INTERNATIONAL ECONOMIICS COURSE

PART TWO(02): OPENED MACROECONOMICS AND INTERNATIONAL

FINANCE

CHAPTER 4: THE INTERNATIONAL MONETARY SYSTEM

The objective of this chapter is to bring the student to understand the internal
and external equilibrum and the issues about the economic policy in international
macroeconomics. They have to master the difficulties to lead the different
economic policy in a given monnetary system. This course throws light on the
mechanism of every monetary system, the standard nowadays and take in to
account the reason which permits the overcoming pre-existing system.

Introduction:

When we talk of international monetary system(SMI), the different methods

which are used to ensure the exchange of goods and services and the debt of a
country having the different currencies. These methods had known an evolution
since the 19th century till date. To give the overseen in the structure of the
course, the principle of economic policy in an open economy shall be seen in the
first section, in the second section, we shall trace the history of the international
monetary system from 1870-1973 and in the third section , we shall tabulate on
the international monetary system since 1973.

Section 1: Principles of Economic Policy in an Opened Macroeconomy

In a closed economy, the monetary policy , budgetary policy and exchange policy
can be mobilised to modify production an employment. But in an opened
economy, interdependency of country is a fact, action are led by the real
exchange rate where the demand of domestic goods has repercussions on
foreign countries. It is convinient to observe how the objectives of the economic
policies are realised in an opened economy.

A) The objectives of the macroeconomic policy in an opened economy

In an opened economy,the objectives of the economic policy carries on the

internal equilibrum and external equilibrum.Internal equilibrum is based on the
full employment of resources and and the general price stability. External
equilibrum is attend when a considered economy, the current account does not
shows an important deficit whic will make so that a country should be unable to
pay its debt, or an excessive excess which will expose foreign country in the same
risk. However, the economic policy varied objectives in a simple way that the
distinction between internal and external equilibrum.Let precise the two notions;

A1; Internal Equilibrum; Full Employment and the Stability of the General
Price Level

Internal equilibrum is attained when all the factors of production are fully utilised
and the general price level stabilised. Underemployment carries a high rate of
unemployment; that is why is it an object of of a particular attention in
macroeconomic policy. Same way as the over employement leads to the
overheating of the economywhich is a situation we need to avoid. These two(02)
phenomenoms exercise pressure on the price and salaries in an economy.

As to what concerns the general price level, inflation unlike deflation, they have
to be avoid in every economy.They take away the properties of unit of account of
moneyand the reserve value,while increasing uncertainty on the different
operations of economic agents. More specifically, the instability of the general
price level influences the real value of the debt contract and leads to the
redistribution of of income and wealth between the debtors and the creditors.
The macro economic policy then consist to maintain the economy at full
employment level and ensure that the growth of the supply of money is not too
rapid nor to slow.

A2) External Equilibrum; The optimal level of current accounts.

External equilibrum of a country is assimilated to that of the current account. A

defit of a current account is not obligatorily desastrous, same as an excess of this
account. As to what concerns the deficit, it translate the fact that this country
borrows resources to the rest of the world, which poses no problem if the
investment opportuinity of this country are more interesting than those offered
in foreign countries. Returns will then be sufficient to cover the capital and the
interest given to other countries. However, if the internal savings are invested in a
more profitable way in the foreign country, then the excess does not have any
problem.These two process leads to the notion of intertemporal commerce for
which it is considered that countries vested with different production structures
gains in a given moment the specialisation of sectors which they are more
productive and sells them. Meanwhile, countries which offers weaker
investment opportuinity has to direct their savings toward more lucrative
investment in foreign countries, and vise versa .

However, the current account balance which maximises the intertemporal

exchange profits are very difficult and even quite impossible to determine.This
optimal level can be verified in an unpreedictable manner. Also, the authorities
tries to "target" a certain level of gain and avoid excessive deficit.

B) The Triangle of Incompatibility and the International monetary system

In international economy, political leaders are always faced in a situation of "

Trilimma" : we cannot do without the choice of monetary regimewhich is
convinient to attend the internal and external objective of macroeconomic policy.

A country which fixes his exchang rate without opposing the free circulation of
capital has to abandonne or leave the control of its monetary policy. This
renouncement illustrates the impossibility of a country to attend simultaneously
the three objectives as follows;

- The stability of the exchange rate.

- A monetary policy orietated towards national objectives.

- The free movement of international capital .

These three objectives are desired by every economy , but only two can be
followed at the same time. This trilimma hgas been brought to evidence by
Robert Mundell and Tommasso Padoa-Schioppa represented as shown below;

A country can with a fixed rate of exchange limit the flow of international finance
(the interest rate parity is not neccesarily verified)conserves the possibility to
modify the internal rate of interestto react in the national economy. It can also
prevent the overheating of the economy by increasing the the interest rate in the
short run, without provocking a fall in the exportations which may result to the
appreciation of money if the circulating capital is empedimented. It si the case
with China nowadays.Since the abandonment of the Bretton Wood in the
begining of 1970s, most industralised countryhas adopted a system which
permits them to combine the free international movement of capital with
monetary policies oriented towards the internal objectives, meanwhile, importers
and the exporters has to face the volativity of exchange rate. This permits to
understand the exchange regime which makes the international monetary
system.

Section II: The International Monetary System of 1870-1973

In this sction we shal present three first period of the international monetary
system . It carries on the standard gold regime ( 1870-1914), Between the two
wars( 1918-1935) and the Bretton Wood system (1946-1973)

A) The Standard Gold Regim (1870-1914)

It is since the antiquity that gold is used as a means of exchange , unit of account
and reserve value but the gold standard was officially instaured in 1819 with the
cancelation by the British government the long time restriction of out flow of
cash and gold bar? This regim was based on the fixed exchange in the 1870 and
1914.

A1) The price-specie flow mechanism.

Gold standard posses a powerful adjustement mechanism which contributes to

the simultaneous equilibrum of the current account of every country ,like the
price- specie flow mechanism . If the global balance of a country is excedentary,
it means that the balance of the current account and the Capital account exceed
the deficitsof the Financial account which is out of the reserve.This disequilibrum
has to be compensated through the entry of gold , which will automatically
increase the supplu of dometic money and reduce that of the world. The result
will be the pressure on the increase of the price of a country and the fall in the
foreign prices, which will lead to the real appreciation of domestic money and
exchange rate being fixed. The demende of national goods and services are
always reduced, meanwhile the national demande of foreign goods and services
increases. These modifications competes to reduce the current national excess
and the current deficit of the rest of the worldtill when the balance of payement
is at equilibrum. This proccess is valuable vice versa.

A-2) The " rules of the game" of the standard gold.

The price-specie flow is a theoritical , authomatic mechanism , which can even if

the authorities can reinforce and contribute to restore the equilibrum current
balance. The rules of the game of the standardised gold makes reference to the
inventions of the central bank when it incits to sell the domestic assets to obtain
at last and face their obligations to convert banknotes. This exercise pressure on
the increase in the internal interest rate and attract foreign capital .Inversely,the
the central bank which accumulates gold reserves are incited to sell them
against domestique assets which is more lucrative.

But in reality, these rules were broken throughout the 19th century. Banks that
accumulated gold have less incentive to intervene than those that experience a
decline in thier gold stock. In practice, it is the deficit country which bears all the
weight of rebalancing the BOP . In addition, these countries found themselves
competing for a limited stockof gold and must therefore adopt sometimes very
restrictive monetary policy. Likewies, some countries sterilize the flow of gold that
is by selling (buying) domestic assetsin the event of an increase(decrease) in
reserve.

A-3) External equilibrum under the gold standard regim

Here , the central bank has an obligation to maintain the official parity betweenits
currency and gold.The foriegn exchange reserves are made up of gold and
current account surpluses or deficits muste be adjusted through the gold
transfert between central banks. External equilibrum of states is not concieved in
terms of level of account but rather as a situation in which central banks does not
haord or lose gold reserves.

A-4)Internal equilibrum under the gold standard regim;

One objective of the gold standard is to imposelimit on the growth of the money
supply, in order to ensure the stability of the general price level. While in the
country subjected to this regim, this level does not increase in the same
proportions between 1870and 1914 as after the second world war, in the short
term , it varies unpredictably, causing alternating periods of inflation and
deflation.The gold standard therefore has a mixed record in price stabilitywhich is
linked to the problem of changing relative gold price and other goods.

Futher more, the gold standard does not really help maintain full employment .
Between 1893 and 1913 , the unemployment rate was on average higher in the
USA (6.7%) than between 1948 and 2010 (5.7%)

B) The interwar Period

During this first great world war, all countries suspended the operation of the
gold standard financed their war effort wuth ticket printing. Labour and
production capacities are severly reduced because of he war . The general price
level was higher every where in 1918 than in1914. And after the war, many
countries continued to increase the supply of money in order to finance
reconstruction, which led to runaway inflation.

B-1) The temporary return of gold.

After the war, countries tried to return to the gold standard includingthe USA in
1919 . At the Genoa Conference in 1922 Great Britain, France and Japan agreed
on an agenda for the return to the standard gold and the coorperation between
central banks . As the quantity of gold available may not be sufficent to meet the
needs of the central bank for international reserves , the participant set up a gold
exchange standard system ; small countries can thus hold currencies of several
large countries as reserves.Countries whose reserves are always entirely made up
of gold.
Britain returned to the gold standard in 1925 with the pre-war parity. This fixing
of the parity at the pre-war level, while the general price level in the 1925 in GB
was higherthan during the period of the gold standard, which forced the country
to conduct a restrictive monetary policy, which has as effect of raising the
unemployment rate. This then weakens the British economy which with the great
depression of 1925( Black Thursday, October 24, 1929) will lead to the
abandonment of the gold standard in 1939.

B-2)The International Consequences of the great depressionof 1929

The great depression of 1929 was maked by its rapid spread to the rest of the
world from the USA. The gold standard is not only one of the trigger, but also a
major factor in the aggravation and contagion of the most serious economic
crisis of the 20th century . In 1929, most countries joined the gold standard .
While the USA and France saw strong capital inflows and accumulated gold( in
1932, these 2 countries own 70% of the world stock ), the other countries had no
choice but to sell domestic assets ,and to increase the interest rate inorder to
conserve their reserve. The result was a global monetary contraction which,
together with the voilent fall out from the October 1929 crash, plunged the world
in to a deep reccesion.

Bank failure resulting from the stcok market crash are spreading and amplifying
the global downward spiral. Many countrie then abandonned the gold standard
in reaction to the crisis. Faced with rising unemployment, the objective of
exchange rate stability came to the fore. The US thus abandonne gold
convertibility between 1933 and 1934 thus increasing the official gold price from
20.67 dollars to 35pounds. By thus abandoning fixed exchange rates , even
temporarily, these countries regained the freedom to carryout expansionary
monetary policies internally, which limits of prevent deflation and reccession.
Those of the countries which stubbornly without devaluing( France
,Switzerland;Belguim,Netherlend and Poland which remained attached to this
system untill 1936) suffered more than the others from the crisis.

To cope with the crisis, many countries took measures to restrict international
trade and payements. These protectionist policies are motivated by the desire to
support the domestic production, limiting imports and controling the outflow of
capital. This is another way to answer the trilemma . Trade barriers, combined
with deflation in industralized economy and leading many countries, especially
those in Latin America whose export outlets are not assured, to repudiate their
debt.

The world economy is disintergrating in to autarkic national units and this

protectionism is very costly and preven a rapid economic recorvery, a recorvery
which was not archeived by a majority of countries in 1939, on the eve of the
second great war.

C) The Bretton woods system and the International Monetary fund (IMF)

It was in 1944 in Bretton Woods, New Hampshire, USA,that the representative of

44 countries who met there and created the IMF. Taking into account the
catastrophic situation of the interwar period, the allied countries intend to set up
a system which will simultaneously allow full employment and the price stability,
external balance and the free movement of capital.

The Betton Woods agreement were about a fixed exchange rate regime with the
reference to the US dollar , which in turn was pegged to the gold at a price of 35
dollar a pound.

C) Objectives and the functioning of the IMF.

The monetary system proposed by the IMF combines disciplines and flexibility.
The main element of discipline is the fixed exchange rate between foreign
currenciens and the dollar, which is tied to gold. Two mechanism are used by the
Bretton Woods agreements to promote external flexibility. On one hand, the
member countrie of the IMF constitute a pool of financial resource by pooling
their currency and their gold order to lend them if necessary to countries in need.
On the other hand, although the exchange rates with the dollar are fixed, they
can be adjusted when needed( in a fundamental imbalanced situation). Only the
US dollar does not benefit from this adjustment possibility. After the second
world war,all countries llinked their currencies to the US dollar. The US takes gold
as a benchmark and agrees to exchange is for dollars at a foreign central banks at
a price of 35 dollars a pound. With the return to convetibility of currencies in
Europe in 1958 , financial market became more intergrated monetary policien
less efficient ( except for the USA), and international reserves more volatile. These
changes reveals a fundamental weakness of the system . In order to archeive
internal and external balance simultaneously, it is necessary to put in places
expenditure exchange policies and expenditure substitution policies. But the
second ( change in exchange rates) can give rise to speculative capital movement
which weaken fixed exchange rates. The US, the country issuing the reserve
currency, is faced with the single problem of external balance: the confidence
problem. The later inevitably arised as dollar reserves held by foreign central
banks increasing relatively to US gold reserves. US policies at the end of the
1960s partly brought about trhe downfall of the Bretton Wooods system. An
overly expansionary fiscal policy to a devaluation of the dollar in the early 1970s.
Fears associated with this situation caused a flow of speculative capital against
the dollar , which inflated the supply of money in other countries. The growing
supply of US money is fueling domestic and foreign inflation. Foreign officials
became increasingly reluctant to import US inflation through fixed exchange
rates. A series of international crisis gradually led to a complete abandonement in
March 1973 of the link between the dollar and gold of fixed parities between the
dollars and the currencies of industralised countries.

C-2) Internal and External Balance under the Bretton Wood Regime

We assume an economy (other then the USA) that wants to restore its internal
and external balances. For this it is considered that the degree of capital mobility
is sufficiently high, so tthat the interest rate and the exchange rate are linked.

a) Maintaining internal balance.

Here full employment is considered sufficient to characterisez internal equilibrum.

Aggregate demand is the equal to the level of full employment of the domestic
product Yf

The aggregate demande for domestic product is equal to the sum of

consumption C investment I, public expenditure G and the cuurent account
balance CC. The share of this demand expressed by residents only, also called
Absorbtion which is denoted by A=C+I+G . The current account surplus is a
decreasing function of net income and an increasing functionof the real exchange
rate EP*/P,but since imports increase with domestic demand, we can therefore
express the current account as a decreasing function af internal request
CC(EP*/P,A) internal equilibrum is then archeived if :

Yf=A+CC(EP*/P,A)

In this model, any expansionary fiscal policy (increase in public spending or

decrease in taxes) stimulates aggregate demand and leads to an increase in
domestic product, even if part of the spending is used to purchase imported
goods. Likewise, devaluation of the currency (increase of E) makes goods services
cheaper than those abroad and increase domestic demand and product (
monetary policy has no effect on domestic product at fixed exchange rates)

Figure1; Internal balance (II) , external balance (XX) and the four zone of
economic discomfort

The effect of changes in rates of changeand political budget on employment

and the current account . Along II in the interior product is at its optimal level Yf.
Along XX , the current account is the desired .

b) Maintainance of external balance.

Suppose the authorities aim for a current account surplus. They should guid
domestic demand and rates of change so as to meet the following equations:

CC(EP*/P, A)=X

Given P and P*, an increase in E improve the price competitiveness of household

goods and the current account. An increase in spending by non-residents and yet
the opposite effects of the car increses the demand for foreign goods, which has
a negative empact onthe currenct account balance. In order to keep the current
account level as E increases the authorities need to ensure increased domestic
spending. In the figure above, the curve XX along which the external equilibrum
is acheived is accelerated. It shows what additional level of economic spending is
needed to maintain the level of the current account surplus when the currency is
devaluated by a certain rate. Since an increase in E increases net exports , the
current account isin excess of its above XX target. Conversely, below XX the
current account is in deficit compared to its objective X.

C-3) Expenditure change and expenditure substitution policies

In figure1, the curve II and XX divide the daigram in to 4 regions called " the 4
zones of each economic discomfort''.Each rpresents the effects of different
economic policies. Zone 1 presents a situation of of over employment, with an
excessively large current account surplus. Zone 2 gives an excessively high level
of employment and an excessive current account deficit. Zone 2 givesan
excessively high level of employment and an excessive current account deficit .
Zone 3 is characterized by a situation of underemployment with an excessive
deficit. In Zone 4, the level of employment is too low and the current account
surplus higher than desired. The joined use of fiscal policycan allow the economy
to be placed at the intersection of curves II and the XX (point 1). This is the
point of balanceboth internally and externally II( Y=Yf).

If the economy is initially far from point 1, domestic demands and exchange rate
adjustments are needed to reach equilibrum. A change in fiscal policy that alters
domestic demand is refered to as a change in expenditure policy because it
affects the level of aggregate demand for goods and services. The ajustment of
exchange rates crresponds to a policy of expenditure substitution , because it
acts on the direction of demand, by modifying the distribution between domestic
production and import

Under the Bretton Wood regime, changes in the exchange rate are exceptional.
Politics is therefore the main tool used to acheive internal and external balances.
Howevere, this tool bis sufficient because it only allows horizontal movment, and
its use is subject to parliamentary approve. In addition, repeated expansionary
fiscal policies lead to chronicfiscal deficitwhich, moreovre undermine their
effectiveness.

All these weaknesses combine with the problem of the US trade deficit and the
phenomenon of imported inflation will lead to the abandonment of the Bretton
Woods System in 1973and switch to floating exchange rate.

Section III; The Floating Exchange System

In this section we analyze the argument that support the floating exchange rates,
tha application phase of the flaoting exchange rate since 1973, and come out
with an assessment of this monetary system.

A) The argument in favour of floating exchange rates.

At the end of the 1960s, weakness of the Bretton Wood system led meny
economistto call for the establishment od the floating exchange rate. Four main
argument are developed to support floating exchange rate;

• The autonomy of the monetary policy. Under the Bretton Wood fixed
exchange rate regime, only the US has the ability to conduct the monetary
policy. If the central bank are no longer forced to intervene in the foreign
exchange market to defend fixed parities, it is to hope that monetary plicy
once moreagain meets internal and external objectives. No country is
forced to import inflation or deflation anymore. The mechanism that
proviudes protection against inported inflation is purchasing power
parity(PPP). If all changes in the wolrd economy are monetary, PPP holds
for the long term : exchange rates change until they exactly compensate
for the inflation differential countries.

• The symmetry.In floating exchange rates, the asymetries inherent in the

Bretton Wood system disappeared and the US ceased to to define the
world monetary conditions. At time the same , the US , like other countries,
has the ability to influence their exchange rate . The principal role of the
Dollar in the Bretton wood system creates two types of asymetries. On one
hand, as the central banks peg dollar as international reserve , the US
Federal reserve plays a leading role in determining the global supply for
money. Other central banks have little leeway in determining their own
money supply. On the other hand, all countries except the USA can devalue
 their currency against the dollar if they find themselves in a condition of
"fundamental imbalance" but the system doesnot offer the possibility of
devalueing the dollar against foreign currencies.

• Exchange rates as automatic stabilizers. Even in the absence of an

active monetary policy, rapid adjustment of exchange rates helps countries
to miantaintheir domestic and external balances in the face of changes in
aggregate demand. The ong period of speculation, which preceded the
currency realignements in the Bretton Woods system, are not supposed to
recur in floating exchange.

• The equilibrum of the trade balance. By leaving it to the market to set the
parities, we expect them to automatically adjust in such a way as to prevent
the emergence of excessive current account surpluses or deficit.

B) Macreconomic interdepence in floating exchange rates

To analyze the interactions between countries, we consider industralized

countries on one hand and the rest of the world on the other hand.One can no
longer imagine that the foreign interest rate or foreign export demand is
exogenous. In a short-term analysi, assume that nominal producer prices are
fixed.

If we consider a permanent monetary expansion in the rest of the world, the

currency depreciates and the domestic product increases. The same phenomenon
occurs in the case of industralized countries with the difference that the
difference that this time , the rest of the world is also affected . If a small country
experiences real currenciey depreciation, the foreign country must experience
real currency appreciation which makes its products relatively more expensive,
which has a negative effect on its dometic product. The increased production of
the domestic country, however moving in the opposit direction as this country
willspend part of its additional income to import foreign products. The result is
an increase in global demand addressed to the foreign country. The monetary
expansion of the domestic country therefore has two opposite effect on foreign
production , with the net result depending on which effect wins, so taht the
production country may rise or fall.

In the case of a permanent fiscal expansion in the domstic country, it causes a

real appreciation of the current account which cancels out any positive effect
on aggregate demand. Indeed, the expansionary impact of the domestic fiscal
loosening dissipate entirely abroad. In the case of a large country, foreign
production increases as its exports become chaeper when the currency
appreciates.

In addition, some of the increased spending abroad stimultaesdomestic exports,

so that the domestic country actually follows the movement of the production of
the foreign country. Thus the following important conclusions can be drawn;

- Effect of permanent monetary expansion; production increases, the currency

depreciates and foreign production increases or decreases as the case may be

- Effect of permanent budget increase; production increases, the currency

appreciates and foreign increases.

C) The Application Phases of the Floating Exchange Rates since 1973

Between 1973 and 1980, the floating exchange rate regime worked quite well. In
any event, it is unlikely that the industralized countries would have been able to
keep exchange rate fixing during this period of stagflation following the two oil
shock. The dollar depreciated sharply after 1976, when the US adopted more
expansionary macroeconomic policies than other countries.

The tightening of monetary policy in the USA, associated with a growing

budget deficit contributed to massive appreciate of the dollar between 1980
and 1985. The other developed contries then continued a policy of
disinflation. The resulting monetary tightening leads to recession. Despite a
tentative recovery that only lasted until the end of the 1984, the US current
account recorded a deficit which rekindled political presure for trade restrictions.
This protectionist orientation took hold only in september 1985 with the
adoption of the PLaza Accords, following which the G5 countries decided to
pursue concerted action and to lower the dollar. Stability of exchange rates was
not seen as a macroeconomic priority objectives in the 1990s and 2000s.
States intead experienced low inflation, while trying to support economic growth.

From 2000, global macroeconomic imbalance increase dramatically. At the same

time, we are witnessing in the US how other countries appreciates in the price of
real estate. The subprime property bubble burst in 2007, dragging the world in
to a severe financial crisis followed by a severe economic crisis.

Conclusion

If there is one lesson to be learned from the functioning of the internal monetary
system since the second world war, it is that there is no exchange rate system
that doesnot require international economic cooperation for its proper
functioning. Measures to restrict exchange rate flexibility are unlikely to be
implemented in the near future.