International Economics: Theory and

Policy
Eleventh Edition, Global Edition

Chapter 19
International
Monetary
Systems: An
Historical
Overview
Copyright © 2018 Pearson Education, Ltd. All rights reserved.
Learning Objectives (1 of 2)
19.1 Explain how the goals of internal and external
balance motivate economic policy makers in
open economies.
19.2 Understand the monetary trilemma that policy
makers in open economies inevitably face and
how alternative international monetary systems
address the trilemma in different ways.
Learning Objectives (2 of 2)
19.3 Describe the structure of the international gold
standard that linked countries’ exchange rates
and policies prior to World War I and the role of
the Great Depression of the 1930s in ending
efforts to restore the pre-1914world monetary
order.
19.4 Discuss how the post–World War II Bretton
Woods system of globally fixed exchange rates
was designed to combine exchange rate stability
with limited autonomy of national
macroeconomic policies.
Macroeconomic Goals (1 of 2)
• “Internal balance” describes the macroeconomic
goals of producing at potential output (at “full
employment”) and of price stability (low inflation).
– An unsustainable use of resources
(overemployment) tends to increase prices; an
ineffective use of resources (underemployment)
tends to decrease prices.
• Volatile aggregate demand and output tend to create
volatile prices.
– Price fluctuations reduce economy’s efficiency by
making the real value of the monetary unit less
certain and thus a less useful guide for economic
decisions.
Macroeconomic Goals (2 of 2)
• “External balance” achieved when a current
account is
– neither so deeply in deficit that the country
may be unable to repay its foreign debts,
– nor so strongly in surplus that foreigners
are put in that position.
The Open-Economy Trilemma (1 of 2)
• A country that fixes its currency’s exchange rate
while allowing free international capital
movements gives up control over domestic
monetary policy.
• A country that fixes its exchange rate can have
control over domestic monetary policy if it
restricts international financial flows so that
interest parity R = R* need not hold.
• Or a country can allow international capital to flow
freely and have control over domestic monetary
policy if it allows the exchange rate to float.
The Open-Economy Trilemma (2 of 2)
• Impossible for a country to achieve more than two
items from the following list:
1. Exchange rate stability.
2. Monetary policy autonomy.
3. Freedom of financial flows.
The Monetary Trilemma for Open
Economies

The vertices of the triangle show three features that policy makers in
open economies would prefer their monetary system to achieve.
Unfortunately, at most two can coexist.
The Gold Standard 1870-1914
• The gold standard is a fixed-exchange rate regime,
in which a currency's value is pegged to gold.
• A country that uses the gold standard sets a fixed
price for gold and buys and sells gold at that price.
• If the U.S. sets the price of gold at $35 an ounce,
the value of 1 USD would be 1/35 ounce of gold.
• International trade was settled using physical gold.
• Countries with trade surpluses (deficits)
accumulated (lost) gold.
Macroeconomic Policy under the Gold
Standard 1870–1914
• The gold standard from 1870 to 1914 and after
1918 had mechanisms that prevented flows of gold
reserves (the balance of payments) from becoming
too positive or too negative.
– Prices tended to adjust according the amount of
gold circulating in an economy, which had
effects on the current account.
– Central banks influenced financial asset flows
(by following the rules of the game), so that
the nonreserve part of the financial account
matched the current account in order to reduce
gold outflows or inflows.
Macroeconomic Policy under the Gold
Standard (1 of 5)
• Price-specie-flow mechanism is the adjustment of
prices as gold (“specie”) flows into or out of a
country, causing an adjustment in the flow of goods.
– An inflow of gold tends to inflate prices.
– An outflow of gold tends to deflate prices.
– If a domestic country has a current account
surplus, gold earned from exports flows into the
country—raising prices in that country and
lowering prices in foreign countries.
 Goods from the domestic country become
expensive and goods from foreign countries
become cheap, reducing the current account
surplus of the domestic country and the
deficits of the foreign countries.
Macroeconomic Policy under the Gold
Standard (2 of 5)
• Thus, price-specie-flow mechanism of the gold
standard could automatically reduce current
account surpluses and deficits, achieving a
measure of external balance for all countries.
Macroeconomic Policy under the Gold
Standard (3 of 5)
• The “Rules of the Game” under the gold standard
refer to another adjustment process that was
theoretically carried out by central banks to speed up
gold adjustments:
– The selling of domestic assets when gold
exited the country as payments for imports.
This decreased the money supply, raised interest
rates, and reduced prices.
 This reversed or reduced gold outflows.
– The buying of domestic assets when gold
enters the country as income from exports.
This increased the money supply, reduced interest
rates, and raised prices.
 This reversed or reduced gold inflows.
Macroeconomic Policy under the Gold
Standard (4 of 5)
• Banks with decreasing gold reserves had a strong
incentive to practice the rules of the game: they
could not redeem currency without sufficient
gold.
• Banks with increasing gold reserves had a weak
incentive to practice the rules of the game: the
interest rate became lower for domestic assets.
• In practice, central banks with increasing
gold reserves seldom followed the rules.
• Sometimes central banks sterilized gold flows,
trying to prevent any effect on money supplies
and prices.
Macroeconomic Policy under the Gold
Standard (5 of 5)
• The gold standard’s record for internal balance
was mixed.
– The U.S. suffered from deflation, recessions,
and financial instability during the 1870s,
1880s, and 1890s while trying to adhere to a
gold standard.
– The U.S. unemployment rate was 6.8% on
average from 1890 to 1913, but it was less
than 5.7% on average from 1946 to 1992.
Interwar Years: 1918–1939

• The gold standard was stopped in 1914 due to war,

but after 1918 it was attempted again.
– The U.S. reinstated the gold standard from
1919 to 1933 at $20.67 per ounce and from
1934 to 1944 at $35.00 per ounce (a
devaluation of the dollar).
– The U.K. reinstated the gold standard from
1925 to 1931.
• But countries that adhered to the gold standard for
the longest time, without devaluing their
currencies, suffered most from reduced output and
employment during the Great Depression.
Bretton Woods System: 1944–1973
• In July 1944, 44 countries met in Bretton Woods,
NH, to design the Bretton Woods system:
– a fixed exchange rate against the U.S.
dollar and a fixed dollar price of gold ($35
per ounce).
• Under a system of fixed exchange rates, all
countries but the U.S. had ineffective monetary
policies for internal balance.
• The principal tool for internal balance was fiscal
policy.
• The principal tools for external balance were
borrowing from the IMF, restrictions on financial
asset flows, and infrequent changes in exchange
Bretton Woods System
• In order to avoid sudden changes in the financial
account (possibly causing a balance of payments
crisis), countries in the Bretton Woods system
often prevented flows of financial assets across
countries.
• Yet they encouraged flows of goods and services
because of the view that trade benefits all
economies.
– Currencies were gradually made convertible
(exchangeable) between member countries to
encourage trade in goods and services valued
in different currencies.
Policies for Internal and External
Balance (1 of 3)
• Suppose internal balance in the short run occurs
when production is at potential output or when “full
employment” equals aggregate demand:

( )
∗
𝑓 𝐸𝑃
𝑌 =𝐶+𝐼+𝐺+𝐶𝐴 , 𝐴
𝑃
• A = C+I+G, which is domestic spending.
• An increase in government purchases (or a
decrease in taxes) increases aggregate demand
and output above its full employment level.
• To restore internal balance in the short run, a
revaluation (a fall in E) must occur.
Policies for Internal and External
Balance (2 of 3)
• Suppose external balance in the short run occurs
when the current account achieves some value X:

𝐶𝐴 (
𝐸 𝑃∗
𝑃
, 𝐴 =𝑋)
• An increase in government purchases (or a
decrease in taxes) increases aggregate demand,
output and income, decreasing the current account.
• To restore external balance in the short run, a
devaluation (a rise in E) must occur.
Internal Balance (II), External Balance (XX),
and the “Four Zones of Economic Discomfort”

The diagram shows what different levels of the exchange rate, E, and
overall domestic spending, A, imply for employment and the current
account. Along II, output is at its full-employment level, Y f. Along XX,
the current account is at its target level, X.
Policies to Bring about Internal and External
Balance

The initial point is 2. Unless the currency is devalued and the level of domestic
spending rises, internal and external balance (point 1) cannot be reached.
Acting alone, a change in fiscal policy, for example, enables the economy to
attain either internal balance (point 3) or external balance (point 4), but only at
the cost of increasing the economy’s distance from the goal that is sacrificed.
Policies for Internal and External
Balance (3 of 3)
• But under the fixed exchange rates of the
Bretton Woods system, devaluations were
supposed to be infrequent, and fiscal policy was
supposed to be the main policy tool to achieve
both internal and external balance.
• But in general, fiscal policy cannot attain both
internal balance and external balance at the
same time.
Case for Floating Exchange Rates (1 of 6)
1. Monetary policy autonomy
– Without a need to trade currency in foreign
exchange markets, central banks are more free
to influence the domestic money supply,
interest rates, and inflation.
– Central banks can more freely react to changes
in aggregate demand, output, and prices in
order to achieve internal balance.
Case for Floating Exchange Rates (2 of 6)
2. Automatic stabilization
– Flexible exchange rates change the prices of a
country’s products and help reduce
“fundamental disequilibria.”
– One fundamental disequilibrium is caused by
an excessive increase in money supply and
government purchases, leading to inflation, as
we saw in the US during 1965–1972.
– Inflation causes the currency’s purchasing
power to fall, both domestically and
internationally, and flexible exchange rates can
automatically adjust to account for this fall in
value, as purchasing power parity predicts.
Case for Floating Exchange Rates (3 of 6)
– Another fundamental disequilibrium could
be caused by a change in aggregate
demand for a country’s products.
– Flexible exchange rates would
automatically adjust to stabilize high or low
aggregate demand and output, thereby
keeping output closer to its normal level
and also stabilizing price changes in the
long run.
Effects of a Fall in
Export Demand

The response to a fall in export demand (seen in the shift from DD1 to DD2)
differs under floating and fixed exchange rates. (a) With a floating rate, output
falls only to Y2 as the currency’s depreciation (from E1 to E2) shifts demand back
toward domestic goods. (b) With the exchange rate fixed at E1, output falls all
the way to Y3 as the central bank reduces the money supply (reflected in the
Case for Floating Exchange Rates (4 of 6)
– In the long run, a real depreciation of domestic
products occurs as prices fall (due to low
aggregate demand, output, and employment)
under fixed exchange rates.
– In the short run and long run, a real
depreciation of domestic products occurs
through a nominal depreciation under flexible
exchange rates.
• Fixed exchange rates cannot survive for long in a
world with divergent macroeconomic policies and
other changes that affect national aggregate
demand and national income differently.
Case for Floating Exchange Rates (5 of 6)
3. Flexible exchange rates may also prevent
speculation in some cases.
– Fixed exchange rates are unsustainable if
markets believe that the central bank does not
have enough official international reserves.
Case for Floating Exchange Rates (6 of 6)
4. Symmetry (not possible under Bretton Woods)
– The U.S. is now allowed to adjust its exchange
rate, like other countries.
– Other countries are allowed to adjust their
money supplies for macroeconomic goals, like
the U.S. could.
Macroeconomic Interdependence under
Floating Exchange Rates (1 of 5)
• Previously, we assumed that countries are “small”
in that their policies do not affect world markets.
– A domestic currency depreciation was assumed
to have no significant influence on aggregate
demand, output, and prices in foreign countries.
– For countries like Costa Rica, this may be an
accurate description.
• However, large economies like the U.S., EU, Japan,
and China are interdependent because policies
in one country affect other economies.
Macroeconomic Interdependence under
Floating Exchange Rates (2 of 5)
• If the U.S. permanently increases the money supply,
the DD-AA model predicts for the short run:
1. an increase in U.S. output and income
2. a depreciation of the U.S. dollar
• What would be the effects for Japan?
1. an increase in U.S. output and income would raise
demand for Japanese products, thereby increasing
aggregate demand and output in Japan.
2. a depreciation of the U.S. dollar means an
appreciation of the yen, lowering demand for
Japanese products, thereby decreasing
aggregate demand and output in Japan.
– The total effect of (1) and (2) is ambiguous.
Macroeconomic Interdependence under
Floating Exchange Rates (3 of 5)
• If the U.S. permanently increases government
purchases, the DD-AA model predicts:
– an appreciation of the U.S. dollar.
• What would be the effects for Japan?
– an appreciation of the U.S. dollar means a
depreciation of the yen, raising demand for Japanese
products, thereby increasing aggregate demand and
output in Japan.
• What would be the subsequent effects for the U.S.?
– Higher Japanese output and income means that more
income is spent on U.S. products, increasing
aggregate demand and output in the U.S. in the short
run.
Macroeconomic Interdependence under
Floating Exchange Rates (4 of 5)
• In fact, the U.S. has depended on saved funds from
many countries, while it has borrowed heavily.
– The U.S. has run a current account deficit for
many years due to its low saving and high
investment expenditure.
Global External Imbalances, 1999–2016

During the first half of the 2000s, the large increase in the U.S. current account
deficit was matched by increases in the surpluses of Asian countries (notably
China), Latin America, and oil exporters. After 2008 the imbalances shrank
Macroeconomic Interdependence under
Floating Exchange Rates (5 of 5)
• But as foreign countries spend more and lend
less to the U.S.,
– Foreign interest rates are rising slightly
– the U.S. dollar is depreciating
– the U.S. current account is increasing
(becoming less negative).
Summary (1 of 4)
1. Internal balance means that an economy enjoys
normal output and employment and price stability.
2. External balance roughly means a stable level of
official international reserves or a current account
that is not too positive or too negative.
3. The gold standard had two mechanisms that helped
to prevent external imbalances:
– Price-specie-flow mechanism: the automatic
adjustment of prices as gold flows into or out of a
country.
– Rules of the game: buying or selling of domestic
assets by central banks to influence flows of
financial assets.
Summary (2 of 4)
4. The Bretton Woods agreement in 1944
established fixed exchange rates, using the U.S.
dollar as the reserve currency.
5. The IMF was also established to provide countries
with financing for balance of payments deficits
and to judge if changes in fixed rates were
necessary.
6. Under the Bretton Woods system, fiscal policies
were used to achieve internal and external
balance, but they could not do both
simultaneously, so external imbalances often
resulted.
Summary (3 of 4)
7. Internal and external imbalances of the U.S.—
caused by rapid growth in government purchases
and the money supply—and speculation about
the value of the U.S. dollar in terms of gold and
other currencies ultimately broke the Bretton
Woods system.
8. Arguments for flexible exchange rates are that
they allow monetary policy autonomy, can
stabilize the economy as aggregate demand and
output change, and can limit some forms of
speculation.
Summary (4 of 4)
9. Arguments against flexible exchange rates are
that they allow expenditure switching policies,
can make aggregate demand and output more
volatile because of uncoordinated policies
across countries, and make exchange rates
more volatile.
Question 1

Under a gold standard, describe how balance of payments

equilibrium between two countries, A and B, would be
restored after a transfer of income from B to A.
Question 2

Use the DD-AA model to examine the effects of a one-time

rise in the foreign price level, P*. If the expected future
exchange rate Ee falls immediately in proportion to P* (in line
with PPP), show that the exchange rate will also appreciate
immediately in proportion to the rise in P*. If the economy is
initially in internal and external balance, will its position be
disturbed by such a rise in P*?
Question 3

China had a current account surplus and was facing

moderate inflationary pressures in 2008. Show the location
of this economy on the II-XX diagram. What would be your
advice about Chinese fiscal policy?