Book Title
International Economics: Theory and Policy 9th Edition

978-0132146654 Chapter 19 Lecture Notes

December 18, 2019
Chapter 19 International Monetary Systems: An Historical Overview    107
Overview of Section IV:
International Macroeconomic Policy
Section IV of the text consists of four chapters:
Chapter 19 International Monetary Systems: An Historical Overview  
Chapter 20 Optimum Currency Areas and the European Experience  
Chapter 21 Financial Globalization: Opportunity and Crisis  
Chapter 22 Developing Countries: Growth, Crisis, and Reform  
.1 nSection IV Overview
This final section of the book, which discusses international macroeconomic policy, provides historical
and institutional background to complement the theoretical presentation of the previous section. These
chapters also provide an opportunity for students to hone their analytic skills and intuition by applying and
extending the models learned in Section III to a range of current and historical issues.
The first two chapters of this section discuss various international monetary arrangements. These chapters
describe the workings of different exchange rate systems through the central theme of internal and external
balance. The model developed in the previous section provides a general framework for analysis of gold
standard, reserve currency, managed floating, and floating exchange-rate systems.
Chapter 19 chronicles the evolution of the international monetary system from the gold standard of
1870–1914, through the interwar years, and up to and including the postwar Bretton Woods period. These
historical episodes are put into the context of the international economics trilemma, the observation that
you can simultaneously achieve two, but never three of the following policy goals: exchange rate stability,
independent monetary policy, and open capital markets.
The chapter discusses the price-specie-flow mechanism of adjustment in the context of the discussion
of the gold standard. Conditions for internal and external balance are presented through diagrammatic
analysis based upon the short-run macroeconomic model of Chapter 17. This analysis illustrates the
strengths and weaknesses of alternative fixed exchange rate arrangements. The chapter also draws upon
earlier discussions of balance of payments crises to make clear the interplay between “fundamental
disequilibrium” and speculative attacks. There is a detailed analysis of the Bretton Woods system that
includes a case study of the experience during its decline beginning in the mid-1960s and culminating
with its collapse in 1973.
Europe’s switch to a single currency, the euro, is the subject of Chapter 20, and provides a particular example
of a single currency system. The chapter discusses the history of the European Monetary System and its
precursors. The early years of the E.M.S. were marked by capital controls and frequent realignments.
By the end of the 1980s, however, there was marked inflation convergence among E.M.S. members,
few realignments and the removal of capital controls. Despite a speculative crisis in 1992–1993, leaders
pressed on with plans for the establishment of a single European currency as outlined in the Maastricht
Treaty which created the Economic and Monetary Union (EMU). The single currency was viewed as an
important part of the EC 1992 initiative which called for the free flow within Europe of labor, capital,
goods, and services. The single currency, the euro, was launched on January 1, 1999 with 11 original
participants. These countries have ceded monetary authority to a supranational central bank and constrained
their fiscal policy with agreements on convergence criteria and the stability and growth pact. A single
currency imposes costs as well as confers benefits. The theory of optimum currency areas suggests
conditions which affect the relative benefits of a single currency. The chapter provides a way to frame
this analysis using the GG-LL diagram which compares the gains and losses from a single currency.
Finally, the chapter examines the prospects of the EU as an optimal currency area compared to the
United States and considers the future challenges EMU will face.
The international capital market is the subject of Chapter 21. This chapter draws an analogy between the
gains from trade arising from international portfolio diversification and international goods trade. There
is discussion of institutional structures that have arisen to exploit these gains. The chapter discusses
the Eurocurrency market, the regulation of offshore banking, and the role of international financial
supervisory cooperation. The chapter examines policy issues of financial markets, the policy trilemma of
the incompatibility of fixed rates, independent monetary policy, and capital mobility as well as the tension
between supporting financial stability and creating a moral hazard when a government intervenes in
financial markets. The chapter also considers evidence of how well the international capital market has
performed by focusing on issues such as the efficiency of the foreign exchange market and the existence
of excess volatility of exchange rates. The chapter also includes a thorough discussion of how increased
capital mobility and the difficulty of regulating international banking contributed to the 2007–2009
financial crisis.
Chapter 22 discusses issues facing developing countries. The chapter begins by identifying characteristics
of the economies of developing countries, characteristics that include undeveloped financial markets,
pervasive government involvement, and a dependence on commodity exports. The macroeconomic
analysis of previous chapters again provides a framework for analyzing relevant issues, such as inflation
in or capital flows to developing countries. Borrowing by developing countries is discussed as an attempt
to exploit gains from intertemporal trade and is put in historical perspective. Latin American countries’
problems with inflation and subsequent attempts at reform are detailed. Finally, the East Asian economic
miracle is revisited (it is discussed in Chapter 10), and the East Asian financial crisis is examined. This
final topic provides an opportunity to discuss possible reforms of the world’s financial architecture.
Chapter 19
International Monetary Systems:
An Historical Overview
.2 nChapter Organization
Macroeconomic Policy Goals in an Open Economy
  Internal Balance: Full Employment and Price Level Stability
  External Balance: The Optimal Level of the Current Account
Classifying Monetary Systems: The Open-Economy Trilemma
International Macroeconomic Policy under the Gold Standard, 1870–1914
Chapter 19 International Monetary Systems: An Historical Overview    109
  Origins of the Gold Standard
  External Balance Under the Gold Standard
  The Price-Specie-Flow Mechanism
  The Gold Standard “Rules of the Game”: Myth and Reality
  Internal Balance Under the Gold Standard
Box: Hume versus the Mercantilists
  Case Study: The Political Economy of Exchange Rate Regimes:
Conflict Over America’s Monetary Standard During the 1890s
The Interwar Years, 1918–1939
  The Fleeting Return to Gold
  International Economic Disintegration
  Case Study: The International Gold Standard and the Great Depression
The Bretton Woods System and the International Monetary Fund
  Goals and Structure of the IMF
  Convertibility and the Expansion of Private Capital Flows
  Speculative Capital Flows and Crises
Analyzing Policy Options for Reaching Internal and External Balance
  Maintaining Internal Balance
  Maintaining External Balance
  Expenditure-Changing and Expenditure-Switching Policies
The External Balance Problem of the United States Under Bretton Woods
Case Study: The End of Bretton Woods, Worldwide Inflation, and the Transition to Floating Rates
The Mechanics of Imported Inflation
The Case for Floating Exchange Rates
Monetary Policy Autonomy
Exchange Rates as Automatic Stabilizers
Exchange Rates and External Balance
Case Study: The First Years of Floating Rates, 1973–1990
Macroeconomic Interdependence Under a Floating Rate
Case Study: Transformation and Crisis in the World Economy
What Has Been Learned Since 1973?
Monetary Policy Autonomy
The Exchange Rate as an Automatic Stabilizer
External Balance
The Problem of Policy Coordination
Are Fixed Exchange Rates Even an Option for Most Countries?
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.
Chapter 19 International Monetary Systems: An Historical Overview    111
Figure 19-1
The automatic adjustment process described by the price-specie-flow mechanism is expedited by following
“rules of the game” under which governments contract the domestic source components of their monetary
bases when gold reserves are falling (corresponding to a current-account deficit) and expand when gold
reserves are rising (the surplus case).
In practice, there was little incentive for countries with expanding gold reserves to follow the “rules of the
game.” This increased the contractionary burden shouldered by countries with persistent current account
deficits. The gold standard also subjugated internal balance to the demands of external balance. Research
suggests price level stability and high employment were attained less consistently under the gold standard
than in the post-1945 period.
The interwar years were marked by severe economic instability. The monetization of war debt and of reparation
payments led to episodes of hyperinflation in Europe. An ill-fated attempt to return to the prewar gold
parity for the pound led to stagnation in Britain. Competitive devaluations and protectionism were pursued
in a futile effort to stimulate domestic economic growth during the Great Depression. These
beggar-thy-neighbor policies provoked foreign retaliation and led to the disintegration of the world
economy. As one of the case studies shows, strict adherence to the gold standard appears to have hurt
many countries during the Great Depression.
Determined to avoid repeating the mistakes of the interwar years, Allied economic policy makers met
at Bretton Woods in 1944 to forge a new international monetary system for the postwar world. The
exchange-rate regime that emerged from this conference had at its center the U.S. dollar. All other
currencies had fixed exchange rates against the dollar, which itself had a fixed value in terms of gold.
An International Monetary Fund was set up to oversee the system and facilitate its functioning by lending
to countries with temporary balance of payments problems.
A formal discussion of internal and external balance introduces the concepts of expenditure-switching and
expenditure-changing policies. The Bretton Woods system, with its emphasis on infrequent adjustment
of fixed parities, restricted the use of expenditure-switching policies. Increases in U.S. monetary growth to
finance fiscal expenditures after the mid-1960s led to a loss of confidence in the dollar and the termination
of the dollar’s convertibility into gold. The analysis presented in the text demonstrates how the Bretton
Woods system forced countries to “import” inflation from the United States and shows that the breakdown
of the system occurred when countries were no longer willing to accept this burden.
Following the breakdown of the Bretton Woods system, many countries moved toward floating exchange
rates. In theory, floating exchange rates have four key advantages: they allow for independent monetary
policy, they are symmetric in terms of the costs of adjustment faced by deficit and surplus countries, they
act as automatic stabilizers that mitigate the effects of economic shocks, and they help maintain external
balance through stabilizing speculation that depreciates the currency of a country with a large
current-account deficit.
These advantages must be matched with the experience of countries running floating exchange rate regimes.
First, exchange rates have become less stable. For example, in the mid 1970s, the United States chose to
pursue monetary expansion to fight a recession, whereas Germany and Japan contracted their money supplies
to counter inflation. As a result, the dollar sharply depreciated against these currencies. The symmetry
benefit of floating rates is also limited by the fact that the dollar still serves as the world’s reserve currency,
much as it did under Bretton Woods. While floating rates do work as automatic stabilizers, the effects may
be unevenly distributed within countries. For example, the U.S. fiscal expansion of the 1980s appreciated
the dollar, limiting inflation overall. However, U.S. farmers were hurt by this action as the stronger dollar
weakened exports. With immobile factors of production, these asymmetric effects can have long-run
consequences. Finally, empirical evidence suggests that external imbalances have actually increased since
the adoption of floating exchange rates. The chapter concludes with a discussion of policy coordination
under floating exchange rates. For example, a large country with a current-account deficit that attempts
to reduce their imbalance could cause global deflation. There is also a market failure at work here in that
policies by one country have external effects. For example, the 2007–2009 financial crisis sparked a
number of fiscal expansions in countries. Increased government spending in the United States for example,
helped lift demand not just in the United States but in other countries as well. Since the benefits of fiscal
expansion are not fully internalized (though the costs are through accumulated budget deficits), there will
be an inefficiently small expansion from a global perspective. Thus, international policy coordination,
even in a world of flexible exchange rates, may still be warranted.