Chapter 18 The International Monetary System,

Slide 18-2Copyright © 2003 Pearson Education, Inc. Introduction The interdependence of open national economies has made it more difficult for governments to achieve full employment and price stability. The channels of interdependence depend on the monetary and exchange rate arrangements. This chapter examines the evolution of the international monetary system and how it influenced macroeconomic policy.

Slide 18-3Copyright © 2003 Pearson Education, Inc. Macroeconomic Policy Goals in an Open Economy In open economies, policymakers are motivated by two goals: Internal balance –It requires the full employment of a countrys resources and domestic price level stability. External balance –It is attained when a countrys current account is neither so deeply in deficit nor so strongly in surplus.

Slide 18-4Copyright © 2003 Pearson Education, Inc. Internal Balance: Full Employment and Price-Level Stability Under-and overemployment lead to price level movements that reduce the economys efficiency. To avoid price-level instability, the government must: –Prevent substantial movements in aggregate demand relative to its full-employment level. –Ensure that the domestic money supply does not grow too quickly or too slowly. Macroeconomic Policy Goals in an Open Economy

Slide 18-5Copyright © 2003 Pearson Education, Inc. Macroeconomic Policy Goals in an Open Economy External Balance: The Optimal Level of the Current Account External balance has no full employment or stable prices to apply to an economys external transactions. An economys trade can cause macroeconomic problems depending on several factors: –The economys particular circumstances –Conditions in the outside world –The institutional arrangements governing its economic relations with foreign countries

Slide 18-6Copyright © 2003 Pearson Education, Inc. Problems with Excessive Current Account Deficits: –They sometimes represent temporarily high consumption resulting from misguided government policies. –They can undermine foreign investors confidence and contribute to a lending crisis. Macroeconomic Policy Goals in an Open Economy

Slide 18-7Copyright © 2003 Pearson Education, Inc. Macroeconomic Policy Goals in an Open Economy Problems with Excessive Current Account Surpluses: –They imply lower investment in domestic plant and equipment. –They can create potential problems for creditors to collect their money. –They may be inconvenient for political reasons.

Slide 18-8Copyright © 2003 Pearson Education, Inc. International Macroeconomic Policy Under the Gold Standard, Origins of the Gold Standard The gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of value. The Resumption Act (1819) marks the first adoption of a true gold standard. –It simultaneously repealed long-standing restrictions on the export of gold coins and bullion from Britain. The U.S. Gold Standard Act of 1900 institutionalized the dollar-gold link.

Slide 18-9Copyright © 2003 Pearson Education, Inc. International Macroeconomic Policy Under the Gold Standard, External Balance Under the Gold Standard Central banks –Their primary responsibility was to preserve the official parity between their currency and gold. –They adopted policies that pushed the nonreserve component of the financial account surplus (or deficit) into line with the total current plus capital account deficit (or surplus). –A country is in balance of payments equilibrium when the sum of its current, capital, and nonreserve financial accounts equals zero. Many governments took a laissez-faire attitude toward the current account.

Slide 18-10Copyright © 2003 Pearson Education, Inc. Internal Balance Under the Gold Standard The gold standard systems performance in maintaining internal balance was mixed. –Example: The U.S. unemployment rate averaged 6.8% between 1890 and 1913, but it averaged under 5.7% between 1946 and International Macroeconomic Policy Under the Gold Standard,

Slide 18-11Copyright © 2003 Pearson Education, Inc. The Interwar Years, With the eruption of WWI in 1914, the gold standard was suspended. The interwar years were marked by severe economic instability. The reparation payments led to episodes of hyperinflation in Europe.

Slide 18-12Copyright © 2003 Pearson Education, Inc. The Bretton Woods System and the International Monetary Fund International Monetary Fund (IMF) In July 1944, 44 representing countries met in Bretton Woods, New Hampshire to set up a system of fixed exchange rates. –All currencies had fixed exchange rates against the U.S. dollar and an unvarying dollar price of gold ($35 an ounce). It intended to provide lending to countries with current account deficits. It called for currency convertibility.

Slide 18-13Copyright © 2003 Pearson Education, Inc. Goals and Structure of the IMF The IMF agreement tried to incorporate sufficient flexibility to allow countries to attain external balance without sacrificing internal objectives or fixed exchange rates. Two major features of the IMF Articles of Agreement helped promote this flexibility in external adjustment: –IMF lending facilities –IMF conditionality is the name for the surveillance over the policies of member counties who are heavy borrowers of Fund resources. –Adjustable parities The Bretton Woods System and the International Monetary Fund

Slide 18-14Copyright © 2003 Pearson Education, Inc. Internal and External Balance Under the Bretton Woods System Speculative Capital Flows and Crises Current account deficits and surpluses took on added significance under the new conditions of increased private capital mobility. –Countries with a large current account deficit might be suspected of being in fundamental disequilibriumunder the IMF Articles of Agreement. –Countries with large current account surpluses might be viewed by the market as candidates for revaluation.

Slide 18-15Copyright © 2003 Pearson Education, Inc. Maintaining External Balance How do policy tools affect the economys external balance? –Assume the government has a target value, X, for the current account surplus. –External balance requires the government to manage fiscal policy and the exchange rate so that: CA(EP*/P, Y – T) = X (18-2) –To maintain its current account at X as it devalues the currency, the government must expand its purchases or lower taxes. Analyzing Policy Options Under the Bretton Woods System

Slide 18-16Copyright © 2003 Pearson Education, Inc. Expenditure-Changing and Expenditure-Switching Policies Point 1 (in Figure 18-2) shows the policy setting that places the economy in the position that the policymaker would prefer. Expenditure-changing policy –The change in fiscal policy that moves the economy to Point 1. –It alters the level of the economys total demand for goods and services. Analyzing Policy Options Under the Bretton Woods System

Slide 18-17Copyright © 2003 Pearson Education, Inc. Expenditure-switching policy –The accompanying exchange rate adjustment –It changes the direction of demand, shifting it between domestic output and imports. Both expenditure changing and expenditure switching are needed to reach internal and external balance. Analyzing Policy Options Under the Bretton Woods System

Slide 18-18Copyright © 2003 Pearson Education, Inc. Fiscal ease (G or T ) Exchange rate, E XX II Figure 18-3: Policies to Bring About Internal and External Balance 1 3 Devaluation that results in internal and external balance 2 4 Fiscal expansion that results in internal and external balance Analyzing Policy Options Under the Bretton Woods System

Slide 18-19Copyright © 2003 Pearson Education, Inc. The External Balance Problem of the United States The U.S. was responsible to hold the dollar price of gold at $35 an ounce and guarantee that foreign central banks could convert their dollar holdings into gold at that price. Foreign central banks were willing to hold on to the dollars they accumulated, since these paid interest and represented an international money par excellence. The Confidence problem The foreign holdings of dollars increased until they exceeded U.S. gold reserves and the U.S. could not redeem them.

Slide 18-20Copyright © 2003 Pearson Education, Inc. Special Drawing Right (SDR) An artificial reserve asset SDRs are used in transactions between central banks but had little impact on the functioning of the international monetary system. The External Balance Problem of the United States

Slide 18-21Copyright © 2003 Pearson Education, Inc. The acceleration of American inflation in the late 1960s was a worldwide phenomenon. It had also speeded up in European economies. When the reserve currency country speeds up its monetary growth, one effect is an automatic increase in monetary growth rates and inflation abroad. U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early Worldwide Inflation and the Transition to Floating Rates

Slide 18-22Copyright © 2003 Pearson Education, Inc. Table 18-1: Inflation Rates in European Countries, (percent per year) Worldwide Inflation and the Transition to Floating Rates

Slide 18-23Copyright © 2003 Pearson Education, Inc. Figure 18-5: Effect on Internal and External Balance of a Rise in the Foreign Price Level, P* Fiscal ease (G or T ) Exchange rate, E XX 1 II 1 1 Distance = E P*/P* II 2 XX 2 2 Worldwide Inflation and the Transition to Floating Rates

Slide 18-24Copyright © 2003 Pearson Education, Inc. Table 18-2: Changes in Germanys Money Supply and International Reserves, (percent per year) Worldwide Inflation and the Transition to Floating Rates

Slide 18-25Copyright © 2003 Pearson Education, Inc. Summary In an open economy, policymakers try to maintain internal and external balance. The gold standard system contains a powerful automatic mechanism for assuring external balance, the price-specie-flow mechanism. Attempts to return to the prewar gold standard after 1918 were unsuccessful. As the world economy moved into general depression after 1929, the restored gold standard fell apart and international economic integration weakened.

Slide 18-26Copyright © 2003 Pearson Education, Inc. Summary The architects of the IMF hoped to design a fixed exchange rate system that would encourage growth in international trade. To reach internal and external balance at the same time, expenditure-switching as well as expenditure- changing policies were needed. The United States faced a unique external balance problem, the confidence problem.

Slide 18-27Copyright © 2003 Pearson Education, Inc. U.S. macroeconomic policies in the late 1960s helped cause the breakdown of the Bretton Woods system by early Summary