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
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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)
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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: , .
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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
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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
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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 recessionWilliam 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
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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.
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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.
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* 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
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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-
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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
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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
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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

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