International Monetary Exchange in
Theory
Satirical Cartoon of John Law’s Mississippi Scheme (Paris, 1720)
Lecture 11 – Tuesday, 18 October 2011
J A Morrison
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We’re at another turning point in
the course…
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PS 0304 Int’l Pol Econ
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Unit 1: Studying the Global Economy
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Unit 2: Trading Goods & Services
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Topic 4: Trade in Theory
Topic 5: Trade in Practice
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Unit 3: The International Monetary System
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Topic 1: Introductory
Topic 2: Perspectives on IPE
Topic 3: Explaining Foreign Economic Policy
Topic 6: The IMS in Theory
Topic 7: The IMS in Practice
Unit 4: Migration
Unit 5: Special Topics in IPE
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Lec 11: Money in Theory
I. Introductory: Money is Hard
II. The Basics of Monetary Exchange
III.The International Connection
IV.Exchange Rate Politics
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Lec 11: Money in Theory
I. Introductory: Money is Hard
II. The Basics of Monetary Exchange
• The International Connection
• Exchange Rate Politics
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Before we launch into the specifics
of international monetary
exchange, let’s step back to
consider international monetary
exchange in the context of
international trade.
How does money compare to
trade?
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Simply put, money is hard…
Money is hard for us—the
academicians—to understand.
And it is hard for policymakers to
control.
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Money is Hard for Us
• Less familiar than trade
• More abstract than trade & migration
• Money has changed more over time
– Variation in policies: fixed versus flexible
•  akin to change in trade policy: liberal versus
managed
– But money itself might be different:
commodity currency is governed by different
rules than is fiat currency
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Money is Hard for Policymakers
• More difficult to understand
• Imprecise, blunt instruments
• Money is more mobile  more difficult to
control
• Severe market constraints: attacks,
competition, counterfeiting, contagion, &c.
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So, the international monetary
system is more difficult for
policymakers to manage than is
trade.
But, arguably, the stakes are
higher…
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Money Matters
• The downside risk is greater
– Collapse of trade: ouch!
– Currency collapse  catastrophic!
• All interests are affected
– Some groups rely relatively little on trade
– Everyone uses money  tighter coupling with
macroeconomic effects
• Damage is harder to repair
– Violating a trade agreement causes upset
– States spend decades trying to repair reputations
after currency disorders
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Here’s our plan…
We’ll proceed as we did for trade: first
theory, then empirics.
Be prepared that money will be
challenging. I’ll do my best to unpack
the key terms and concepts. But you
might have to turn things up a notch.
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Lec 11: Money in Theory
I. Introductory: Money is Hard
II. The Basics of Monetary Exchange
• The International Connection
• Exchange Rate Politics
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II. BASICS OF MONETARY EXCHANGE
1. Background on Money
• Monetary Systems
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It’s easy to understand why we
trade goods & services: the
benefits of specialization are
readily apparent.
Understanding the invention
and use of money, however, is
less immediately obvious.
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Money serves three functions…
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(1) Medium of Exchange
• Money resolves “double coincidence of
wants problem”
Individual
Has
Wants
John
A Fedora
Air Jordans
Adam
Air Jordans
A Sweater Vest
Maynard
A Sweater Vest
A Fedora
 What are the chances that you’ll encounter
someone who has what you want and wants
what you have?
Hint: < Finding True Love
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Money evolves as a means to
resolve this problem.
Individuals accept a common
good with certain characteristics
(high value to bulk ratio,
divisible, durable, uniform in
quality) that becomes the
common medium of exchange.
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(2) Store of Value
• Money allows individuals to convert
perishables into more durable goods
• This allows:
– Storing value between transactions
– Saving by hoarding cash
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(3) Unit of Account
• Money provides a standard relationship
between various g&s in the economy
Non-standard Unit
Standard Unit
1 Blazer = 2 Air Jordans
Blazer = $200
2 Blazers = 5 Fedoras
Air Jordans = $100
4 Air Jordans = 5 Fedoras
Fedora = $80
 Using a standard unit simplifies
accounting and transactions immensely
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II. BASICS OF MONETARY EXCHANGE
1. Background on Money
• Monetary Systems
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Across history, nations have chosen a
wide variety of materials to serve as
money.
The ancient Greeks used cattle, some
Native Americans used wampum, and
the early Chinese used cowry shells.
Today, most countries use “paper”
currency, which is usually made from
cotton and/or linen.
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For most of history, in most places,
markets came to rely on specie-minted, precious metal coins.
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We can organize monetary systems
according to the various values of the
money…
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The Values of Money
• Intrinsic Value: market value of the
currency’s constituent material when used
for non-monetary purposes
– E.g. gold coin sold as material for jewelry
• Exchange Value: market value of the
currency when used as currency in trade
– E.g. gold coin used to purchase jewelry
• Extrinsic/Nominal Value: “official” value
and/or units
– E.g. “1 shilling,” “1 dollar”
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Monetary systems can be grouped
along a continuum according to the gap
between the intrinsic and the exchange
values of the currency.
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Types of Monetary Systems
Monetary
System Type
Intrinsic Value
Exchange Value Gap
Examples
Commodity
Money
Relatively High
High
Narrow or None
England in
1690s; Chinese
Cowry Shells
Fiat Money
Relatively Low
High
Very Large
USD today;
Euro today
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Seigniorage
• Historical Origin: charge at mint to convert
raw material into currency
– Also called “brassage” or “coinage”
• Modern Usage: “the excess of the nominal
value of a currency over its cost of
production” (Cohen, Future of Money, 18)
• Implications:
– Revenue source for state
– Creates incentive to counterfeit—(the
unauthorized creation of currency)
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Seigniorage and Monetary
Systems
• Commodity Money
– High seigniorage might be viewed as revenue
source (e.g. 18th C France)
– Low or no seigniorage would subsidize
exports and encourage capital inflows (e.g.
18th C Britain)
• Fiat Money
– Seigniorage is necessarily high; seigniorage
creates the difference of value between
intrinsic and exchange values
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The historical trend is clearly away from
commodity money and toward fiat money.
Policymakers generally prefer fiat money
because (1) they gain increased revenue
from seigniorage; and (2) the market imposes
fewer constraints on monetary policy when
using fiat money.
But the power to “print” money is frequently
abused. Some economists, like FA Hayek,
appreciated the discipline imposed by
commodity money systems.
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Lec 11: Money in Theory
I. Introductory: Money is Hard
II. The Basics of Monetary Exchange
III.The International Connection
• Exchange Rate Politics
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III. THE INTERNATIONAL
CONNECTION
1. The Nth Currency
2. Exchange Rate Regimes
• The Balance of Payments
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The same logic that impels the
development of a common
medium of exchange within
economies impels the adoption
of international media of
exchange between economies.
Such a currency is sometimes
called the Nth Currency.
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Gold & silver previously
performed this role.
After WWII, the US dollar was
the preeminent Nth Currency.
Today, the dollar faces
competition from the Euro, the
Yen, and the Renminbi.
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“The United States would be mistaken
to take for granted the dollar’s place as
the world’s predominant reserve
currency…Looking forward, there will
increasingly be other options to the
dollar.”
-- World Bank President Robert B. Zoellick (26 Sept 2009)
(Source: NYT 28 Sept 2009)
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Why would foreign states move
away from holding the dollar in
reserve and using the dollar in
international exchanges?
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 Because the dollar doesn’t
perform the functions of money
as well as it used to!
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The Dollar’s Declining Role
• Medium of Exchange
– US share of total GATT/WTO Member GDP
• 1948: ~65%
• 2001: ~38%
(Source: Barton, et al, p 13)
• Store of Value
– Market price of gold (per ounce) in $US
• 1945: $35/ounce
• 14 Oct 2009: $1063/ounce
• 11 Oct 2010: $1348/ounce
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The Falling Value of the USD
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III. THE INTERNATIONAL
CONNECTION
1. The Nth Currency
2. Exchange Rate Regimes
• The Balance of Payments
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How do states determine their
relationships to the Nth
Currency, whatever it might be?
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 Through their exchange rate
regimes.
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An exchange rate (ER) is the specific
valuation between domestic currency
and a foreign/international
currency/commodity.
British Pounds (GBP) per Dollar (USD)
A state’s exchange rate regime
is the set of rules that determine
the relationship (including
valuation) between domestic
currency and foreign currencies,
the Nth currency, and/or key
commodities.
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(For now, we assume governments enjoy
monetary sovereignty, the ability to control
the market value of their currencies.)
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How States Regulate the Value of the
Currency
• Intervention in Foreign Exchange (Forex)
Market
– Buy/sell reserves of domestic currency, foreign
currency, and/or a key commodity to directly affect
market prices
• Adjust Quantity via Monetary Policy
– Open Market Operations
– Fractional Reserve Rate
– Discount Rate (Interest Rate)
• By Proclamation and/or Price Controls
– “What was previously worth $1 shall now be worth
$5.”
– “Grain shall not be sold for less than $5 per bushel.”
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States can regulate the value of
the currency vis-à-vis:
- Foreign currency(ies)
- Key commodity(ies)
- The overall national price
level
 Is it possible to fix a currency with respect
to several things simultaneously?
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 Not usually.
Different parts of the economy grow at
different rates. Maintaining stability with
respect to one generally precludes
stability with respect to the others.
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Pick a Price, Any Single Price
• Assume Different Rates of Growth
– World supply of gold: 2%
– US GDP: 3%
– British GDP: 1%
• What should be rate of increase of US
dollars?
– Stable gold price: 2%
– Stable overall price level: 3%
– Stable ER vis-à-vis pound: 1%
 Stability can only be maintained along
one dimension at a time
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Exchange rate regimes exist
along a continuum: to what
extent does the state use its
monetary sovereignty to
maintain a stable exchange rate
in the market?
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Exchange Rate Regimes
Intervention to Maintain
Stability
Names of ER Regime
Examples
High
Fixed; Pegged
GB on Gold Standard;
Hong Kong Dollar
High Intervention with
Periodic Adjustment
Fixed-but-Adjustable;
Crawling Peg
Mexico in 1990s; Some
Gold Standard Countries;
China
Low or None
Flexible; Floating; Free
Float
US Dollar; Yen; GBP;
Euro
-- We’ll sometimes simplify things, talking here in terms
of regimes that are “fixed” and those that are and
“flexible/adjustable.”
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NOTE: the de facto fluctuations
in market value may not always
align with the de jure regime…
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Government management
sometimes fails to achieve its
goal…
“Fixed” ER regimes do not always
generate stable market ERs.
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And sometimes states claim to
have “flexible” ERs but, in reality,
regulate them such that their
market values remain stable.
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Mexico & Switzerland in the
1990s
Country
De Jure (Official) ER
Regime
Market ER Trends
Mexico
Fixed vis-à-vis the dollar
Volatility; de facto float
Switzerland
Flexible
Stability; de facto peg vis-à-vis the
dollar
Grieco & Ikenberry, 62.
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 So, again, note that the
regime is determined by what
the monetary authority actually
does, not what it promises to
do.
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III. THE INTERNATIONAL
CONNECTION
1. The Nth Currency
2. Exchange Rate Regimes
• The Balance of Payments
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Well, Dewb, I thought
you could use a
refresher...
Bunsen, I thought we
were done with the
balance of
payments!!!
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Remember that the balance of
payments (BoP) reconciles all
of a country’s financial
transactions with the world.
This includes trade, remittances,
investment, loans, &c.
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You should also remember that
the ER regime determines, in
part, how balance in the BoP is
maintained.
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BoP Adjustment under Flexible
ER Regime
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How do states achieve balance
while keeping the ER fixed?
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Remember this slide?
Lecture 6: Balance of Payments (Slide #38)
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Reconciling the Balance of
Payments with Fixed ER
1. Adjustment of Reserves
2. Adjustment of Internal Prices &
Incomes
3. Exchange Rate (ER) Adjustment
4. Exchange Controls
1. Capital Controls: Limit convertibility
2. Commercial Policy
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1. Adjustment of Reserves
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2. Macroeconomic Adjustment
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4.1 Capital Controls
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4.2 Commercial Policy
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Lec 11: Money in Theory
I. Introductory: Money is Hard
II. The Basics of Monetary Exchange
III.The International Connection
• Exchange Rate Politics
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Note that the title of this section comes
from Jeff Frieden’s piece.
We know from scholars like Frieden &
Cohen that states’ choices about their
exchange rates are intensely political.
So, we can draw on our theories of
political economy to understand the
political underpinnings of the
international monetary system.
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Systemic Theories: Distribution
of Power
• Charles Kindleberger (1973)
• International Monetary System requires
stabilization
– Serve as lender of last resort
– Provide liquidity
• Hegemonic Stability Theory: hegemon is
willing and able to stabilize the system
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Domestic Interests
• Jeff Frieden (1988); J. Lawrence Broz
(1997)
• Like trade, exchange rate policy helps &
hurts economic interests
• Interest groups will form coalitions to
lobby for the policies that serve them
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Domestic Institutions
• Karl Polanyi (1973)
• Institutions mediate influence of lobbying
groups
• E.g. Gold Standard
– GS benefits wealthy at the expense of the
poor
– 19th C: workers were disorganized and
unrepresented  tolerate GS
– 20th C: empowered workers bring end to GS
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Policymakers’ Ideas
• Keynes
• Gold standard rested on the theory that it
maximized public good
– Golden handcuffs restrained perfidious
politicians
– Employment would take care of itself
• Abandoning GS required changing
people’s minds!
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