GLOBAL ECONOMIC POLICIES AND INSTITUTIONS PDF

GLOBAL ECONOMIC POLICIES AND INSTITUTIONS HISTORICAL PERSPECTIVE Industrial revolution and Pax Britannica o Trade, money, finance: how they fit together World war I and its aftermath: Dis-integration? World war II and its aftermath: the Bretton Woods era o After Pax Americana:...

GLOBAL ECONOMIC POLICIES AND INSTITUTIONS HISTORICAL PERSPECTIVE Industrial revolution and Pax Britannica o Trade, money, finance: how they fit together World war I and its aftermath: Dis-integration? World war II and its aftermath: the Bretton Woods era o After Pax Americana: how do trade, money and finance fit? Financial globalization, a game-changer New things in money and finance: blockchain technology, cryptocurrencies, CBDC and decentralized finance Are financial «crises» accidents? Economic interdependence: at least two components (war is dependence). The definition is “Economic interdependence is the mutual dependence of the participants in an economic system who trade in order to obtain the products they cannot produce efficiently for themselves”. It means your national actions’ outcome relies on the behaviour of the other nations. After the two global world, some sort of institutions overviewing the procedural matters behind agreement changed the cards on the table. We are spectators of structural transformation in the economic and financial structure of today's world. Success of Britain is the fruit of a vast combination of factors. DEPENDENCE VS INTERDEPENDENCE Interdependence: each decision-maker knows that his decision cannot be made independently from other decisions → You don’t know the consequences/outcomes of your decisions, as they will depend on the contextual outcome of other people’s decisions → What you do will depend on how others react to your actions, or even on how they perceive your actions (not necessarily objective) o EX – Perfect Competition: based on the fact that prices are determined by market conditions → Firms are then dependent on these conditions, but their decisions are based on profit- maximization (MC=MR) → Firms are not dependent on one another o EX – Oligopoly: if competitors lower prices more than you do, they might have an advantage → Interdependence HISTORICAL PERSPECTIVE Between the two wars While before WWI the world was interconnected in terms of trade and economic activity, between the two wars, the world became disconnected (autarky, self-sufficiency, trade interrupted since charged by heavy tariffs) → Trade imploded, finance disappeared, flexible exchange rates During WWII leaders had interests in stopping the war: Bretton-Woods Conference in 1944 o Agreement in 1971: End of fixed exchange rate system Global recession 1980-19882: US crisis looking very much like the current situation Mexico crisis 1985; South-East Asian tigers crisis 1997/98 1 05/10/2023 GLOBALIZATION AND RODRIK’S POLICY TRILEMMA 1989: THE YEAR OF GLOBALIZATION (THE GOLDEN AGE) Globalization can undermine itself, as it produces winners and losers: o By allowing countries to specialize, globalization of trade in goods and services can expand the consumption possibilities of all nations o BUT the freer movement of capital around the world in search of profit-making opportunities also allows businesses to seek countries with lax environmental regulation and low taxation or where workers do not have rights → Policies to attract overseas investments, often are in contrast to policies that would address problems of environmental sustainability and economic justice o The free movement of goods and capital also limits the effectiveness of policies to stabilize aggregate demand and employment → The free movement of labor, goods and capital from one country to another, creates gains for some countries BUT also losses for others (which, if ignored, make globalization politically unsustainable in a democracy) THE POLITICAL TRILEMMA OF THE WORLD ECONOMY - Rodrick 2000S ARTICLE BY RODRICK: TRADE + MONEY AND FINANCE = INTERCONNECTED The trilemma refers to three things, all of which are valued, BUT which cannot all occur at the same time: 1. Hyperglobalization: a world in which there are virtually no political or cultural barriers to the location of goods and investment 2. Democracy within nation states: This means that the government respects both individual liberty and political equality 3. National sovereignty: Each national government can pursue policies that it chooses without any significant limits imposed on it by other nations or by global institutions → Trade-off: like that between low inflation and low unemployment (hard to have both), but on three dimensions EXAMPLE OF TENSION AMONG THESE OBJECTIVES According to hyper-globalization, countries have to compete with each other for investment → With the result that wealth owners will seek locations for their investments in which labor is cheaper (fewer rights) and the environment is less protected → Difficult for national governments to adopt regulatory standards or national policies (national sovereignty), or raise taxes on mobile capital or highly paid workers, even when citizens claim for it (democracy) → Implementing hyper-globalization may be impossible in a democratic society (demise of one of the two necessary) 2 THE GLOBALIZATION PARADOX in the advanced countries Legitimacy and efficacy all require an EFFECTIVE REGULATORY STATE BUT hyper-globalization undermines: o Regulations (ex. Financial regulations, product safety rules) o Tax regime (ex. income and capital taxes) o Domestic norms (“What’s an acceptable redistribution?”) o Institutional practices (ex. employer-employee bargaining → Proof that globalization works best when it is not pushed too far → When domestic policy authorities retain adequate policy space We can respond by: 1) Ignoring the problem and pushing for deeper globalization o At the cost of aggravating the undermining of domestic rules 2) Harmonizing rules across countries o At the cost of imposing ill-lifting rules on all 3) Restricting the scope of globalization o At the cost of giving up on some of the gains from trade → Which brings us to a trilemma In sum, by allowing countries to specialize, globalization of trade in goods and services can expand the consumption possibilities of all nations. BUT the freer movement of capital around the world in search of profit-making opportunities also allows businesses to seek countries with lax environmental regulation and low taxation or where workers do not have rights to organize in trade unions. The freer movement of goods and capital also limits the effectiveness of policies to stabilize aggregate demand and employment. The movement of labor from one country to another creates gains for some but threatens losses for others. If the losers, whether from the mobility of goods, investment or people, are ignored, globalization may turn out to be politically unsustainable in a democracy 3  1. Hyper-globalization is ruled out: if national sovereignty and democracy at the national level endure, there have to be limits on labor and capital mobility in order to deliver effective national policies of stabilization, environmental sustainability, and redistribution that will be demanded by a democratic electorate 2. Democracy is ruled out: hyper-globalization policies can only be implemented by the national government if the citizens’ opposition to them is weakened by a dilution of democratic processes 3. National sovereignty is ruled out: if hyper-globalization policies are accompanied by supranational institutions that can prevent a race to the bottom in sensitive topics, such as environmental labor standards, and gain democratic support, this restricts the ability of countries to choose national policies independently o EX – Existing arrangements in federations (like US or Germany): there is free flow of goods, investments and people across states from the federation (hyper-glob) + the race to the bottom is prevented by federal legislation and by democratic elections at the federal level (democracy) → The ability of states to implement policies that would interfere with the benefits of hyper- globalization or with the protection of standards and the operation of stabilization policies, is restricted o EX – Europe: political integration of European governments, - free trade, free movement of capital and labor (hyper-glob) - while retaining some ability at the supranational Eu level to regulate profit making in the interest of fairness and economic stability (democracy) CHALLENGE POSED BY GLOBALIZATION: If you have a global market, who will provide the required institutional underpinnings? o How to make sure that this EU-wide or global governance is democratic as well as technocratic, and to allow voters to change the system if they don’t like it? HISTORY Gold Standard World Triangle made of hyper globalization + national sovereignty + democracy o BUT there was no real democracy, power was inherited Golden straitjacket: a period in which there was one leader (UK), and free trade o But between colonies and motherland, there was financial mobility, and lots of investments abroad o £ was the common currency and the golden standard was used to define how much gold corresponded to a unit of local currency Between the two Wars Trade unions, Marx, new players → National policies and democracy were born (= regimes supported by consensus) o Totalitarian regimes could survive only if opposition was small → Explosion of nationalism → Period of deglobalization Bretton Woods System Allied countries created a new triangle: democracy + national sovereignty + hyper globalization o It negotiated the view that people mattered, therefore they had to renounce to hyper globalization which became soft globalization made only by trade (no finance and no migration) – Bretton Woods Compromise Flexible Exchange Rates In the 70s: countries gave up the fixed exchange rates system 4  In the 90s: the financial globalization was driven by transnational economic actors (financial institutions) which were successful Democracy + national sovereignty + hyper globalization (Money, Finance and Trade) o Nowadays, we are stuck in the Rodrick’s dilemma: countries cannot avoid the global involvement in the financial system if they want to survive as states, they need the international financial market to cover their debts 20th century OECD: Organization for Economic Cooperation and development o A Multinational organization of ‘rich countries’: where governments are represented (representatives of each government reside in Paris) → They support global education also through the diffusion of cultural events and knowledge Functions: o It has a rule of collection and diffusion of cooperation, information and development o Financial regulation: It also tackled the drafting of regulation, mostly to regulate the financial system through the web of transparency (countries divided according to their transparency statistics – gradatory was published and made public) UNCTAD: the database where to get the data for foreign direct investment o It proposed a resolution to tackle the financial transparency issue: a form of taxation based on the place where the value added is created, and how many workers contributed to the final product based on their nationality → SO, hyper globalization: every country is ‘pushed’ to be part of the integrated game Cheap wage = cheaper production = attractiveness for foreign investor 5 10-10-23 TRADE, MONEY AND FINANCE FOR INTERDEPENDENT COUNTRIES TRADE, MONEY AND FINANCE: THE «NEXUS» International arrangements concerning trade, money and finance across countries tend to come in «waves» 1. TRADE: bilateral and trilateral agreements yielded to nationalisms and autarchy in the inter WWI – WWII period; o Multilateralism and (growing) regionalism post WW II; o «Deep» integration (MNE, global value chains); o Regional preferences, fading multilateralism and unilateral protectionist policies in the XXI century 2. MONEY: informal international monetary arrangements across the centuries, mostly based on precious metals o Usually money came in form of coins (easily recognizable and exchangeable) o Paper money: initially convertible into precious metals (mostly gold), o Then «flat» money (not backed up by a physical commodity, but rather a promise of payment by who issued it) convertible into goods and services → INFLATION as a major problem o Converting one currency into another: fixed (more cooperation between states is needed) versus flexible exchange rates (Gold Standard) o Subsequent international monetary regimes: from Gold Standard to Bretton Woods to current prevalence of flexible exchange rates. Exchange rate: The price in terms of a currency of buying a unit of another currency o Nothing like national interest plays a role when it comes to exchange rates considering the impact that it has on international trade and the subsequent domestic condition o Flexible exchange rates were introduced after the end of Bretton Woods, it is still in place but a number of other agreements are in place within countries fr what concerns exchange rates ( Eurozone) and some other countries which proceed with the so called “dollarisation”, the straightforward replacement of the national currency with dollars (Ex. Ecuador) 3. FINANCE: similarly, waves of liberalisation and regulation of international (and transnational) capital flows, in different monies (including electronic currencies) Finance is a close relative of money although you can have finance also in barter economy, as it is an inter temporal trade The difference between money and finance is the fact that: o MONEY is something that concerns here and now that are directly related to the present o FiNANCE is projected and depends on time and future, it is dependent on time Bonds: inter temporal promise that two agents (a giver and a receiver) make about the future (therefore carrying a certain degree of uncertainty) - no matter whether a short or long term one Equities: stocks/shares o Financial tools ≠ promises of payment o You buy a share and you become the owner of that share → You can sell shares in stock mkt Derivatives: you take the bet on the direction that the share will take o CRISIS 2008: 1995 Mexico had just become part of the intentional agreement of NAFTA → Boosted the international reputation and made it therefore easier to receive money from other countries in the form of derivatives → Really quickly the bad financial management of the country led to the total downfall of the situation NOTE: (A loan only exists when a connection is found between the lender and the borrower) 6  The period between the two wars witnessed the basic disappearance of international financing to an extent: o GERMANY – Young plan (The treasury chief of the US) which established a number of investments coming directly from the US to Germany, to try and maintain the global equilibrium to an extent after the incredible amount of reparations that had been imposed upon Germany after WWI For each dollar of international trade we estimate 60-70 dollars of finance → Not positive as the financial sector in itself is intrinsically insecure and the bigger finance gets, the riskier it is Crisis is about to explode (when, why specifically?): As the covid crisis has ended and things “go back to normal” we go back to the piling debt that was already present before and the financial sector has just become too huge to allow for single countries to be able to go through and face the type of crisis that will result from this collapse → Crisis about to happen THE BALANCE OF PAYMENTS IDENTITY BoP = Statement of all transactions made between entities in one country and the rest of the world, over a defined period of time (ex. a quarter or a year) Current account (CA) + Financial/capital account (F) + Official Reserves flows ≡ 0 (by definition) → Nothing gets created and nothing gets destroyed) o Note: The BoP identity makes it possible to measure (by difference) the amount of Errors and Omissions (E&O) → The nexus between money, trade and finance is taken care of by BoP identity The current account = current expenditures/transactions: expenditures that you need to keep repeating o In the current account imports and exports of goods and services + Factor of payments ( the income that derives from outside workers) + if you have high debt, every year you need to repay interests upon i → There is a flow of money → Factor of payment Financial Account: financial bonds, derivatives + capital (immobili) Another factor would be the personal decision of proceeding to give parts of the money you earn in a country to others in another country → Remittances Finally unilateral transfers Difference between GDP and GNP BALANCE OF PAYMENT EQUILIBRIUM A short run perspective: External equilibrium is satisfied if net international flows of goods and net international flows of financial assets balance each other (BofP «financing») o If you can pay anything you buy: if you cannot pay for something now, you ask for a loan (imports are paid through exports or money transactions) 7 A longer run (intertemporal) perspective: Satisfying the intertemporal budget constraint requires a balanced current account that is: no systematic loss of official reserves, no systematic indebtment, or crises ensue → BofP «adjustment» → There is a basic symmetry between debtors and creditors: o The power of the debtors is much less than the power of the creditors o Sometimes the creditors are just few financial institutions whose power is huge in the hands of few o This may be a problem because if the financial institution collapses, you’ll have trouble. For how long a country can borrow from another country? Not for so long → After a while, the country will need to implement austerity in order to recover o Fiscal correctness is not the same in Italy and Germany due to reputation Consider: how long is the “long run”? there is no precise answer, it depends on the relative power and relative reputation of the countries 17/10/2023 NATURE AND FUNCTIONS OF MONEY True public good is not rivalled, it is available to everyone – EX: Bench o It is difficult to introduce exclusiveness, so it is very hard to discriminate within the potential pool of people which may access it (non-rivalry and non-excludability) o EX – Radio: You can have signal, it’s public → BUT different degrees of ‘public’ → The degree of private/public depends on the degree f non-rivalry and non-excludability Common good (≠ public): a public good which is enjoyed by myself as well as by other people → I enjoy it because other people have it NATIONAL, INTERNATIONAL, TRANSNATIONAL NATURE? MONEY: monetary instrument acceptable as: o Means of payment o Unit of account → Prerequisite for the development of international trade (without these functions, back to barter) Barter hampers international trade by imposing large search costs (= looking for a person who has the exact reverse desire in exchanging two products) BUT despite the obvious benefits of money, still no single money in the international economy, acceptable to everyone CHARACTERISTICS OF MONEY – DE GRAUWE 1. Money = a collective good: the benefit of money to an individual derives exclusively from the fact that others also use it (= no utility when used by one person only, contrary t private goods) o It circulates and is enjoyed by many – The state can establish what’s common but the people may transform that o Originally, it is provided by an entity which may generate profit from the supplying of this good, with the risk of creating instability within the system o As the financial system evolved, even the system itself is exposed to this risk The larger the group of people using the same money, the greater the utility to the individual using it → Utility of money comparable to that of language BUT problems arise when a collective good is supplied in private market: since it is difficult to induce individuals to contribute voluntarily to a collective good system, when it is hard to exclude them from its use → Free riders →Collective goods are undersupplied in a market system 2. Special collective good: users of money can be made to pay quite easily 8  Money balances (cash, demand deposits) hold by people holding money, carry no interest rate → User of money loses by the fact that he forgoes a higher interest rate on other assets Mechanism in the supply of this collective good which avoids the free rider problem →It is profitable for private agents to supply money services 3. Held on the basis of Confidence: the willingness to hold money balances depends on the confidence of holders that assets will not use value For a money to be accepted, economic agents must be confident that the supplier of money will not do things that reduce its value (if they fear it may happen, they will not voluntarily hold these money balances) Confidence building schemes (by suppliers) a. Investing in all kinds of confidence building schemes: ex invest in sunk capital (= physical assets that lose much of their value if the business is discontinued, ex. large buildings) o Like that the supplier ties its hands, convincing agents that he will not run away b. Convertibility = Guarantee that the money can be converted at a fixed price into another asset, over whose value the supplier has no control o During the gold standard: such guarantee was gold o Today: bank deposits can be converted into currency at a fixed price → Problem of credibility (there might be situation in which it will not be in the interest of the issuer of money to fulfil this commitment) → Necessary to convince money holders that the supplier of money will not willingly engage in activities leading to a reduction in the value of money 4. Economies of scale: The larger the supply, the lower costs of supplying goods (ex. money) Liquidity presence → R increases → L decreases → Firms’ pattern Bankers receive deposits which shall be given back, since depositors do not collect money altogether, the bankers can safely bet that money out of the landing → They lend depositors money Purchasing power: people pay an interest if they want to borrow it o If you loan money, you get interest rates, a premium Economies of scale make firms bigger, reduce their AC and tend to produce monopoly, as other companies get out of business … that people are willing to pay for (positive network externalities) We are paying for keeping cash in our wallets: We are trapping money (= purchasing power) which may have been used alternatively BUT the prices we pay must be balanced with the opportunity costs As we navigate uncharted water, we look for riskier investors which may grant us higher interest rates Nevertheless, these riskier borrowers may need more money to financially support the previous debt and risk failure Suppose a country has two issuers of different currencies (A and B) o These issuers are likely to follow different policies →Different changes in the value of these currencies →The price of one currency into the other might fluctuate o The fact that there are two currencies within the same country also reduces their utility of each of them to the residents (certain transactions made with A, others with B) →No universal units of account and media of exchange in this country o If then, for a certain reason, currency A gained acceptance for all transactions →Its usefulness would increase (collective good aspect) →Residents would be willing to pay a higher price for currency A o Scope for issuer of currency A to increase its profitability by expanding the size of its operations and supplanting currency B 9  Supply of money involved a double operation: o Supplier issues a liability (used as money) and purchases an asset (extends credit) o Source of the profit of the issuer of the money (= Bank) = margin between the interest rate earned on the asset and the interest rate paid on liability CONSEQUENCES (NATIONAL, INTERNATIONAL) Concentration + Periodical crisis: you start lending money to the ??, if you want to expand the share of your business o They will need extra borrowing if they can’t pay in the first place → They can fail → Negative consequences – Financial Sector connected to money Confidence/credibility crisis Commitment and/or coercion OR: The monopolist can issue money in one national currency → CB (primus inter pores) only the bank of England can print money → Small banks receive deposits + make loans o We no longer have a single bank → Endogenous instability solved by the creation of a monopoly (post currency) → Paper money FLAT MONEY (moneta legale): strumento di pagamento non coperto da mole di certi materiali (= privo di valore intrinseco) → esiste e ha un valore in virtù del fatto che ha una credbilità ed è un mezzo di scambio THE CONENTRATION OF THE MONEY SUPPLY PROCESS Strong pressure towards capturing the benefits of the economies of scale, through: a) Concentration of the money supply in the hands of a few (possibly even one issuer) → Supplier achieves monopoly which allows him to maximize the interest margin b) Cartelization of the market: several suppliers make an agreement to tie to each other the currencies they issue (ex. by fixing their exchange rates) and to regulate the supply process o By doing so they create one monetary area and increase the usefulness of their currencies → Also increases their margin between the interest rate on their assets and on their liabilities → To achieve either concentration or cartelization, no smooth process, but upheavals and crises PROCESS: An individual bank takes more risk (to capture a larger part of the market): portfolio of assets will be enlarged by loans to less reputable (more risky) borrowers o Some banks will be successful in this policy of enlarging market share o Others not: borrowers fail to repay debt → Bank crisis →Customers of bank (= holders of the currency issued by the bank) present their holdings for conversion in hard cash (ex. gold) → Not all customers can be satisfied (sine the bank only covers a fraction of its liabilities by cash reserves) → Domino effect undermining the confidence in the whole system, in which even banks with no issues, may face such a liquidity problem → Fewer banks will be left and those that remain will have a larger market share and be more profitable MONEY AND STATE MONOPOLIES The tendency towards concentration of the money issuing business is inevitable →This leads to another phenomenon: THE INVOLVEMENT OF THE STATE IN THE MONEY SUPPLY PROCESS The pressure of the state to take over the business, will mount with each crisis: o Crisis → Losses for several people (holding worthless paper) → Popular discontent calls for government action + few banks left after crisis have an interest in preventing newcomers from entering the market (call for government control on unsound banking practices) In all countries of the world, the government has gradually acquired more control over the money supply process 10  Most industrial countries = complete nationalization of the money supply process o State has a monopoly power to: issue currency AND deposits o BUT still some division of labor between the state and the private sector: Private banks have kept their position in the money supply process by issuing deposits – Supply of deposits not nationalized since: ▪ After the great banking crises of 1930s, monetary authorities have reacted by providing a lender of last resort service to the banks (Sound banks which faced a liquidity problem during a banking crisis, would be able to obtain all the currency needed to satisfy their deposit holders) ▪ By imposing one currency on the whole country and by guaranteeing that deposits could be converted into that currency, the government made sure that economies of scale in the supply of money were fully exploited (= Small and large banks issuing deposits, capture the same benefits of the economies of scale involved in creating money) →Many banks who compete, without the inevitable tendency towards the monopolization of the supply of deposits MONEY AND INFLATION In a competitive system, there is an automatic control on the over-issue of currency A bank wishing to expand its loan portfolio faster than other banks → Reduce interest margin between loans and liabilities → Reduce the loan rate (since currency carries a zero interest rate) and expand its activities → Operations become riskier → Currency becomes riskier than other currencies in circulation → Economic agents tempted to convert the currency of the over-issuing bank into hard cash or other currencies o This process may lead to disturbances and crises, BUT not to generalized inflation: if the hard cash becomes more plentiful, we may have inflation (the source of inflation is however external to the operation of the free banking system) IF the state takes over the supply of currency, and attempts to expand credit (= the supply of currency), for instance to finance a war: same reactions of currency holders willing to convert it o BUT the government cand declare the currency to be inconvertible, without going broke → Coerce citizens to use the inconvertible currency as a domestic unit of account and medium of exchange NATIONAL AND INTERNATIONAL MONEY NATIONAL MONEY 1) International Payments 2) Store of Value: money as a form of wealth storage 3) Unit of account: compare things in terms of prices INTERNATIONAL MONEY 1) International Payments 2) Store of Value: international reserves (gold is too little to be a stable reserve) → Not all currencies are good → A good currency is one that is stable, has an extended network and is widely accepted 3) Which unit of account, in the world?: How does one currency ‘translate’ into another? Fixed versus flexible exchange rates, and «middle of the road» regimes o Exchange rates are the key issue and shape the international system → Several currencies compete (no single currency imposed on the whole world) – 2 Main Problems Collective good problem An individual country managing to have its currency accepted over several international transactions, provides a collective good or service to the world → Benefits by obtaining a larger spread between assets and liabilities → Economies of scale in the supply of money (incentive for suppliers to extend their money beyond national boundaries) 11  o But strong competitive forces exist at the international level, between suppliers of different currencies Why no single currency? Absence of a central authority at the international level (As states who took over the Supply of Money nationally), to monopolize the currency issue Problems of confidence and credibility How does the issuer of national currency convince potential foreign users that it is a currency that will keep a stable and predictable value? o Since no international authority with the power to force the use of a currency, if no trust in it, the currency will disappear as an international medium of exchange and unit of account →National currency can graduate to international one ONLY if there is confidence that it will maintain a stable purchasing power Suppliers have to invest in confidence building devices (confidence does not come freely): o EX: Announce that the national currency will be freely convertible at a fixed price into another asset, over whose value the issuing country has no control (often gold or other national currencies) BUT what guarantee does the currency holder have that such commitment will be honored in the future? → No international authority o The issuing country will compare the benefits of holding its commitment towards convertibility (fixed price) with the costs (= subverting monetary policy to the requirements of convertibility) of doing so → If costs larger than benefits, promise not maintained o BUT all other countries and currencies suffer form the same credibility problem → Economic agents have to evaluate how credible these different commitments are → International supply of money = bumby road: benefits of supplying money vs continuous distrust of money users THE N-1 ISSUE OF THE BALANCE OF PAYMENT We lived in ‘closed’ global economy, thus by definition: Sum of world exports = Sum of world imports o This holds for goods, financial assets and money (it exits a country and enters another) ▪ In financial accountings they are not precisely equal due to omissions and errors: For example, drugs and human trades won't show up in the financial accountings. o Remarkable Implication: Sum of World Current Accounts = 0 → That is, only ”N-1” out of N countries can independently pursue a national current account target Firms with surpluses are accumulating wealth (= same happens with countries): Not all countries can experience a surplus → N-1 Problem o Out of 3 countries, not all three can experience a surplus and therefore reach their national current account target THE N-1 ISSUE FOR EXCHANGE RATES There is only one independent exchange rate between two currencies A, B: A/B = 1/(B/A) There is only two independent exchange rates among three currencies A, B, C: o A/B and A/C imply B/C → Generalization: in a world with N currencies, there are only N-1 independent exchange rates Remarkable implication, if we countries issue national currencies: only N-1 out of N countries can independently pursue a national exchange rate target 12 19/10/2023 THE INTERNATIONAL MONETARY SYSTEM CH.13 KOM Because of the N-1 issue, there MUST be some sort of practical arrangements (informal or formal; symmetric* or asymmetric) for making sovereign targets reciprocally consistent Practical arrangements must cover: 1. Payments and accounting: which convertibility practices? (at fixed or flexible exchange rates? Flexible after 1971) 2. Store of value: Reserve instruments (reserves need to be acceptable to partners) o Valuable possessions are not necessarily a store of value that can be translated into money o An asset that can be easily transformed into money = liquidity o Special Drawing Rights are flat money created by the IMF and distributed among members 3. And finally: Who bears the burden of adjustment, in case of imbalances? *Symmetrical System: each country freely stablishes its own currency and the ER (only if power is equally distributed among countries) THE GOLD STANDARD AND THE GOLD EXCHANGE STANDARD IN THE INTERWAR PERIOD XIX CENTURY: THE GOLD STANDARD 1870 until 1914 ORIGIN: the use of gold coins as medium of exchange, unit of account and store of value → IN 1819 the British Parliament repealed long-standing restrictions on the export of gold coins and bullion from Britain = Gold Standard as a legal institution o In the 19th century other countries adopted it following British precedents (London = center of international monetary system) GOLD STANDARD: monetary arrangement among the major countries of the world, that each participating country committed itself to guaranteeing the free convertibility of its currency into gold at a fixed price (System with commitment and little coercion) o Each currency convertible into gold at fixed price = Each currency convertible into other currencies at a fixed price o Professional arbitrage made sure that: if currency A worth 1g of gold, currency B 1/2g →Economic agents could directly convert one unit of A into two units of B (without first having to buy gold and then sell it) 13  → Each participating currency was an international currency (importers could use their own money to buy foreign goods) → Greater efficiency + stability in the international monetary system → Participating countries also had to accept some ‘rules of the game’ for the system to work Pax Britannica: relatively calm economic situation – Britain led the world o Britain stood up as an economic power + model for economic and political institutions o The domestic monetary system was the Gold Standard: gold local currency regulated the system and it set the ‘rules of the game’ as unilateral decisions** o The bank knew the total amount of Gold to be issued o Convertibility was the warranty that the rules of the games were respected o Proportionality between the amount of gold and paper money supply: CB reserves ready to be converted and paper money issued in proportion to gold Many countries switched from bimetallism (gold and silver) to imitation of the institutional setting of the most successful economy (i.e. Gold Standard), due to increasing financial integration among countries PRACTICAL ARRANGEMENT: N countries, N national currencies plus Gold: N+1 monies, N independent exchange rates → Total autonomy for national decisions The relative price of gold and silver became unstable because the role of monetary gold overcame the role of gold as a metal o Special use of gold much more than silver, since much more attractive for trades o This period led to the ESTABLISHING OF THE GOLD STANDARD as outcome of national independent decisions THE SIMPLE MACROECONOMICS OF THE XIX CENTURY: INTERNAL EQUILIBRIUM INTERNAL EQUILIBRIUM = full employment + stable prices o Under-and overemployment lead to price level movements that reduce the economy’s efficiency by making the real value of monetary unit less certain and a less useful guide for economic decisions → Government must prevent substantial movements in aggregate demand relative to its full employment level, to maintain stable and predictable price levels o To avoid price level instability, government must prevent large fluctuations in output (also undesirable in themselves) → Avoid inflation and deflation by ensuring that money supply does not grow too quickly or too slowly Money is a «veil»: the quantity theory of money (= the total value of transactions equals the amount of money times velocity of circulation): P*Y = M*v o Price times income equals money in circulation times its velocity of circulation → The amount of money establishes its price o The velocity of circulation is relatively stable since it is linked with habits «Neutrality» of money: money creation has no impact on income growth; it only determines inflation rates: M /M = P /P o Increase in Money Supply, leads to an increase in price Prices and wages are flexible and provide market adjustment: unemployment may be severe over the cycle, but it tends to be temporary THE SIMPLE MACROECONOMICS OF THE GOLD STANDARD: EXTERNAL EQUILIBRIUM Y = C + I + G + (EX – IM) → External Equilibrium CA = Exp – Imp = Y – Expenditure (Y, P, Pworld, Efixed) o Textbooks often define external balance as balance in a country’s current account o Since there are some important important gains from trade over time (intertemporal trade = trade of consumption over time) and they are not allowed by a CA equilibrium, policymakers usually only adopt some balanced current account targets as objectives 14  o Target level of CA usually is not 0: BUT large surpluses or deficits usually avoided by governments**** Primary responsibility of CB was to fix the exchange rate between currency and gold External balance = CB was neither gaining nor having to ship gold abroad → Surpluses or deficits in CA financed by gold shipments SO, they tried to maintain a Balance of payments equilibrium: sum of current and capital accounts – Nonreserve components of net financial flows abroad = 0 Suppose there is a CA deficit (CA