APPENDIX TO CHAPTER 19: International Policy Coordination Failures
.3 nChapter Overview
This is the first of four international monetary policy chapters. These chapters complement the preceding
theory chapters in several ways. They provide the historical and institutional background students require
to place their theoretical knowledge in a useful context. The chapters also allow students, through study of
historical and current events, to sharpen their grasp of the theoretical models and to develop the intuition
those models can provide. (Application of the theory to events of current interest will hopefully motivate
students to return to earlier chapters and master points that may have been missed on the first pass.)
Chapter 19 chronicles the evolution of the international monetary system from the gold standard of
1870–1914, through the interwar years, the post-World War II Bretton Woods regime that ended in March
1973, and the system of managed floating exchange rates that have prevailed since. The central focus of
the chapter is the manner in which each system addressed, or failed to address, the requirements of internal
and external balance for its participants. A country is in internal balance when its resources are fully
employed and there is price level stability. External balance implies an optimal time path of the current
account subject to its being balanced over the long run. Other factors have been important in the definition
of external balance at various times, and these are discussed in the text. The basic definition of external
balance as an appropriate current-account level, however, seems to capture a goal that most policy makers
share regardless of the particular circumstances.
Underlying each of these exchange rate systems is the “open economy trilemma,” the observation that you
can have two, but never three, of the following: exchange rate stability, independent monetary policy, and
free capital mobility. Whereas the gold standard traded independent monetary policy for exchange rate
stability and capital mobility, the Bretton Woods system allowed for autonomous monetary policy by
limiting capital flows and the modern floating era sacrifices exchange rate stability for the other two goals.
The price-specie-flow mechanism described by David Hume shows how the gold standard could ensure
convergence to external balance. You may want to present the following model of the price-specie-flow
mechanism. This model is based upon three equations:
1. The balance sheet of the central bank. At the most simple level, this is just gold holdings equals the
money supply: G M.
2. The quantity theory. With velocity and output assumed constant and both normalized to 1, this yields
the simple equation M P.
3. 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).
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 toward 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.