International Economic Policy:

Up to this end the economy's exchange rate is a floating rate one that rises and falls freely as provide balances demand in the market for foreign exchange. This chapter alters the focus and considers alternative international monetary arrangements. How do substitute arrangements chiefly fixed exchange rate systems work? What relative costs as well as benefits are of fixed versus floating exchange rates? How did we appear at our current system of largely floating exchange rates? And what dissimilarity does it make?

For most of the past century the leading international exchange rate regime has been one of fixed not floating exchange rates. This chapter starts on by sketching out the economic history of the international monetary system in order to understand how we got from here to there. It then examines how the economy works when the government fixes the exchange rate. The chapter concludes by analyzing a few of the major international shocks to the world economy in the 1990s. Three separate main international financial crises struck during that decade- the Mexican crisis of 1995, the European crisis of 1992 and the East Asian crisis of 1997-1998.

The Classical Gold Standard:

In the generation prior to World War I nearly all of the world economy was on a particular fixed exchange rate system- the gold standard. A government would describe a unit of its currency unit as worth such-and-such an amount of gold. It would set ready to buy or sell its currency for gold at that price at any time for any amount. Such a currency was convertible for it could be transformed into gold freely and gold could be converted into it freely. The currency’s worth in terms of gold was its parity.

While two countries were on the gold standard their nominal exchange rate was fixed at the ratio of their gold parities. Someone desiring to turn British currency pounds sterling into U.S. currency American dollars could start by taking British currency to the Bank of England and exchanging it for gold at the pound's parity. They would then transport the gold across the Atlantic to New York takes it to the U.S. Treasury office in New York as well as exchanges it for dollars.

At the post World War II parities of the Bretton Woods gold exchange standard the U.S. dollar was define as equivalent to 1/35 of a troy ounce of gold and the British pound sterling was set equal to 1/15.58333 ounces of gold. Therefore the exchange rate of the dollar for the pound was £1.00 = $2.40. At the parities that had succeed from 1869 to 1931 with an interruption for World War I the dollar-pound exchange rate was £1.00 = $4.86.

Suppose that supply as well as demand in the market for foreign exchange in 1910 had balanced not at £1.00 = $4.86 however at some other value--say £1.00 = $5.00. Someone with an inoperative pound sterling note could then get $5 for it if they sold it on the foreign exchange market. However with their $5 they could then buy enough gold at the U.S. Treasury to recuperate their original £1 and have fourteen cents left over. Therefore if the market exchange rate ever drifted up from £1.00 = $4.86 to £1.00 = $5.00 a enormous mass of people selling pounds would enter the market and drive the exchange rate back to £1.00 = 4.86 as they try to carry out this currency arbitrage outlined at greater length.

Therefore under the gold standard nominal exchange rates were fixed at the ratio of countries' gold parities. The gold typical was a fixed exchange rate system:

This system grew up slowly. Its origins approach when Sir Isaac Newton in his government job as Master of the Mint in Britain fixed the gold parity of the British pound sterling. For the reason that the industrial revolution began in Britain, Britain grow to be the largest trading nation in the world in the nineteenth century. Other countries’ governments sought simple access to the British market for the products made by their citizens. A fixed gold parity intended the prices their countries’ producers charged would appear stable to British customers. A fixed gold parity intended that British investors would not fear that depreciation and devaluation would erode the value of the principal that they had lent. All through the late nineteenth century country after country joined the gold standard. Through the eve of World War I the overwhelming fraction of world commerce and investment flowed between countries all on the gold standard.

A Gold Standard Tends to Produce Contractionary Policies

Even in its turn-of-the-last-century heyday around 1900 it was already obvious that the gold standard had definite serious weaknesses as an international monetary system. The most significant of these weaknesses was that the gold standard tended to be deflationary. It tended in a few circumstances to push countries to raise their interest rates to reduce production and raise unemployment. And it never offered a countervailing push to other countries to lower their interest rates to elevate production and to lower unemployment.

To see why we require digressing for a moment into the role played under a gold standard by a country’s gold and other foreign-exchange reserves. If the exchange rate is floating foreigners' domestic-currency earnings should be used to buy domestic exports or be invested in the home country- there is nothing else that is able to be done with them. Under floating rate system a country’s net exports NX plus net investment from abroad NIA should add up to zero:

NX + NFI = 0
     
As well as the exchange rate moves up or down in response to the supply and demand for foreign exchange in order to make this so.

In a gold standard things are different. There is an added participant in the market- the country's Treasury or central bank. There is something besides that you can do with your foreign-currency earnings other than using them to acquire imports or for investments abroad. You can as well take your foreign-currency earnings to the foreign country’s Treasury turn them into gold and ship the gold back home take the gold to your own Treasury and turn your gold into real spendable ready cash. In a gold standard it is net exports plus net investment from abroad deficiency the flow of gold into your country FG that together add up to zero:

NX + NIA – FG = 0

What happens if a country discovers that net exports plus net investment from abroad are less than zero? Its Treasury will discover itself losing gold as a long line of foreigners come into its office demand gold in exchange for currency and then ship the gold out of the country. With every transaction the country’s gold reserves shrink. Ultimately the government's gold reserves are gone.

At this time the country has a choice. One alternative. Is for it to dispose of the fixed exchange rate system. It shut the gold window announces that the country will no longer buy back its currency at the established gold parity abandon its fixed exchange rate and let the exchange rate float. The merely other option is to solve its gold-outflow problem by making it more attractive for foreigners to invest. The way to raise net investment from abroad is to raise domestic interest rates. If net investment from abroad increases enough gold will no longer flow out.

Therefore under gold standard countries running persistent balance of payments deficits-- losing gold should eventually increase interest rates to stay on the gold standard. Nevertheless excess countries those gaining gold face no symmetrical crisis in which they should lower interest to stay on the gold standard. Their central bank is able to lower interest rates if they wish. However if they don’t so wish they can keep interest rates constant and watch their gold reserves grow.

This asymmetry signifies that a fixed exchange-rate system like the gold standard puts periodic contradictory pressure on the world economy. Such force turned the interwar period into a disaster for such contradictory pressure on countries to raise interest rates imposed by the gold standard played a main role in generating the worldwide Great Depression of the 1930s.

The Collapse of the Gold Standard:

The international gold standard was hovering when World War I began in 1914. Each country used inflation to help finance its massive war expenditures. Inflation was contradictory with the gold standard. In the gold standard attempted inflation simply leads everyone to immediately trade their currency into solid gold.

Subsequent to the destruction of World War I was over politicians as well as central bankers sought to restore the gold standard. They supposed that the pre-World War I gold-standard fixed exchange-rate system had been a success. They supposed that restoring it was an significant step to restoring general economic prosperity. The pre-World War I gold standard had finally delivered forty years of more rapid economic and industrial growth than the world had ever before seen.

It took additional than half a decade to fully restore the gold standard. However the revived gold standard did not produce prosperity. In its place in less than half a decade the Great Depression began and the restored gold standard broke apart. The consensus of economic historians at present is that the Great Depression had its principal origin in the United States where for reasons not fully understood a few combination of small shocks set off a downward spiral of destabilizing deflation. However a combination of mistaken policies and flaws in the functioning of the post-World War I gold standard then speedily amplified the Great Depression and propagated it around the world.

Economists Barry Eichengreen along with Ben Bernanke argue that four factors made the post-World War I gold standard a much less secure monetary system than the pre-World War I gold standard

a) Everyone recognized that governments could abandon their gold parities in an emergency. Finally they had done so during World War I. Therefore everyone was eager to turn their holdings of currency into gold at the first sign of trouble. This denoted countries had to maintain much larger gold reserves in order to keep the gold standard functioning.

b) Everyone recognized that governments had taken on the additional responsibility of trying to keep interest rates low sufficient to produce full employment.

c) Countries subsequent to World War I held their reserves not in gold but in foreign currencies. This was fine in normal times however it meant that at the first sign of trouble not only would citizens show up trying to turn their currency into gold but foreign central banks would do so too greatly multiplying the magnitude of the gold outflow.

d) The post-World War I excess economies the United States and France didn’t lower their interest rates as gold flowed in.

These factors denoted that as soon as a recession set in and gold drains began from countries with weak currencies their governments found themselves under immediate and massive pressure to raise interest rates and lower output further if they were to stay on the gold standard. If they reside on the gold standard, they guaranteed themselves high real interest rates and deep depression. If they discarded the gold standard they went against all the advice of bankers and gold standard advocates.

There was a clear deviation in the 1930s among those countries that abandoned the gold standard early in the Depression and those that stubbornly clung to gold. Those that adhere to their gold parities found themselves forced to raise interest rates and contract their money supplies in order to avoid large gold losses that would rapidly exhaust their reserves. Those that discarded the gold bloc and floated their exchange rates could avoid deflation and avoid the worst of the Great Depression. In the middle of the 1930s the Great Depression was in full swing and the gold standard was over.

The Bretton Woods System:

After World War II everyone received careful note of what they thought had gone wrong subsequent to World War I. Led by Harry Dexter ashen for the United States and John Maynard Keynes for Great Britain governments attempted to set up an international monetary system that would have all the advantages and none of the drawbacks of the gold standard. The system they set up arrives to be called the Bretton Woods system after a New Hampshire mountain resort town that was the location in late 1944 of a key international financial conference.

Three principles directed this post-World War II international monetary system.
a) In ordinary times exchange rates must be fixed- fixed exchange rates encouraged international trade by formulating the prices of goods made in a foreign country predictable and so had powerful advantages.

b) In extraordinary times whenever a country find itself in recession with a considerably overvalued currency that discouraged its exports or found itself suffering from inflation for the reason that an undervalued currency raised the prices of imports and stimulated export demand exchange rates must be changed. Such fundamental disequilibrium could be fixed by revaluing or else devaluing the currency and should be fixed.

c) An institution was required the International Monetary Fund to watch over the international financial system. The IMF would formulate bridge loans to countries that were adjusting their economic policies. It would make sure that countries didn’t abuse their privilege of changing exchange rates. Exchange rate devaluation as well as revaluation would remain an exceptional measure for times of fundamental disequilibrium, rather than flattering a standard tool of economic policy.

Our Current Floating-Rate System:

The Bretton Woods system in its turn bankrupt down in the early 1970s. The United States observes inflation accelerate in the 1960s. It found itself with an overrated exchange rate and an important trade deficit at the end of the 1960s. The United States sought to lessen its currency- to reduce the value of the dollar in terms of other currencies, thus that exports would rise and imports would fall.

Policy makers in other countries supposed that the United States should instead raise interest rates. Elevated United States interest rates would formulate foreigners more willing to invest in the United States. The foreign currency loyal to those investments could then be used to finance the excess of imports over exports that was the U.S. trade deficit. In the end the impasse was broken by unilateral American action and the Bretton Woods system fell apart.

Ever since the early 1970s the exchange rates at which the currencies of the major industrial powers trade against every other have been “floating” rates. The exchange rate is set by the government however fluctuates according to the balance of demand and supply on that day in the foreign exchange market. There seem to be some if any prospects for a restoration of a global system of fixed exchange rates over the next generation. Therefore this book has assumed as its standard case that exchange rates are free to float and are set by market forces.

Nevertheless the older system is worth studying for three reasons. First of all understanding the functioning of a fixed-rate system sheds light on how a floating rate system works and Secondly economic policy makers are and will continue to debate the costs and benefits of fixed rate relative to our current floating-rate system. Third maybe the pendulum will swing back in a generation and we will find ourselves once more in a fixed exchange rate system.

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