Money and Exchange Rate History 2024 PDF

The History of the International Monetary System Block II 2024 Dr. Toenshoff 1 Review Questions What is NOT a way a Central Bank can react to balance of payments imbalances under fixed exchange rates? Adjust the money supply by selling/buying reserves Introd...

The History of the International Monetary System Block II 2024 Dr. Toenshoff 1 Review Questions What is NOT a way a Central Bank can react to balance of payments imbalances under fixed exchange rates? Adjust the money supply by selling/buying reserves Introduce tariffs on trade Change the domestic interest rate Impose capital controls Match the type of international transaction with he correct account in the Balance of Payments Trade in goods – Current Account Foreign Direct Investment – Capital and Financial Account 2  Review Questions One more time: the trilemma Financial integration (capital mobility) Trilemma Fixed exchange rates Independent monetary policy Why are capital controls difficult (today)? 3 Game Plan The Gold Standard Bretton Woods and its Fall Central Bank Independence Will Crypto replace Central Bank-backed currencies? 4 A bit of history: 1870-1914: Gold Standard (fixed) + Open Capital Flows 1919 – 1939: Gold Standard reestablished briefly, but abandoned in the Great Depression 1944-1971: Bretton Woods: US-backed fixed (but adjustable) + Low capital flows 1971-Today: Floating XR + High capital flows in most developed countries, peg to dollar/Euro in many developing countries The Puzzle: What Caused The Changes? 5 6  The Unholy Trinity/ Trilemma Financial integration (capital mobility) Classical Gold Standard Floating Rates (1900 - 1914) (1971- ) Trilemma Fixed exchange rates Independent monetary policy Bretton Woods (1945-1971) 7 Pure Gold Standard in Theory Country A imports more from Country B Gold moves from A to B (re-coined/minted) Less money in A ➔ lower prices More money in B ➔ higher prices ➔ Country B imports more from Country A Balance is restored Remember, this is the same story as we saw on Monday: fixed XR, BOP restored as domestic prices adjust 8 Reality with Paper Money Gold didn’t actually flow (that would require huge transaction costs and a lot of gold at the bottom of the Atlantic Ocean). Central Banks fix the value of their currency to gold  E.g. 1 Pound sterling = 7.322g of gold  People could, in theory, exchange their paper money for gold When imbalances arose, Central Banks intervened by adjusting the money supply and interest rates (remember adjustment under fixed exchange rate regimes…) Gold Standard ➔ strict discipline! 9 What is “discipline”? Central Bank has to cause deflation in times of deficit to lower prices What do “lower prices in Country A” mean? Supply of money down If you expect prices to fall in the future, you don’t buy anything today More expensive to borrow BAD economic crisis! Jobs cut! People don't eat! Kids die! 10  Side-Note: Beyond Imbalances, the Gold Standard is Inherently Deflationary: World’s supply of gold is fixed With economic growth, eventually more goods chase less money -> prices fall, growth constrained The gold standard was able to be established and persist pre-WWI partly because of new gold discoveries 11 How did the Gold Standard End? Breaks down with WWI Countries re-establish it after the war Exacerbated the Great Depression in the early 1930s (more on that in week 6) Countries abandon it again in response to the crisis  Bank of England first because it was running out of gold  Chain reaction across the world, rush on gold, other countries abandon the gold standard 12 Bretton Woods 13  The Unholy Trinity/ Trilemma Financial integration (capital mobility) Classical Gold Standard Floating Rates (1900 - 1914) (1971- ) Trilemma Fixed exchange rates Independent monetary policy Bretton Woods (1945-1971) 14 Why not back to Gold Standard? Remember, Gold Standard dependent on policy “discipline” and deflationary periods Many countries had become more democratic since the 19 th century + stronger labour unions When people don’t eat… Autocracies Democracies Let them eat cake Politicians voted out of office 15 Also: Enter Keynesianism Based on observation of high unemployment in Britain 1920s&30s Alternative to neoclassical economics (“the market will fix it”) Governments can (should) use monetary and fiscal policy to help the economy out of crises 16 What Was “Bretton Woods”? A hotel in New Hampshire… Agreement on the Post WWII monetary system A monetary system is a public good… Coordinating on a common system allowed for: increased international trade and finance a way to manage crises so they didn’t spread Attempted to solve a global problem: How to keep monetary policy autonomy and a fixed XR? 17  What Was “Bretton Woods”? How did Bretton Woods (try to) achieve exchange rate stability and monetary policy autonomy? FOUR INNOVATIONS: 1. Fixed but adjustable XR 2. Capital Controls 3. Stabilization Funds 4. The IMF 18  What Was “Bretton Woods”? Fixed but adjustable XR: The US had a hard peg to gold ($35 an ounce) Other countries were fixed to the US dollar but could adjust within a band to correct an imbalance Capital Controls: Stabilization Funds: The IMF: 19  What Was “Bretton Woods”? Fixed but adjustable XR: Capital Controls: Not total control, but allowed governments to impose controls when faced with speculative threats Current accounts (no controls) Capital accounts (controls) Stabilization Funds: The IMF: 20  What Was “Bretton Woods”? Fixed but adjustable XR: Capital Controls: Stabilization Funds: Provide a fund to help governments avoid controls or devaluation when faced with short-term imbalances The IMF: 21  What Was “Bretton Woods”? Fixed but adjustable XR: Capital Controls: Stabilization Funds: The IMF: Created to monitor state behavior (XR rate changes) and manage stabilization fund. Loans were conditional on policy actions (the teeth!) Made sure governments didn’t undermine system by devaluing for an export advantage… 22  Why did the Bretton Woods system fail? The institutions didn’t work: IMF lacked true authority over XR policy. Governments didn’t comply, they did what they wanted Governments didn’t like conditionality (still don’t) The stabilization fund wasn’t large enough to deal with the new imbalances caused by globalization 23 US Privileged Country holding currency used as reserve (dollar) has an “exorbitant privilege”: Federal Reserve could run BoP deficits and conduct monetary policy to influence aggregate demand, output and employment But US monetary policy influenced economies of other countries, especially as capital mobility rose 24 US Privileged Suppose USA increased its money supply: lower US interest rates, putting downward pressure on the value of the US dollar if other central banks maintain their fixed exchange rates, need to buy dollar-denominated (foreign) assets, increasing their money supplies 25 Why did the Bretton Woods system fail? US unwilling/unable to maintain system: Bretton Woods depended on the US to exchange $ for gold. US was spending more money than was entering the country Expansionary Macroeconomic Policy: More spending Vietnam War + social spending, without higher taxes US dollars left the country (high imports + US investors invest more abroad) Increased claims on US gold by foreigners who received dollars. Eventually… dollars > actual gold. If confidence in peg was in question, investors would rush to sell dollars (speculation), heightened by newly dynamic capital markets. 26 US Balance of Payments Deficit = More Dollars leaving US than coming in 27  Why Speculate? I earned $3500 from selling goods I have the right to 100 ounces of to the US. Gold from Fort Knox If I don’t believe the peg to gold Demand for gold goes up, will last, I buy the gold. demand for dollars goes down If the US has to give up the I sell all my gold for dollars = dollar-gold exchange rate, dollar $5000 falls to $50 – 1 ounce Note: Same with speculation between currencies: Self-fulfilling You foresee an increase in value = buy prophecy! You foresee a decrease in value = sell 28 Why did the Bretton Woods system fail? To “fix” the problem: The US would have to constrain US economy, run trade-surpluses, change foreign policy Adjust the peg to gold (requires coordination, can’t be done unilaterally) Expand economic activity in the rest of the world (many states unwilling to experience inflation). None of these options was politically popular 29  The End of BW First, speculation about devaluation of the dollar caused large purchase of gold by investors  Federal Reserve sold huge quantities of gold in March 1968  US President Nixon “closes the gold window” on August 15 1971 = no more gold-US dollar exchange Second, speculation about devaluation of dollar caused investors to purchase large quantities of foreign currency assets  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 February 1973  Japan and Europe stopped selling their currencies and purchasing of dollars in March 1973, allowing the value of the dollar to fall End of BW monetary system 30  (Gold Finger Wins After All) Before collapse of BW, imports and exports of gold had to be limited through capital controls to allow for Fixed XR & Domestic Monetary Policies As soon as BW system collapses, gold became freely tradeable, and prices shot up: 31 Core Take Aways Bretton Woods Fixed exchange rate hard to maintain with increasing capital mobility + democratic demands for domestic monetary policy Gold standard had been backed by the British, BW had been backed by the US (remember hegemonic stability theory from trade lectures…) While it would’ve been nice to have XR stability, The US was no longer in a position/willing to enforce cooperation.  US acted in self-interested way  As did other countries 32 POST BW Post BW most major economies floated their currency Europe tried to organize a regional monetary cooperation around German policy Eventually, adopt a monetary union (the EURO) More on this next week Other countries floated or pegged to the $US/European currencies Dollar remains world’s reserve currency Despite floating XR, global imbalances still pose a threat to the global economy… Uncoordinated macroeconomic policy still has the potential for large problems… 33  Summary: Increasing Democracy & Capital Mobility Few democracies Growing #’s of democracies + LABOR UNIONS! Fixed Degree of exchange Fixed Floating global rates exchange exchange capital + rates rates mobility Open + + capital Capital Open flows controls capital flows 1870 Interwar period 1944 1971-3 Capital Mobility = Speculation if Fixed XR not deemed to be credible 34 10 Minute Break 35 Central Banks 36 Central Banks: The Problem We just argued that democracy -> demand for monetary policy autonomy. With the fall of BW and floating exchange rates, Central banks were free to use monetary policy domestically Yet, monetary manipulation can lead to runaway inflation: This drags on growth and investment in the long run despite short-run benefits. 37 Upward spiral of inflation Keynes had assumed a stable relationship between unemployment and inflation “Stagflation” in 1970s showed that that assumption could be wrong 38 Upward spiral of inflation Long-run Short-run 39  The Problem: Time Inconsistency In the long-run, governments want price stability, but in the short-run, boosting employment is tempting How can we avoid this problem? Adopt a fixed exchange rate? Ties your hands to stop using expansionary monetary policy This is the choice many developing countries make Democracies don’t do well with fixed XR and free capital flows Domestic price instability… Inability to deal with real crises 40  The Solution: Governments might adopt an INDEPENDENT CENTRAL BANK Appointed for long terms Don’t face electoral pressures Or are distanced from them 41 Central banks as commitment mechanisms Political independence provides the mechanism to maintain monetary policy autonomy but not tempt politicians (too much) to abuse it. Central banks differ in their independence Freedom to choose economic objectives to pursue Inflation and/or employment Freedom to set monetary policy to pursue that objective Whether the policy can be reversed by politicians in government 42  Garriga 2016 43 European Central Bank Mandate for price stability primarily Each country appoints a governing member An executive council sets decisions Appointed to non-renewable 8-year terms Appointed by “common accord” of member governments Can’t be removed by politicians ECB President Lagarde 44 The US Federal Reserve President appoints a Fed Chair every four years (in non-presidential election years) Confirmed by the Senate Can’t be removed Must “report” to Congress bi-yearly Now has a dual mandate to pursue low unemployment and stable prices and interest rates This set -up allows it to act in times of crisis but avoid political time inconsistency problems. 45 Federal Reserve's Jerome Powell Won't Resign Under Trump 46  Other Examples: Swiss National Bank No provision whatsoever for the government to influence monetary policy Highly independent Reserve Bank of Australia Highly subordinate Secretary of Treasury has final authority on monetary policy decisions and interest rate changes Reserve Bank of India Government appoints governor and board of directors to 4-year terms Not constitutionally independent, government can overrule Faces political pressure 47 Other Examples: Central Bank of the Republic of Turkey : highly subordinate Erdogan – “enemy of interest rates” – has fired three central bank chiefs 48 Central banks as commitment mechanisms Does Central Bank Independence Work? Provides greater certainty over monetary policy This Should lead to decreased inflation and greater growth? Does it? 49 Inflation & CBI in Developing Countries 1980-2013 Garriga and Rodriguez 2020 50 Oatley Fig 13.6 Central-Bank Independence and Economic Growth, 1969–1995 51 Crypto = Future of Currencies? 52 What is Cryptocurrency? Decentralized currencies based on the ‘blockchain’ (Typically) not backed by Central Banks Some (e.g. Bitcoin) supposed to be finite in number = meant to combat inflation 53  Crypto = The future of money? Remember the three functions of money: Medium of exchange:  Transactions are VERY computationally expensive - Not clear that blockchains can handle enough transactions & huge energy demands Store of Value and Unit of Exchange = shouldn’t be too volatile 54  Crypto = The future of money? Fixed supply of money is not a good thing:  Fixed money supply = lower growth and/or deflation  See: Gold standard People’s willingness to use a currency to save and invest depends on TRUST 55 Conclusion: To the Moon?  Crypto is one speculative asset you can bet on to make (or lose) money  Under Trump, crypto will likely be deregulated and become a more common asset in mainstream banks’ portfolios HOWEVER:  Not ideal as your MAIN investment for retirement  Cannot fulfill the function of a government-backed currency 56 Example Short Answers Qs Question 2 (out of a choice of 3 questions, 300-500 words) The Doha Round at the WTO has been stalled for the past two decades. a) Outline the main objectives of the Doha Round. b) Name and explain two reasons why the negotiations have stalled. c) Countries have turned to RTAs since the failure of the Doha Round. Give one reason why you think that RTAs are better or worse for developing countries than an agreement at the WTO level. 57 Answer The Doha Round at the WTO has been stalled for the past two decades. Outline the main objectives of the Doha Round. Name and explain two reasons why the negotiations have stalled. Doha’s main objectives:  Main objective: Focus on economic development  (bonus points for also mentioning anti-dumping rules, intellectual property rights, environmental protections etc.) Reasons for failure you could list:  Unwillingness of advanced industrialized countries to liberalize agriculture  First time developed and developing countries pitted against each other  Procedural difficulties: single undertaking & unanimity  Outside options: Developed countries turn to FTAs instead Arguments you could list for c:  Better: Easier to liberalize with only some agreement partners, rather than whole world  Worse: Large developed countries more powerful in RTA negotiations  Worse: RTAs between developed countries might divert trade away from developing countries  Worse: (For all countries) RTAs go beyond tariffs more than WTO would, may not be welfare- enhancing 58 Next up: Societal Interests in Monetary Policy & EMU 59