The Collapse of Bretton Woods 4/29/09
Objectives:
1. Review Bretton Woods Adjustable Exchange Rate System
2. Understand the reasons for the Adjustable Rate System early success
3. Understand the reasons for the collapse of the adjustable rate system
4. Use the Purchasing Price Parity hypothesis to predict currency exchange rates
5. Impact of inflation on exchange rate
6. Review Mundell Trilemma
7. Recognize the role of hot capital and financial instability
Bretton Woods:
? Adjustable Pegged Exchange Rate System
? Central Role of USD and Gold
? Countries can either use USD or gold to settle international imbalances: Dollar becomes the international currency (international contracts written in USD)
Example: Argentina runs a balance of payments deficit with France
? Current Account deficit
? Capital Account deficit
? France can decide:
1. Hold Argentina Peso
2. Ask for Gold from Argentina’s reserves
3. Ask for USD from Argentina’s reserves
? As Argentina loses reserves it can turn to IMF for help
? Short term loans to cover balance of payments deficits
? Eventually may have to devaluate Peso
? What is right exchange rate?
? Purchasing Power Parity (PPP) hypothesis
? Based on the Law of One Price: in perfectly efficient markets identical goods that can be traded will have the same price
? Long run exchange rates should reflect this.
? Example Ton of Steel 500 USD 250 Euro predict exchange rate 2USD:1 Euro
? If US experience inflation and Europe does not price in US $750 3USD:1 Euro
? Possible Cause of Argentinean balance of payments crisis: Inflation
Early BW system: works well
? USD strong relative to other currencies because economy is strong
? Dollar shortage: countries want to hold dollars to finance recovery projects
? Relatively limited short term capital flows
? Replacement of international borrowing with FDI by corporations
? Very low inflation rates in 1952-1966
Later problems
? Convergence of industrial economies
? Increased ability of capital to avoid controls
? Twin Wars: poverty and Vietnam
? Inflation created inequality of $35: oz of gold
? World Experience Dollar overhang
? Depletion of gold reserves
1971
? Richard Nixon faces dilemma
? Raise interest rates to try to defend dollar and set off recession OR
? Take US off gold standard
? Closes “gold window” in 1971 essentially ending BW exchange rate system
? Political or Economic?
Mundell Trilemma: A nation can AT BEST hope for two of the following:
? Fixed Exchange Rate
? Independent use of counter cyclical monetary policy (adjusting interest rates to influence macroeconomy)
? Free Flow of Capital
Advantage of Fixed Exchange Rate
? Increased international trade through reduction of FX risk
? Predictability of international debt
Advantage of Independent monetary policy
? Ability to smooth out business cycle associated with capitalist economies
Advantage of free flow of international capital
? Ability to finance:
? Development projects
? Government deficit spending without “crowding out”
Why the trilemma
? Example of recession
? Lower interest rates (attempt to increase investment and/or consumption)
? Capital tends to flow out of economy
? Recession and low interest rates put downward pressure on currency
Examples of solutions
? Gold Standard
? Fixed Exchange Rate
? Free Flow of Capital
? Monetary policy tends towards pro-cyclical
? Bretton Woods
? Pegged Rate system
? Ability to practice counter cyclical monetary policy
? Capital controls
? Euro Zone
? Fixed Exchange Rate (single currency)
? Free Flow of Capital
? ECB sets monetary policy
? Post 1971 US
? Free flow of capital
? Independent use of monetary policy
? Significant degree of FX risk
? Post 1978 China
? Fixed to dollar
? Limited use of monetary policy
? Significant capital controls
Minsky Instability Hypothesis
? Capitalism is subject to financial bubbles
? Financial bubbles can destabilize international economy
? Current financial Crisis as example
? Traditional solution: lender of last resort to restore capital flows
? Works only if lender of last resort is large enough to make necessary loans
Presentation on Bretton Woods 4/22/09
Objectives
1. Review determinants of foreign exchange values
2. See how historical context influences Bretton Woods system as it relates to currency speculation and capital flows
3. Understand how the Bretton Woods adjustable pegged rate system was supposed to work and the role of the IMF within this system
4. Recognize the underlying ideology in the Bretton Woods system
5. Introduce the Mundel Trilema
Review of determinants of FX
· Demand
o Exports: Foreign desire to buy domestic good
o Capital Flow: Foreign desire to buy domestic financial asset
o Intervention: Governments/central banks buying currency
o Speculation: Buying a currency based on belief it will increase in value
· Supply
o Imports: domestic desire for foreign good
o Capital Flow: Domestic desire to by foreign financial asset
o Intervention: Government/central bank selling currency
o Speculation: Selling currency based on belief it will decrease in value
Note role of speculation in two gold standards
· Stabilizing speculation
o Speculators believe that central banks/state will take coordinated policies to solve problems
· Destabilizing speculation
o Speculators believe that central banks/state will not be able to coordinate policies
· In pre WWI gold standard it was accepted that Bank of England
o Willingness to sacrifice domestic economy through interest rate changes
o Stabilizing speculation
· In interwar gold standard US central bank (Federal Reserve) would not coordinate state/central bank actions to maintain gold standard.
o Explicitly prevented from coordinating state/central bank due to isolationist congress.
o Changes in political climate make it much more difficult to sacrifice domestic economy in order to maintain gold standard
o Competitive nature of state relations leads to competitive devaluation to stimulate exports
Role of capital flows for long run economic growth
· In capitalist system the financial institutions (banks, stock and bonds markets) play a key role in moving savings to investment
· Investment key to economic growth by increasing productivity
· International flows of capital from high saving England important factor in growth in other emerging economies in 19th century
· Fixed rate gold standard promotes capital flows
Role of capital flows in destabilizing capitalist domestic and world macroeconomy
· Hot capital
· Financial bubbles
Bretton Woods
· Goal: restore international trade
o Enhance human material well-being
o Enhance peace through economic cooperation
Two Key players at B-W
o US-Dexter White
o UK-John Maynard Keynes
Note role of ideology in creating institutions
· Classical Liberal consensus: markets self correcting in long run
· Emerging Keynesian consensus: market need rational state intervention to counter emotional nature of markets
Bretton Woods: Adjustable Pegged Rate--solution to FX risk
· Dollar pegged to gold (US gold standard)
o $35 to ounce
· Other currencies pegged to dollar
· Dollar and gold become international reserve currency
· Currency pegs can be adjusted when pegs cannot be maintained
o Depreciation
o Appreciation
Currency depreciation and appreciation coordinated through International Monetary Fund (IMF)
· Nations experiencing trade deficits experience reserve outflows
· IMF can make short term loans to cover outflow
o Conditionality
· Oversee “orderly” revaluation
Bretton Woods: Accommodation of Keynesian counter-cyclical policy
· Keynesian macroeconomic tools: fiscal and monetary policy
· Monetary policy-raising and lowering of interest rates
o Possible impact of capital flows on exchange rates
· Restrict capital flow
Example: France and Germany
· Accommodation of Keynesian counter-cyclical policy
· Due to German experience with hyperinflation prefer higher interest rates to keep inflation rates low
· France prefers lower interest rates to keep employment high
· Without capital restrictions DM would appreciate and FF would depreciate
Mundel Trilema
· At best any international financial system can have 2 of the following 3 components
o Stable Foreign exchange
o Free capital flows
o Independent monetary policy
Bretton Woods: an example of institutional analysis
· Institutions tend to be designed to bring stability and predictability
· Institutions reflect ideology
· Reality unpredictable so institutions give rise to unintended consequences
John Maynard Keynes and Lydia Lopokova
Presentation on Interwar Gold Standard 4/14/09
NOTES
Goals:
Understand and appreciate how economic institutions reflect beliefs/ideology and how they can unintentionally impact economic outcomes.
Understand how the interwar gold standard helped globalize and exacerbate the Great Depression
Describe some of the structural changes that led to the failure of the laissez faire orthodox hypothesis of the self correcting economy.
Understand how the lack of leadership on the part of the US contributed to the failure of the interwar gold standard.
Understand the financial imbalances created by the Treaty of Versailles and the US refusal to forgive war loans created unsustainable international capital flows.
Lecture:
The goal of those in policy making positions was to encourage international economic recovery after WWI by reconstructing the gold standard of the late 19th Century.
 | Trade increases economics activity and wealth by efficiently allocating resources |
| Robust economic activity encourages domestic stability. |
| International trade encourages international peace |
Gold Standard is a fixed rate exchange system where each participating country establishes a fixed price for gold (conversion rate). Example:
| 20 USD= 1oz of gold. |
| 4 UKPS= 1oz of gold |
| 20 USD=4 UKPS |
| or $5 = £1 |
The fixed rate system eliminates foreign exchange rate risk (FX risk) which in turn encourages international trade.
|
Example of two choices- travel of Vancouver BC or New York |
|
Uncertainty (risk) can reduce trade and potentially reduce economic activity |
But how are exchange rates really established?
| In a market system any “exchange rate” is a matter of supply and demand |
| Example: exchange rate between Big Mac and USD is “set/fixed” by government at 1 Big Mac to $2.00 |
| Now suppose that a study shows that the more Big Macs one eats the more likely that they will die before 30 |
| Demand decreases and this puts a downward pressure on price (exchange rate) |
| How does the government get the price back up? |
Currency exchange rates are no different than any other price.
| Demand (for $)
| ||||||||
| Supply
|
Exchange rate systems (regimes) that allow supply and demand determine the exchange rates are called floating systems
| During wars countries suspend convertibility because financing war is more important that reducing FX risk |
| Right after war (1920 to 1925) system allowed to float |
| Exchange rate systems are unstable |
Exchange rate systems that manipulate supply and demand in order to keep exchange rates constant are fixed rate systems. How do they do this? Example:
| Suppose British citizens decide to switch from domestic beer to imported French wine. | ||||
| Pound decreases in value (depreciates) and French Franc increases in value (appreciates) | ||||
| Bank of England needs to increase demand for pound:
| ||||
| Bank of France needs to increase supply of Francs
|
Notice that the interest rate policy is driven by exchange rate concerns rather the domestic economic conditions
| England is contacting economy |
| France is stimulating economy |
Why would economic policy makers sacrifice domestic economic activity for exchange rate stability?
| Self correcting hypothesis of orthodox economic theory |
| Economy always moves towards full employment in the long run regardless of interest rates |
| England: increase unemployment will cause wages to drop and price levels will then drop |
Core assumption of orthodox (classical liberal) school of thought: wages and prices are flexible
| Changes in structure of capitalist economies after 1890 |
| Rise of Oligopoly |
| Increase power of unions |
| Both result resist decrease in prices by decreasing supply |
| Rise of heterodox theory: Keynes |
Source of International Financial instability in during 1920s
|
Treaty of Versailles-War Reparations |
|
Germany had to pay France and Great Britain for damages cause by WWI |
|
War Loans |
|
US insistence that France and Great Britain had to pay off war loans |
|
Impact on International capital flows |
Lack of leadership by US and cooperation among gold standard countries cause speculators to bet against exchange rate stability
|
Nineteenth century speculators believed that governments would cooperate to protect exchange rate England led a coordinated efforts by central banks Participating countries see it in their interest to cooperate
|
|
Interwar speculators doubted that the that governments would cooperate to protect exchange rate US Congress explicitly prohibits Federal Reserve and Treasury department involvement in efforts to coordinate central bank actions Participating countries see no reason to cooperate to help other countries maintain fixed rate |
When financial bubble in US stock market takes off it disrupts capital flows
|
Countries depending on US capital inflows collapse |
|
Countries have to individually handle exchange rate dilemmas |
As world moves into depression countries faced with trade-off of domestic economic performance and maintenance of gold standard
|
Those countries that abandon gold standard early recover more quickly than those that stay with it. |
Modified by Brad DeLong UC Berkeley