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Chapter 19 (8)
International Monetary Systems:
An Historical Overview
◼ Chapter 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
Box: Can a Country Borrow Forever? The Case of New Zealand
Classifying Monetary Systems: The Open-Economy Monetary Trilemma
International Macroeconomic Policy under the Gold Standard, 1870–1914
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
Case Study: Gold Smuggling and the Birth of the UAE Dirham
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
118 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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
Assessment
The Case for Floating Exchange Rates
Monetary Policy Autonomy
Symmetry
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
Symmetry
The Exchange Rate as an Automatic Stabilizer
External Balance
The Problem of Policy Coordination
Are Fixed Exchange Rates Even an Option for Most Countries?
Summary
APPENDIX TO CHAPTER 19 (8): International Policy Coordination Failures
◼ Chapter 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 (8) 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.
Chapter 19 (8) International Monetary Systems: An Historical Overview 119
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.
Figure 19(8)-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
120 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
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.
Floating exchange rates should give countries greater autonomy over monetary policy. However, the
evidence suggests that changes in monetary policy in one country do get transmitted across borders,
limiting autonomy. Second, 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. Although 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 its 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. Because 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.
This is especially relevant given the observation that given increased capital mobility, fixed exchange rates
may not even be an option for most countries in a world without international coordination of monetary
policy.
Chapter 19 (8) International Monetary Systems: An Historical Overview 121
◼ Answers to Textbook Problems
1. a. Because it takes considerable investment to develop uranium mines, you would want a larger
current-account deficit to allow your country to finance some of the investment with foreign
savings.
b. A permanent increase in the world price of copper would cause a short-term current account deficit
if the price rise leads you to invest more in copper mining. If there are no investment effects, you
would not change your external balance target because it would be optimal simply to spend your
additional income.
2. Because the marginal propensity to consume out of income is less than 1, a transfer of income from B
to A increases savings in A and decreases savings in B. Therefore, A has a current account surplus and
B has a corresponding deficit. This corresponds to a balance of payments disequilibrium in Hume’s
3. It is indeed possible for the country to borrow year after year, if it does not borrow too much. If the
country’s net foreign wealth is higher and the interest rate—that the country earns on wealth held
abroad and pays on its liabilities to foreigners—is positive then the country can still borrow without
any problems. Certain data points to New Zealand as being under this category. The currency
depreciation is strongly influenced on account of the large current account deficit. Deficit on the
4. A monetary contraction, under the gold standard, will lead to an increase in the gold holdings of the
contracting country’s central bank if other countries do not pursue a similar policy. All countries cannot
succeed in doing this simultaneously because the total stock of gold reserves is fixed in the short run.
Under a reserve currency system, however, a monetary contraction causes an incipient rise in the
5. The increase in domestic prices makes home exports less attractive and causes a current account deficit.
This diminishes the money supply and causes contractionary pressures in the economy, which serve
to mitigate and ultimately reverse wage demands and price increases.
6. Under the fixed exchange rate system, the monetary policy cannot alter the money supply. Under the
flexible exchange rate system, the change in the exchange rate (through monetary policy) and the
122 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
level of domestic spending (through fiscal policy measure) adjusts the output and employment level,
bringing about an internal balance. In other words, a combination of exchange rates and the domestic
spending holds the output at full employment level, and thus maintains internal balance.
To maintain the internal balance, the aggregate demand needs to be equal to the full employment
level of output. Current account is a decreasing function of spending and an increasing function of the
7. Capital account restrictions insulate the domestic interest rate from the world interest rate. Monetary
policy, as well as fiscal policy, can be used to achieve internal balance. Because there are no offsetting
8. We are given that the growth rate in GDP may be computed as g = (GDPt + 1 – GDPt)/GDPt. Solving
for GDP in time t + 1 yields: GDPt + 1 = GDPt(1 + g). Using this expression alongside that derived for
IIPt + 1 allows us to compute:
Taking this equation and solving for nxt yields nxt = iip(g – r). In order for the international
investment position as a fraction of GDP to stay constant, net exports must grow at a rate equal to the
GDP growth rate less the interest rate earned (paid) on foreign assets (liabilities).
9. a. We know that China has a very large current-account surplus, placing them high above the XX
b. China needs to appreciate the exchange rate to move down on the graph toward the balance.
(Shown on the graph with the dashed line down.)
Chapter 19 (8) International Monetary Systems: An Historical Overview 123
c. China would need to expand government spending to move to the right and hit the overall balance
point. Such a policy would help cushion the negative aggregate demand pressure that the appreciation
might generate.
10. The increase in foreign prices will shift the DD curve out to the right as demand for home products
increases (exports rise, imports fall). If the expected exchange rate also falls, then there will be a
11. Under Bretton wood agreement, the exchange rate between Brazil and Argentina is fixed. High
inflation in Brazil would attract fewer buyers from Argentina, hence the export form Brazil to
Argentina is reduced. On the other hand, for Brazilian consumer, Argentine products are attractive,
12. An increase in the risk premium on domestic assets will shift the AA curve to the right, reflecting the
fact that asset market equilibrium is now attained at a higher exchange rate (depreciated domestic
currency). With floating exchange rates, the depreciated currency will stimulate export demand, leading
to a movement along the DD curve until general equilibrium is restored at both a depreciated currency
(E2) and higher level of output (Y2). With a fixed exchange rate, the central bank would have to respond
124 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
© 2015 Pearson Education Limited
13. The simple model of savings and investment against the real interest rate can be drawn as shown
below. The increase in world savings can be shown as a rightward shift in the savings schedule. The
result is that the world real interest rate falls and the amount of savings and investment rises. We can
think of the “global savings glut” story here. World interest rates went down as large-scale savings
(public and private), in emerging market countries in particular, increased the supply of world
14. Higher Japanese interest rate attracts capital flow from China. This inflow will increase the greater
demand for Japanese yen and a greater outflow of Chinese Yuan. Hence, the yen will appreciate
relative to the Yuan.
15. Under the Bretton wood system the fiscal policy is used as the main instruments for moving the
economy towards the internal and the external balance. This policy is generally insufficient to
maintain the internal and the external balance. The reasons for sole ineffectiveness of fiscal policy
are- (a) the fiscal policy changes are insufficient and infrequent, (b) fiscal policy is mostly
Chapter 19 (8) International Monetary Systems: An Historical Overview 125
politically biased and influenced, (c) the fiscal expansions at times are reversed when the
government faces large budget deficit.
Under this agreement, if country ‘X’ exchange rate was lower than the equilibrium exchange rate
then it would lead to higher export over import. This brings about the surplus in the current account.
A surplus in the current account ultimately shows that the demand of Country X’s currency by the
16. Students may find navigating the Australian Bureau of Statistics website challenging, given the large
volume of information available on this site. That said, once the data has been collected, the solution
to this problem is fairly straightforward.
r = g – nx/iip
