International Business Chapter 19 Gold Arbitrage Implies Interest Rate Parity Across Countries Because The Expected Depreciation

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group of countries are often asymmetric, and it may be difficult for one country to allow

output to deviate from the desired level to help out another country. In the end, these

asymmetric shocks should average out, but this requires a long–term commitment. For

Cooperative and Noncooperative Adjustments to Exchange Rates

Instead of adjusting interest rates, suppose that countries agree to reset their exchange

rate pegs following a shock. Countries that previously had an exchange rate peg at

announce that the new peg is ≠ .

In the following examples, both the home and foreign countries are the noncenter.

Devaluation and revaluation are analogous to depreciation and appreciation, except

these terms are used only to describe changes in exchange rate pegs. Figure 19-12 shows

Cooperative (point 2):

■ The devaluation in the home country leads to a decrease in demand in the foreign

noncenter country.

■ The foreign noncenter country’s IS* curve shifts to the left. The foreign central

Noncooperative (point 3):

■ Here, the home country implements a larger devaluation, causing a large increase

in the demand for home goods and a large decrease in the demand for foreign

goods. LM shifts to the right.

■ IS shifts to the right and IS* shifts to the left by larger magnitudes than under a

We can use the same logic to analyze the effects of a home-country revaluation. Suppose

the home country’s economy is “overheating” with Y higher than the desired level. The

analysis can be expanded to consider a center country’s choice to devalue or revalue.

Caveats A noncooperative adjustment in the exchange rate peg (especially a devaluation)

is known as a beggar-thy–neighbor policy. The home country improves its output at the

expense of the foreign country’s output. This highlights a key problem with

APPLICATION

The Gold Standard

Is it possible to avoid the problem of asymmetric shocks in an exchange rate system?

This would require that all countries are noncenter, avoiding the Nth currency problem so

that one country is unable to dominate the others with autonomous monetary policy. The

gold standard is an example of such a system. Because all countries pegged to gold, no

single country could act as a center country with its own currency.

Mechanics of the gold standard: Britain (Home) and France (Foreign):

■ Gold and money are seamlessly interchangeable. The money supply, M, equals

the combined value of gold and money in the hands of the public. (Under the pure

gold standard, the only acceptable money was gold coins.)

● Each country’s currency is pegged to a gold local currency price: , .

● The gold standard depends heavily on maintaining free convertibility: central

■ Arbitrage keeps exchange rates fixed. Consider what happens when the French

franc appreciates against the British pound:

● If E > Epar, then Epar/E = / < 1. This means that an ounce of gold costs

fewer pounds in Britain ( ) than it does in France ( ).

● Gold flows out of Britain and into France, expanding France’s money supply

and contracting Britain’s money supply. These flows lead to a decrease in E

Considerations and limitations:

■ The arbitrage process is not without cost. If the exchange rate deviates from the

par value by a very small amount, it will not be worthwhile to exploit the

■ The arbitrage process works in reverse if the exchange rate is below its par value.

Gold flows out of France and into Britain, expanding Britain’s money supply and

contracting France’s. These flows lead to an increase in E until the par exchange

rate is achieved.

■ Gold arbitrage implies interest rate parity across countries because the expected

■ Under the gold standard, there is no center country. All countries cooperate

without explicit policy intervention.

The gold standard has one major advantage: it is inherently symmetrical. All countries

4 International Monetary Experience

This section provides a historical overview of exchange rate systems, beginning in 1870

and continuing through the present. The following text summarizes this information in a

timeline and key points.

The Rise and Fall of the Gold Standard

1870–1918: The first era of globalization and World War I

■ Origins:

● A combination of technological developments in transport and

● A stabilization policy was politically irrelevant and price stability was the

primary goal.

■ Experience on the gold standard:

● A few countries adopted a gold peg, increasing the benefits to others adopting

a fixed exchange rate regime thereafter (network externality).

● Many countries joined the gold standard, only to leave during a domestic

economic crisis.

* U.S. 1890 deflation and recession—William Jennings Bryan blames them

■ Collapse and World War I:

● During World War I, the inflation tax became an important source of revenue,

leading to several countries leaving the gold standard.

● Conflict reduced trade.

1918–1945: The Great Depression and World War II

■ 1920s:

■ The Great Depression (1930s):

● More severe output fluctuations caused stabilization policies to become

increasingly popular.

● Remaining on the gold standard meant continued deflation because of slow

growth in the world’s gold supply.

● Developing countries experienced recession earlier; some devalued as early

● Weakened confidence and credibility of gold pegs indicated by currency

traders.

■ The trilemma revisited (Figure 19–13):

● Option 1: remain on the gold standard and forgo monetary policy autonomy

(France).

In the end, the system collapsed because:

■ The efficiency gains from trade were diminished as the results of war and poor

macroeconomic policy.

■ Slow growth in the world’s gold supply led to a worldwide deflation.

Bretton Woods to the Present

■ Background and design:

● In 1944, economic policy makers gathered at Bretton Woods, New

● The objective was to maintain a system of fixed exchange rates to rebuild

trade among countries.

* All countries that signed the Bretton Woods agreement pegged their

currencies to the U.S. dollar. The dollar, in turn, was pegged to gold.

■ Bretton Woods performance and collapse:

● Market pressures and the trilemma:

* To trade, some system of international credit was needed. Countries

● From the trilemma, the deterioration of capital controls meant a loss of

monetary policy autonomy to remain part of the Bretton Woods system.

* Countries compromised on a “fixed but adjustable” system in which

● In the 1960s, the United States experienced inflation as the result of fiscal

expansion during the Vietnam War era.

* Countries pegged to the dollar would be forced to follow by expanding

● In 1971, the U.S. dollar was no longer convertible to gold.

■ Aftermath and options:

● Countries faced several options after the collapse of the Bretton Woods

system:

* Most advanced countries have moved to a floating exchange rate regime,

* Some developing countries have maintained capital controls, but most

with limited flexibility (India).

* A small number of countries still rely on capital controls today (China),

but this is changing.

● As of 2017, there is no real international monetary system in the sense of

5 Conclusions

This chapter considered the choice of whether to adopt a fixed or a floating exchange rate

regime. The primary factors are economic integration and stability costs, with other

factors such as fiscal discipline and liability dollarization playing an important role in

Teaching Tips

Teaching Tip 1: Rep. Ron Paul (R-Texas) advocates returning the United States to the

gold standard, eliminating the Federal Reserve, and allowing privately issued currency to

compete with the dollar (http://www.ronpaul.com/2010-01-26/ron-paul–legalize–

lead on this issue. Then ask them whether privately issued currencies are allowed in the

United States. Give them a few days to do some research. You, luckily, have this

resource: the E. F. Schumacher Society (Small Is Beautiful, Blond & Briggs, 1973)

Teaching Tip 2: German reunification was one of the biggest news stories of 1990.

Twenty–five years later, the shockwaves continue. As we saw in this chapter,

reunification imposed large fiscal costs on the West German government, ultimately

resulting in the United Kingdom’s decision to leave the ERM. As of 2014,

unemployment in eastern Germany was 9.0%, almost double the 5.6% rate in the west.

And government subsidies of € 80 billion flowed into the east, half of which paid for

So here’s the question for your students: What, if anything, should the West German

government have done differently?

IN–CLASS PROBLEMS

1. Examine the empirical evidence on the benefits and costs of currency pegs. First,

identify the potential costs and benefits, and then evaluate each based on the

empirical analysis presented in the chapter.

Answer: The potential benefits of a fixed exchange rate regime are efficiency gains

from the reduction of transactions costs and convergence in prices, fiscal discipline in

■ Benefits:

● Countries with a common currency and direct exchange rate peg have a higher

volume of trade relative to those with floating exchange rates. There is no

■ Costs:

● Interest rate movements in home countries relative to a base country. The

2. The Bulgarian lev is currently pegged to the euro. Using the IS‒LM diagrams for

Home (Bulgarian lev) and Foreign (Eurozone) illustrates how each of the following