feb 05 2004 lesson 2 by john kennes international monetary economics
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TRANSCRIPT
Feb 05 2004
Most students will not have previously been facing the question of
what is an international monetary system, and yet it is the underlying
issue behind the adoption of a single currency.
It is a collective decision, distinct from the individual choice of an
exchange rate regime, presented in Chapter 11.
The evolution of International monetary systems
Feb 05 2004
• Monetary union is the controversial end of a long process. History helps understand.
• Since paper money was invented, Europe’s monetary history has been agitated. Each bad episode carries important lessons.
• Before paper money, Europe was a de facto monetary union. Understand how it worked helps understand how the new union works.
Why study history?
Feb 05 2004
• The workings of the gold standard are described by David Hume’s price-specie mechanism
• Depends on (i) long-run neutrality of money and (ii) the effect of money on interest rates
• Money and the balance of payments are linked by trade flows
• Hume’s mechanism implies an automatic change in the money stock to achieve balance of payments equilibrium
• Figure 10.1
How did the Gold Standard work?
Feb 05 2004
• Money determines the price level in the long-run.• The price level affects the trade balance
– If domestic prices are relatively high (low), we have a deficit (surplus)
• Trade balance is achieved when the stock of money is M1
• Hume’s mechanism: Return to balance is automatic– If we start with deficit (point A, high money stock M ), money
flows out until we get back to balance
• Much the same story applies to the financial account– If the domestic interest rate is high (low), capital flows in (out)
and the return to balance is automatic
• The balance of payments adds the current and financial accounts
Hume’s price-specie mechanism
Feb 05 2004
Using Figure 10-1, work out graphically what happens following an
initial balance of payments surplus. Why is the capital outflow,
prompted by lower interest rates, only partially offsetting financing
the current account surplus? Why is there automatic monetary
relaxation despite capital outflows?
Hume’s price-specie mechanism example
Feb 05 2004
Using Figure 10-1, work out graphically what happens following an
initial balance of payments surplus. Why is the capital outflow,
prompted by lower interest rates, only partially offsetting financing
the current account surplus? Why is there automatic monetary
relaxation despite capital outflows?
In Figure 10-1, in the rightmost graph we move from point C to point
A as the money stock increases, the price level rises and the interest
rate declines.
Hume’s price-specie mechanism example
Feb 05 2004
• Money starts circulating widely• Yet the authorities attempt to continue on with the
gold standard but– No agreement on how to set exchange rate between paper
currencies– An imbalanced starting point with war legacies
• High inflation• High public debts
The interwar period
Feb 05 2004
1. The British Case: A refusal to devalue an overvalued currency brings economic decline
2. The French Case: Devaluation, undervaluation and beggar-thy-neighbor policies, until others retaliate and currency becomes overvalued
3. The German Case: Hyperinflation, devaluation and finally, evading the choice of an appropriate exchange rate by resorting to ever widening non-market controls
The interwar period: Case studies
Feb 05 2004
1. We need a system, one way or another2. The gold standard – monetary unions – delivers
automatic return to equilibrium, but at the cost of booms and Recessions
3. No agreement leads to misalignments, competitive devaluations and trade wars
4. Agreements require “rules of the game”, including a conductor
Lessons so far
Feb 05 2004
An overriding desire for exchange rate stability
– Initially provided by the Bretton Woods system– The US dollar as anchor and the IMF as conductor
Once Bretton Woods collapsed, the Europeans were left on their own
– The timid Snake arrangement– The European Monetary System– The monetary union
European Postwar Arrangements
Feb 05 2004
Agreeing on stabilizing intra-European bilateral parities
No enforcement mechanism: too fragile to survive
The Snake Arrangement
Feb 05 2004
Complements bilateral exchange rate commitment with a support
mechanism.
Allows for prompt realignments to avoid misalignments.
Emergence of the Deutschemark as the system’s anchor.
The EMS: Super Snake
1. Most European countries saw (nominal, they thought, but actually real) exchange rate stability as a pre-condition for trade integration, itself seen by post-war political leaders as the way to end wars.
Observation 1
2. Once the dollar standard stopped playing its anchoring role, Europeans switched to the search for their own system, preparing the ground for the monetary union, probably unwittingly.
Observation 2
3. Without a common disciplinary device, inflation rates diverged widely, calling for realignments that became increasingly difficult to manage as capital mobility increased. Hence the search for a system that would rule out inflation differentials. The EMS could not do that for political reasons (it had first to be symmetric and next the Bundesbank’s dominance was not sustainable).
Observation 3
Feb 05 2004
The excess money supply in the US leaked out to the rest of the world, reducing the
dollar’s anchoring role.
Different balance of payment surpluses led to different inflation rates.
Why did fiscal and monetary indiscipline in the US lead to the collapse of the Bretton Woods system?
Feb 05 2004
The excess money supply in the US leaked out to the rest of the world, reducing the
dollar’s anchoring role.
Different balance of payment surpluses led to different inflation rates.
Why did fiscal and monetary indiscipline in the US lead to the collapse of the Bretton Woods system?
Feb 05 2004
They required realignments that were increasingly foreseen.
Why did growing inflation differentials create a problem for exchange rate stability in Europe?
Feb 05 2004
Facing a partner’s competitive devaluation, a country can either
devalue even more or raise tariffs. Since it is impossible that everyone
devalues vis a vis everyone else, competitive devaluations become
self-defeating.
During the interwar era, misalignments led to competitive devaluations, which then
prompter a tariff war. Explain the links from one step to the next.
Feb 05 2004
Money is created by the Eurosystem and disseminated throughout the
area. Countries with balance of payments deficits will lose money
base.
How can the Hume mechanism be applied to the flows of euros within the euro area?