InternationalEconomics

TenthEditionTheInternationalMonetarySystem:Past,Present,andFutureDominickSalvatoreJohnWiley&Sons,Inc.CHAPTER

TWENTYONE21Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.InternationalEconomics

Tenth1Inthischapter:IntroductionTheGoldStandardandtheInterwarExperienceTheBrettonWoodsSystemOperationandEvolutionoftheBrettonWoodsSystemU.S.BalanceofPaymentsDeficitsandCollapseoftheBrettonWoodsSystemInternationalMonetarySystem:PresentandFutureSalvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.Inthischapter:IntroductionSa2IntroductionAninternationalmonetarysystemreferstotherules,customs,instruments,facilitiesandorganizationsforeffectinginternationalpayments.Agoodinternationalmonetarysystemisonethat:

maximizestheflowofinternationaltradeandinvestments.Leadsto“equitable”distributionofgainsfromtradeamongnations.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.IntroductionAninternationalm3IntroductionAninternationalmonetarysystemcanbeevaluatedintermsof:Adjustment–processbywhichbalanceofpaymentsdisequilibriaarecorrected.Liquidity–amountofinternationalreserveassetsavailabletosettletemporarybalanceofpaymentsdisequilibria.Confidence–knowledgethattheadjustmentmechanismisworkingadequately,andthatinternationalreserveswillretaintheirabsoluteandrelativevalues.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.IntroductionAninternationalm4TheGoldStandardandtheInterwarExperienceTheGoldStandardPeriod(1880-1914)Nationsdefinedthegoldcontentofitscurrencyandpassivelystoodreadytobuyorsellanyamountofgoldatthatprice.Exchangerateswerefixedatmintparity,allowedtofluctuatebycostofshipping.AdjustmentmechanismwasHume’sprice-specieflowmechanism(seechapter16).Nationscouldnotusemonetarypolicyforachievingfullemploymentwithoutinflation.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte5TheGoldStandardandtheInterwarExperienceTheGoldStandardPeriod(1880-1914)Inreality,adjustmentprocessworkedmuchtoosmoothlyandquickly,withfewactualtransfersofgold.Adjustmentsoccurredbecauseofspecialconditionsthatexistedduringthistime:Greateconomicexpansionandstabilityinmostoftheworld.Poundsterlingwasonlyimportantinternationalcurrency.Greaterpriceflexibilitythantoday.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte6TheGoldStandardandtheInterwarExperienceTheInterwarExperienceClassicalgoldstandardendedwithoutbreakofWorldWarI.Wildlyfluctuatingexchangeratesfrom1919to1924lednationstoreturntoamodifiedgoldstandard.Thegold-exchangestandardallowedgoldandcurrenciesconvertibleintogoldtobeusedasinternationalreserves.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte7TheGoldStandardandtheInterwarExperienceTheInterwarExperienceCausesofgold-exchangestandardcollapse:LackofadequateadjustmentmechanismsHugedestabilizingcapitalflowsfromLondontoNewYorkandParis.OutbreakoftheGreatDepression.From1931to1936,greatinstabilityandcompetitivedevaluations,increasedprotectionism,internationaltradecutalmostinhalf.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte8TheBrettonWoodsSystemGold-ExchangeStandard(1947-1971)BrettonWoodswasagold-exchangestandard,withtheUnitedStatesmaintainingthepriceofgoldat$35perounce,standingreadytoexchangedollarsforgold.Othernationsfixedtheirexchangeratesintermsofdollars,maintainingrateswithinonepercentaboveorbelowparvalue.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheBrettonWoodsSystemGold-E9TheBrettonWoodsSystemGold-ExchangeStandard(1947-1971)SystemdevisedatBrettonWoodscalledforestablishmentofInternationalMonetaryFund(IMF)forpurposesof:Overseeingthatnationsfollowedrulesofconductininternationaltradeandfinance.Providingborrowingfacilitiesfornationsintemporarybalanceofpaymentsdifficulties.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheBrettonWoodsSystemGold-E10TheBrettonWoodsSystemInborrowingfromtheIMF,anationreceivesconvertiblecurrenciestofundbalanceofpaymentsdisequilibria.Anationmayborrownomorethan25percentofitsquotaduringanygivenyearwithamaximumborrowinglimitof125percent.Thefirst25percentborrowed,thegoldtranche,comeswithoutrestrictionsorconditions.Subsequenttranchescomewithhigherinterestchargesandstricterconditions.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheBrettonWoodsSystemInbor11OperationandEvolutionofthe

BrettonWoodsSystemBrettonWoodsallowedchangestoparvaluesincasesoffundamentaldisequilibria.Deficitnationssawdevaluationasasignofweakness.Surplusnationsresistedrevaluation,preferringinsteadtoaccumulateinternationalreserves.Sincefewnationschangedparvalues,adjustmentmechanismwashindered.Resultedindestabilizinginternationalcapitalflows.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.OperationandEvolutionofthe12U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemBeginningin1958,theU.S.beganrunningsignificantbalanceofpaymentsdeficits.Becausedollarwasaninternationalcurrency,U.S.feltitcouldnotdevaluetocorrectbalanceofpayments.Effects:DepletionofU.S.goldreservesDeclininggoldreservesforcedtheU.S.tosuspendgoldconvertibilityin1971.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic13U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemTheabilitytosettleitsbalanceofpaymentsdeficitwithdollarsconferredanimportantprivilegeontheUnitedStatesthatothernationsdidnothave.Seignorage-benefitaccruingtoanationfromissuingitscurrencyorwhenitscurrencyisusedasaninternationalcurrency.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic14U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemButtheUnitedStatescouldnotdevalueitscurrencywithoutbringingdowntheBrettonWoodssystem.SincetheUnitedStatescouldnotusemonetarypolicy,ithadtorelyheavilyonfiscalpolicytoachievedomesticobjectives.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic15U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemTheunwillingnessofGermanyandJapantorevaluetheircurrencyforcedtheUnitedStatestodevaluethedollar,collapsingtheBrettonWoodssystem.ThiswasapoliticaldecisiontoremovetheUnitedStatesfromitspositionasthe“world’sbanker”.Ironically,theU.S.dollarremainedaninternationalcurrencyevenwithoutthegoldbacking.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic16U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemSmithsonianAgreement(1971)Dollarpriceofgoldincreasedto$38/ounceOthermajorcurrenciesrevaluedFluctuationbandsincreasedto+/-2.25percentEffectivelygeneratesadollarstandardContinuingbalanceofpaymentsdeficitsforcedasubsequentdevaluationofthedollarin1973($42.22perounce)andfinallyasuspensionofdollarconvertibilitytogold.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic17TheInternationalMonetarySystem:PresentandFutureFollowingthecollapseoftheBrettonWoodsSystem,themonetarysystemmovedtoasystemofmanagedfloats.OfficiallyacknowledgedbytheJamaicaAccordsof1976.InternationalreservesforcurrencyinterventionstillprovidedbytheIMF.ThelendingabilityoftheIMFwasexpandedin1997bytheNewArrangementtoBorrow.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheInternationalMonetarySys18TheInternationalMonetarySystem:PresentandFutureTheuseofIMFconditionalityhascometobeasourceofgreatcontentionwithintheinternationalmonetarysystem.IMFConditionsforLoansandSpecialHelp:ReductionsingovernmentspendingGrowthofthemoneysupplyWageincreasestoreduceimports,stimulateexports,andmakecountrymoreself-sustainingSalvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheInternationalMonetarySys19TheInternationalMonetarySystem:PresentandFutureProblemswithPresentExchangeRateArrangementsLargevolatility,andwideandpersistentmisalignmentsofexchangeratesDollaroverhang–largequantitiesofdollarsheldbyforeignersandreadytomovefrommonetarycentertomonetarycenterinresponsetofluctuationsinexchangeratesSalvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheInternationalMonetarySys20TheInternationalMonetarySystem:PresentandFutureProblemswithPresentExchangeRateArrangementsFailuretopromotegreatercoordinationofeconomicpoliciesamongleadingindustrialnationsInabilitytopreventinternationalfinancialcrisesordealwiththemadequatelywhentheyariseSalvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheInternationalMonetarySys21FIGURE21-1ExchangeRatesofMajorCurrenciesAgainsttheDollar.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.FIGURE21-1ExchangeRatesof22TheInternationalMonetarySystem:PresentandFutureCurrentInternationalProblemsFinancialcrisesinemergingmarketeconomies.Tradeprotectionisminadvancedcountriesinarapidlyglobalizingworld.StructuralimbalancesintheUnitedStates,slowgrowthinEuropeandJapan,andinsufficientrestructuringintransitioneconomies.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheInternationalMonetarySys23InternationalEconomics

TenthEditionTheInternationalMonetarySystem:Past,Present,andFutureDominickSalvatoreJohnWiley&Sons,Inc.CHAPTER

TWENTYONE21Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.InternationalEconomics

Tenth24Inthischapter:IntroductionTheGoldStandardandtheInterwarExperienceTheBrettonWoodsSystemOperationandEvolutionoftheBrettonWoodsSystemU.S.BalanceofPaymentsDeficitsandCollapseoftheBrettonWoodsSystemInternationalMonetarySystem:PresentandFutureSalvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.Inthischapter:IntroductionSa25IntroductionAninternationalmonetarysystemreferstotherules,customs,instruments,facilitiesandorganizationsforeffectinginternationalpayments.Agoodinternationalmonetarysystemisonethat:

maximizestheflowofinternationaltradeandinvestments.Leadsto“equitable”distributionofgainsfromtradeamongnations.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.IntroductionAninternationalm26IntroductionAninternationalmonetarysystemcanbeevaluatedintermsof:Adjustment–processbywhichbalanceofpaymentsdisequilibriaarecorrected.Liquidity–amountofinternationalreserveassetsavailabletosettletemporarybalanceofpaymentsdisequilibria.Confidence–knowledgethattheadjustmentmechanismisworkingadequately,andthatinternationalreserveswillretaintheirabsoluteandrelativevalues.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.IntroductionAninternationalm27TheGoldStandardandtheInterwarExperienceTheGoldStandardPeriod(1880-1914)Nationsdefinedthegoldcontentofitscurrencyandpassivelystoodreadytobuyorsellanyamountofgoldatthatprice.Exchangerateswerefixedatmintparity,allowedtofluctuatebycostofshipping.AdjustmentmechanismwasHume’sprice-specieflowmechanism(seechapter16).Nationscouldnotusemonetarypolicyforachievingfullemploymentwithoutinflation.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte28TheGoldStandardandtheInterwarExperienceTheGoldStandardPeriod(1880-1914)Inreality,adjustmentprocessworkedmuchtoosmoothlyandquickly,withfewactualtransfersofgold.Adjustmentsoccurredbecauseofspecialconditionsthatexistedduringthistime:Greateconomicexpansionandstabilityinmostoftheworld.Poundsterlingwasonlyimportantinternationalcurrency.Greaterpriceflexibilitythantoday.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte29TheGoldStandardandtheInterwarExperienceTheInterwarExperienceClassicalgoldstandardendedwithoutbreakofWorldWarI.Wildlyfluctuatingexchangeratesfrom1919to1924lednationstoreturntoamodifiedgoldstandard.Thegold-exchangestandardallowedgoldandcurrenciesconvertibleintogoldtobeusedasinternationalreserves.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte30TheGoldStandardandtheInterwarExperienceTheInterwarExperienceCausesofgold-exchangestandardcollapse:LackofadequateadjustmentmechanismsHugedestabilizingcapitalflowsfromLondontoNewYorkandParis.OutbreakoftheGreatDepression.From1931to1936,greatinstabilityandcompetitivedevaluations,increasedprotectionism,internationaltradecutalmostinhalf.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheGoldStandardandtheInte31TheBrettonWoodsSystemGold-ExchangeStandard(1947-1971)BrettonWoodswasagold-exchangestandard,withtheUnitedStatesmaintainingthepriceofgoldat$35perounce,standingreadytoexchangedollarsforgold.Othernationsfixedtheirexchangeratesintermsofdollars,maintainingrateswithinonepercentaboveorbelowparvalue.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheBrettonWoodsSystemGold-E32TheBrettonWoodsSystemGold-ExchangeStandard(1947-1971)SystemdevisedatBrettonWoodscalledforestablishmentofInternationalMonetaryFund(IMF)forpurposesof:Overseeingthatnationsfollowedrulesofconductininternationaltradeandfinance.Providingborrowingfacilitiesfornationsintemporarybalanceofpaymentsdifficulties.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheBrettonWoodsSystemGold-E33TheBrettonWoodsSystemInborrowingfromtheIMF,anationreceivesconvertiblecurrenciestofundbalanceofpaymentsdisequilibria.Anationmayborrownomorethan25percentofitsquotaduringanygivenyearwithamaximumborrowinglimitof125percent.Thefirst25percentborrowed,thegoldtranche,comeswithoutrestrictionsorconditions.Subsequenttranchescomewithhigherinterestchargesandstricterconditions.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.TheBrettonWoodsSystemInbor34OperationandEvolutionofthe

BrettonWoodsSystemBrettonWoodsallowedchangestoparvaluesincasesoffundamentaldisequilibria.Deficitnationssawdevaluationasasignofweakness.Surplusnationsresistedrevaluation,preferringinsteadtoaccumulateinternationalreserves.Sincefewnationschangedparvalues,adjustmentmechanismwashindered.Resultedindestabilizinginternationalcapitalflows.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.OperationandEvolutionofthe35U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemBeginningin1958,theU.S.beganrunningsignificantbalanceofpaymentsdeficits.Becausedollarwasaninternationalcurrency,U.S.feltitcouldnotdevaluetocorrectbalanceofpayments.Effects:DepletionofU.S.goldreservesDeclininggoldreservesforcedtheU.S.tosuspendgoldconvertibilityin1971.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic36U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemTheabilitytosettleitsbalanceofpaymentsdeficitwithdollarsconferredanimportantprivilegeontheUnitedStatesthatothernationsdidnothave.Seignorage-benefitaccruingtoanationfromissuingitscurrencyorwhenitscurrencyisusedasaninternationalcurrency.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic37U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemButtheUnitedStatescouldnotdevalueitscurrencywithoutbringingdowntheBrettonWoodssystem.SincetheUnitedStatescouldnotusemonetarypolicy,ithadtorelyheavilyonfiscalpolicytoachievedomesticobjectives.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic38U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemTheunwillingnessofGermanyandJapantorevaluetheircurrencyforcedtheUnitedStatestodevaluethedollar,collapsingtheBrettonWoodssystem.ThiswasapoliticaldecisiontoremovetheUnitedStatesfromitspositionasthe“world’sbanker”.Ironically,theU.S.dollarremainedaninternationalcurrencyevenwithoutthegoldbacking.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic39U.S.Balance-of-PaymentsDeficitandCollapseoftheBrettonWoodsSystemSmithsonianAgreement(1971)Dollarpriceofgoldincreasedto$38/ounceOthermajorcurrenciesrevaluedFluctuationbandsincreasedto+/-2.25percentEffectivelygeneratesadollarstandardContinuingbalanceofpaymentsdeficitsforcedasubsequentdevaluationofthedollarin1973($42.22perounce)andfinallyasuspensionofdollarconvertibilitytogold.Salvatore:InternationalEconomics,10thEdition?2010JohnWiley&Sons,Inc.U.S.Balance-of-PaymentsDefic40TheInternationalMonetarySystem:PresentandFutureFollowingthecollapseoftheBrettonWoodsSystem,themonetarysystemmovedtoasystemofmanagedfloats.OfficiallyacknowledgedbytheJamaicaAccordsof1976.InternationalreservesforcurrencyinterventionstillprovidedbytheIMF.ThelendingabilityoftheIMFwasexpandedin1