International Monetary

Arrangements

Introduction

What were the various international

monetary system that existed from
late 1800s to the present?
How did adjustments to external
balances occur under these systems?
What are the discussions around
international monetary reform?

The Gold Standard

Operated from 1870 to 1914

Each country defined the gold content
of its currency

Could exchange a piece of paper for gold

Primary function of central bank was to

preserve parity between currency and
gold by buying or selling gold at official
parity price

Price of each currency in terms of gold

The Gold Standard

Since each currency was known and

fixed, exchange rates between
countries were also fixed
Little to no inflation
Fixed exchange rates gave significant
security to overseas business
Some costs also associated with gold
standard

Gold Standard & Monetary

Policy

Countrys monetary base consisted

of gold or currency backed by gold
Any balance of payments
imbalance at current fixed
exchange rate would set into
motion a correction process to
correct the imbalance

Gold Standard & Monetary

Policy

Balance of payments deficit

Rest of world accumulates more dollars

than desired
Gold outflows from US to rest of world

Occurred automatically as dollars become

cheaper in foreign exchange market

Traders could make small profit purchasing

gold at fixed price with cheaper dollars
Exchange rate would be stable in short run

Gold Standard & Monetary

Policy

Long run would not hold without

other adjustments

Outflow of gold causes monetary base

to fall or grow at slower rate
Change in money supply would affect
interest rate and aggregate demand to
correct balance of payments deficit

Opposite is also true (inflow of gold)

Gold Standard & Monetary

Policy

Under current system

Contractionary money decrease in money

supplys growth rate
Expansionary money increase in money
supplys growth rate

Under gold standard

Would actually have a decrease or increase

in money supply
Makes domestic economic relatively unstable
But, fixed exchange rate and long run stable
prices

Macroeconomics & Gold

Standard

Assume economy is expanding

Higher income in domestic economy

leading to increased level of imports
Higher domestic prices make imports
relatively cheaper
Balance of payments deficit at current
fixed exchange rate
Demand for foreign exchange increases
causing gold to flow out of country (A to
B)

Foreign Exchange Market

Macroeconomics & Gold

Standard

Gold outflow causes countrys

money supply to decrease

Consumption and investment decline

as interest rates increase
Aggregate demand decreases
Output and price level fall
Recession in domestic economy in
order to bring external balance back
into balance at the fixed exchange rate

Domestic Economy

Macroeconomics & Gold

Standard

Decrease in consumption spending leads to

decrease in imports
Domestic goods become relatively cheaper
Exports increase
Balance of payments improves
Outflows of gold decline (eventually to zero)
Money supply stabilized (stops falling) at
lower level
Domestic economy completes automatic
adjustment

Gold Standard Costs &

Benefits

Benefits
1.

Adjustment of price level and output

to an external imbalance is
completely automatic

Country only needs to be willing to buy

and sell gold at stated price
No question what would happen if
experience an external imbalance

Gold Standard Costs &

Benefits

Benefits
2.

Long run price stability for economy

Average inflation rate for US during gold standard

was 0.1 percent

Costs
1.

Does not guarantee short run price stability

Could have inflation some years and deflation

others
Could vary significantly from year to year
Deflation as common as inflation

Gold Standard Costs &

Benefits

Costs
2.

Overall balance of payments position

heavily influences countrys money
supply

Balance of payments deficit means

contracting money and contracting economy
Balance of payments surplus means
overheated economy with inflation
With completely fixed exchange rates came
extremely unstable GDP growth rate

Bretton Woods System

After gold standard ended, exchange

rates were extremely unstable
Desire for some form of international
monetary system was desirable
Conference in Bretton Woods, NH

44 countries met to create a new

international monetary system
Press referred to it as the Bretton Woods
System

Bretton Woods System

Gold Exchange Standard

US dollar tied to gold but all other

foreign currencies tied to dollar

Countries agreed to creation of

International Monetary Fund (IMF)

International monetary institution

Bretton Woods System

Purpose
1.

2.

Countries strong desire for a

monetary system with fixed
exchange rates
Design a method to decouple the
link between balance of payments
and money supply

Necessary to link currencies to

something other than gold

Bretton Woods System

Solutions
1.

Price of gold fixed at $35

2.

US to maintain fixed price

US would exchange dollars for gold at stated
price without limitation or restrictions

Other currencies fixed to US dollar

Meant other currencies fixed in relation to

one another
No longer necessary to sacrifice internal
balance to maintain external balance

Bretton Woods System

Faults

Logically impossible to have balanced

balance of payments in both short and long
run
Long run balancing important for sustaining
monetary system
Government had to actively intervene in the
foreign exchange market

Governments would have to buy or sell domestic or

foreign currency to keep domestic currency from
appreciating or depreciating

Bretton Woods System

Example

Country in a recession with balance of

payments deficit
Policies to obtain external and internal
balances did not match
Internal balance requires expansionary
monetary or fiscal policy

Would make external deficit worse

Bretton Woods System

Example (cont.)

Government might choose to fight

recession and sell accumulated foreign
exchange to keep exchange rate fixed
Once domestic economy recovers, can
reestablish external balance
Only if country had sufficient
international reserves could it deal with
internal balance ignoring external
balances in short run

Bretton Woods System

Example (cont.)

If country kept pursuing policies that were

inconsistent with external and internal
balances, country might have no choice but
to devalue currency
In this occurred in many countries, then no
longer have a fixed exchange rate
Need mechanism to encourage countries to
maintain policies producing external balance
and stable exchange rates
Mechanism unclear in Bretton Woods system

International Monetary
Fund

They were to oversee the

reconstruction of the worlds
international payments system
Also allowed for creation of a pool
of reserved from which funds could
be drawn by countries with
temporary payments imbalances

International Monetary
Fund

Pool of funds

Each country in IMF assigned a quota

of money to contribute to pool
One quarter of quota in gold, the rest
in that countrys currency
A country could borrow up to of its
quota at anytime without restrictions
A country trying to borrow more came
with restrictions

International Monetary
Fund

IMF restricted borrowing government to

pursue monetary and fiscal policies
consistent with long run external balance
Most borrowing counties carried external
deficits so required tighter policies

Once own reserves were used, country was

limited on pursuing inconsistent policies

IMF loans are short term to be paid back

in three to five years

International Monetary
Fund

Loans from IMF to countries have

problems

If country has serious imbalances, may

be difficult to correct in short run
Policies to correct imbalances may lead
to short run economic contraction
Cost of lost output may be high
IMF often involved in solution to country
not performing well IMF not popular

Demise of Bretton Woods

Problems developed with Bretton
Woods

1.

Not symmetrical
A country with balance of payment
deficit must follow policies to fix
problem or no new loans
A country with balance of payments
surpluses could not be dealt with

Could not force country to pursue

policies to correct surpluses

Demise of Bretton Woods

Problems developed with Bretton Woods

2.

All currencies fixed to dollar, but US developed

persistent balance of payments deficits
Foreign banks increased holding of dollars
Surplus countries had to sell domestic currency
for dollars to keep domestic currency from
appreciating
Foreign central banks holding amount of dollars
larger than US stock of gold at $35/ounce

Demise of Bretton Woods

End of Bretton Woods

US faced with choices
1.

2.

3.

Change macroeconomic policies to reduce or

eliminate external deficit
Have foreign central banks demand gold in
exchange for dollars held
Devalue dollar and let it float against gold and
other currencies

US chose to devalue dollar ending system

Post Bretton Woods Era

Two options since breakup of
Bretton Woods

1.

2.

Clean float government essentially

leaves exchange rate alone and lets
market determine value of currency
Fix or peg exchange rate to the
currency of another country or
group of countries

Clean Floats
Decide internal balances are more
important than external balances

Set monetary and fiscal policy to achieve

acceptable levels of economic growth
and inflation
Resulting mix determines current and
capital account balances

Monetary policy is very effective and

fiscal policy is less so
Leads to exchange rate value
inconsistent with PPP

Clean Floats

Macroeconomic policy mix could

lead to real appreciation of currency
where the economy is doing well

Might cause significant hardship of

tradable goods portion of economy
Exporters could lose business because
of overvaluation of exchange rate

Clean Floats

Policy mix could lead to

depreciated exchange rate

Could lead to boom in tradable goods

sectors
Imports become more expensive
Countrys goods become cheaper so
exports rise
If at full employment, resources need
to come from somewhere

Clean Floats

Policy mix could lead to depreciated

exchange rate (cont.)

Prices and output increase

Can lead to decreasing prices in nontradable goods sector

Letting exchange rate find its own level

maybe optimal, but not costless
Tradeoff is overall internal balance
versus potential hardship for certain
parts of the economy

Pegging the Exchange

Rate

If international trade is significant

portion of GDP, then ignoring external
balances may not be optimal
Country may wish to peg exchange
rate

Country sets value of nominal exchange

rate against another countrys
Likely to choose a country with whom it
trades a significant amount and/or has
large cross border financial flows

Pegging the Exchange

Rate

If the pegged rate is credible, it

creates security for investors and
traders
However, if currency it is pegged
against is floating, then that currency
is still changing

Value against other currencies changes as

the other countrys exchange rate
changes

Pegging the Exchange

Rate

Example Mexico wishes to peg peso

to US dollar

In long run, Mexicos inflation rate must

match that of the US
Mexico must keep domestic real interest
rates similar to those of US to keep
capital from flowing between the
countries
Mexico cannot use policies to target
internal balance

Pegging the Exchange

Rate

Example Mexico wishes to peg peso to

US dollar (cont.)

If conditions in Mexico are similar to US then

fairly costless.
If conditions in Mexico are different from US,
must choose to focus on external or internal
(no peg) balance
Price of pegging currency is willingness to
sometimes sacrifice internal balance to keep
fixed exchange rate

Pegging the Exchange

Rate

Internal versus external balance choice

may be partially avoided

1.

Fix exchange rate in real terms instead of

nominal terms
In long run real exchange rate is what
matters
Government could periodically change
nominal rate based on changes in inflation
between the countries
Could peg real exchange rate and keep
some control over macroeconomic policies

Pegging the Exchange

Rate

Fix exchange rate in real terms instead

of nominal terms (cont.)

1.

Still uncertainty in nominal rate

Governments may target a rate of
devaluation to keep it somewhat constant
Still requires some changes in nominal
rates

Domestic policy may diverge from other country

causing inflation rates to diverge

Generally more certain that free float

Pegging the Exchange

Rate

Internal versus external balance

choice may be partially avoided
2.

Fix countrys currency to basket of

currencies
If depreciates against one currency in
basket, my appreciate against another
Long run may be more stable than
fixing to one currency

Pegging the Exchange

Rate
2.

Fix countrys currency to basket of

currencies (cont.)
Problems

a.

b.

c.

Construction of basket is not clear: how

many currencies, which currencies, etc.
Should government tell which currencies
are in the basket?
More difficult for private markets to handle
a.

Traders exposed to more risk than fixed rate

Options for Monetary

Reform
Current System Problems
Businesses dislike floating exchange
rates since volatility increases risk

1.

Can choose between taking risk or

protection through hedging neither of
which are costless
Current system forces businesses to
implicitly forecast exchange rates

Options for Monetary

Reform
Current System Problems
Floating exchange rates impose
externality of world economy

2.

Varying exchange rates make

international trade and investment riskier
Higher risk and higher costs lead to less
of that activity
Lower total volume of trade and
investment with volatile exchange rates

Options for Monetary

Reform
Current System Problems
Governments have similar views
as business

3.

Overvalued currency can hurt

tradable goods sector
Undervalued currency can create a
boom that cannot be sustained
Collapse in currency can cause
microeconomic crisis

Options for Monetary

Reform

Why not change the system?

Note figure 18.3

Horizontal axis shows level of cooperation in
international system

Left set own policies for internal balance

Right complete cooperation

Vertical axis shows degree of rules in

system

Top rigid rules

Bottom much discretion (no agreed upon rules)

Exchange Rate Map (Fig.

18.1)

Exchange Rate Map

Gold Standard

1.

Rigid rules since each country defined

currency in terms of gold
Significant discretion no need to
coordinate policies
Took monetary policy out of
government control
Other trade policies could be freely set

Exchange Rate Map

Bretton Woods System

2.

More rules but less rigid than gold

standard

Obligations with IMF

Required more cooperation

Countries with imbalances had to fix

them
Fixing imbalances often required
working with other countries

Exchange Rate Map

Current System

3.

No rules
Each country can pursue their own
choices of policies
Countries are free to target internal
balances

Exchange Rate Map

Why no new system?

Movement toward more stable

exchange rates requires more rules
and/or more cooperation
Moving toward gold standard takes
away monetary policy so unlikely
Increasing cooperation in almost
impossible if there are no rules
Unlikely to move from current system