failures throughout the world.
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
Governments effectively suspended the gold standard during world War I and financed part of their massive military expenditures by printing money. As a result,price levels were higher everywhere .

16. THE BRETTON WOODS SYSTEM AND THE IMF
The system set up by Bretton Woods agreement, it’s a gold exchange standard with the dollar as its principal reserve currency .
Goals and Structure of the IMF
The exchange rates be fixed to the $,which in turn,was tied to gold.
The IMF agreement tries to incorporate sufficient flexibility :
IMF lending facilities ;
adjustable parities.
Convertibility
General inconvertibility would make international trade extremely difficult,the IMF Articles of Agreement urged members to make their national currencies convertible as soon as possible.

17. INTERNAL AND EXTERNAL BALANCE UNDER THE BRETTON WOODS SYSTEM
As the world economy evolved in the years after World War Ⅱ,the meaning of “external balance ”changed and conflicts between internal goals increasingly threatened the fixed exchanged rate system. The special external balance problem of the United States, the issuer of the principal reserve currency, was a major concern that led to proposals to reform the system.

18. INTERNAL AND EXTERNAL BALANCE UNDER THE BRETTON WOODS SYSTEM
The Changing Meaning of External Balance
In the first decade of the Bretton Woods system, many countries ran current account deficits as they reconstructed their war-torn economies. Since the main external problem of these countries, taken as a group, was to acquire enough dollars to finance necessary purchase from the United States, these years are often called the period of “dollar shortage”.
Each country ’s overall current account deficit was limited by the difficulty of borrowing any foreign currencies in an environment of heavily restricted capital account transactions. So these countries had to reduce their foreign exchange reserves. Central banks were unwilling to let reserves fall to low levers, in part because their ability to fix the exchange rate would be endangered.
The restoration of convertibility in 1958 gradually began to change the nature of policymakers’ external constraints.

19. INTERNAL AND EXTERNAL BALANCE UNDER THE BRETTON WOODS SYSTEM
Speculative Capital Flows and Crises
Because of expectation of the overage fluctuation of the current account, the private capital flows. This affects the foreign reserve and affects the internal and external balances.

20. Speculative Capital Flows and Crises
Current account deficits→expectation of devaluation → people want to change local currency to foreign currency → in order to keeping the fixed exchange rate the central bank has to sale the foreign currency and buy the local currency → the decline of the foreign reserve amount → if the foreign reserve decreases to a certain level → this country can not maintain the fixed exchange rate → the devaluation of the local currency.
Currency account surplus→ expectation of revaluation→people want to change foreign currency to local currency→in order to keeping the fixed exchange rate the central bank has to sale the local currency and buy the foreign currency→the increasing of the foreign reserve amount→the money supply increases→the local price level increases→this destroys the internal balance.

21. ANALYING POLICY OPTIONS UNDER THE BRETTON WOODS SYSTEM
Maintaining Internal Balance
Both P*and E are permanently fixed. The condition of internal balance is
Yf=C(Yf -T)+I+G+CA(EP*/P, Yf -T)
Yf: output at its full employment C: consumption I: investment G: government purchase
CA: current account EP*/P: the real exchange rate

22. Maintaining Internal Balance
Overemployment
excessive
The Ⅱschedule in figure 1 shows combinations of exchange rates and fiscal policy that hold output constant at Yf and thus maintain internal balance.
The schedule is downward-sloping because currency devaluation (a rise in E ) and fiscal expansion (a rise in G or a fall in T) both tend to rise output.
Exchange rate E
Underemployment
excessive Ⅱ
Figure1
Fiscal ease
(G or T )

23. Maintaining External BalanceXX
Current account
deficit
surplus
Figure2
Exchange rate E
Fiscal ease
(G or T )
The condition of external balance is
CA(EP*/P, Yf -T)=X
Figure 2 shows that the XX schedule, along which external balance holds, is positively sloped. The XX schedule shows how much fiscal expansion is hold the current account surplus at X as the currency is devalued by a given amount.

24. Internal Balance (II), External Balance (XX), and the “Four Zones of Economic Discomfort”
Exchange rate E
Fiscal ease
(G or T )
Overemployment
excessive current
account surplus
account deficit XX Ⅱ
Figue3
The diagram shows what different levels of the exchange rate and fiscal ease imply for employment and the current account. AlongⅡ,output is at its full-employment level, Yf. Along XX, the current account is at its target level, X.
Underemployment
excessive current
account surplus
Overemployment
excessive current
account deficit

25. Expenditure-Changing and Expenditure-Switching Policies
The expenditure-changing policy is the policy which can alters the level of the economy’s total demand for goods and services.
The expenditure-switching policy is the policy which can change the direction of demand, shifting it between domestic output and import.

26. Expenditure-Changing and Expenditure-Switching Policies
Fiscal ease
(G or T)
Exchange
rate, E XX II 1 3
Devaluation
that results
in internal
and external
balance 2 4
The expenditure-changing policy is the policy which can alters the level of the economy’s total demand for goods and services.
The expenditure-switching policy is the policy which can change the direction of demand, shifting it between domestic output and import.

27. Expenditure-Changing and Expenditure-Switching Policies1 2 4 3
Exchange rate E
Fiscal ease
(G or T ) XX Ⅱ
Figure4
Devaluation
that result
in internal
and external
balance
Fiscal expansion that
results in internal and
external balance
Unless the currency is devalued and the degree of fiscal ease increased, internal and external balance (point 1) can not be reached. Acting alone, fiscal policy can attain either internal balance (point 3) or external balance (point 4), but only at the cost of increasing the economy’s distance from the goal that is sacrificed.

28. THE EXTERNAL BALANCE PROBLEM OF THE UNITED STATES
Triffin dilemma:
After World War Ⅱ the foreign countries need a lot of money to developing their domestic economy. The central banks’ international reserve needs grew over time, their holdings of dollars would necessarily redeem these dollars at $35 an ounce, it would no longer have the ability to meet its obligations should all dollar holder simultaneously try to convert their dollars into gold. This would lead to a confidence problem: central bank, knowing that their dollars were no longer “as good as gold ”, might become unwilling to accumulate more dollars and might even bring down the system by attempting to cash in the dollars they already held.

29. THE EXTERNAL BALANCE PROBLEM OF THE UNITED STATES
Possible solution:
One possible solution at the time was an increase in the official price of gold in terms of the dollar and all other currencies. But this possibly worsening the confidence problem rather than solving it.
Another is setting up the IMF which issues its own currency (SDRS), which central banks would holds as international reserves in place of dollars.

31. WORLDWIDE INFLATION AND THE TRANSITION TO FLOATING RATES
This part mainly talks about the American inflation flowing to the other countries. And facing the inflation how other countries choose the policy to solve this problem.
The acceleration of American inflation in the late 1960’s was a worldwide phenomenon.
It had also speeded up in European economies.
When the reserve currency country speeds up its monetary growth, one effect is an automatic increase in monetary growth rates and inflation abroad.
U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early 1973.

32. WORLDWIDE INFLATION AND THE TRANSITION TO FLOATING RATES
The process of import inflation:
American inflation increases
American domestic price level rise
the demand of the foreign commodity will increases
when the price level is higher than the other countries’
the inflation will spread from America to other countries
the import will increase
the other countries’ domestic amount of commodity will decrease
the price level will rise in the other countries
the demand of commodity will increase

33. WORLDWIDE INFLATION AND THE TRANSITION TO FLOATING RATES
Exchange rate E
XX1
XX2 Ⅱ2 Ⅱ1 2 1
Fiscal ease
(G or T )
Distance=
EΔP*/ P*
Figure 5

34. WORLDWIDE INFLATION AND THE TRANSITION TO FLOATING RATES
The other countries’ governments have two choices:
If nothing is done by the government, overemployment puts upward pressure on the domestic price level, and this pressure gradually shifts the two schedules back to their original positions. The schedules stop shifting once P has risen in proportion to P*. At this stage the real exchange rate, employment, and the current account are at their initial levels, so point 1 is once again a position internal and external balance.

35. WORLDWIDE INFLATION AND THE TRANSITION TO FLOATING RATES
The way to avoid the imported inflation is to revalue the currency (that is ,lower E) and move to point 2. A revaluation restores internal and external balance immediately, without domestic inflation, by using the nominal exchange rate to offset the effect of the rise in P* on the real exchange rate .only an expenditure-switching policy is needed to respond to a pure increase in foreign prices.
In order to maintain the internal balance the government chooses the last policy to remove the effect of importing inflation. And the exchange rate begins to float. So at this situation the fixed exchanged rate system is hard to maintain. And then the fixed exchanged rate system transforms to the floating exchanged rate system.

36. Question

37. Thanks