Lecture 9: Globalization &
international monetary regimes
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Starting observation: tremendous variation in
international monetary regimes over time.
First wave of globalization: gold standard floats
Interwar: gold exchange standard floats
Bretton Woods: (gold) dollar exchange standard
Post-BW: dirty/crawling/hard pegs
Introduction
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Introduction
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Key policy question here is whether countries fix
their exchange rate—that is, peg it—or let it to
be determined by the market—that is, float it.
If we understand countries’ constraints and
subsequent decisions, we might be able to
explain big swings in regimes like:
1.) Gold standard (70%) versus pure float, 1913
2.) Gold standard (0%) versus pure float, 1939
Introduction
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Need to examine in more detail the nations of the
world’s experience with international monetary
regimes.
Allows us to answer the following questions:
1.) why do countries fix exchange rates?
2.) what allows countries to fix exchange rates?
Introduction
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First, need to be more explicit with what we
mean by a fixed exchange rate regime.
Simply, a policy objective adopted by a country
to fix the relative value of their currency in terms
of another currency or a basket of currencies.
NER held (relatively) constant by intervention,
Organizing principles
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Second, need to consider why a country might
peg its exchange rate with another currency.
Simply, a peg might boost trade and capital
flows, especially those flows of longer durations.
Why? A reduction in uncertainty over payments
and profits; also a reduction in transaction costs.
Organizing principles
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But do countries that have a peg trade more with
each other (all else equal)?
Use a gravity model:
GDP1  GDP2
Trade12  

n
d12
ln(Trade12 )  1 (GDP1  GDP2 )   2 ln(d12n )  3 ( peg12 )
Organizing principles
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Organizing principles
At the same time, gains from a peg are larger
when cross-border transactions are larger in size.
That is, a country is more likely to enter a
pegged exchange rate with another country if
they already trade a lot with one another.
Thus, an endogeneity problem
Organizing principles
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If pegs stimulate trade and investment (and if
these are good things), then why don’t all
countries peg their exchange rates?
Naturally, there are costs associated with a fixed
exchange rate regime.
This idea of comparing the benefits and costs
Organizing principles
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And so, what is this trilemma business?
A trilemma is when there are three options and a
choice must be made between them.
Here, countries face the following menu:
1.) Fixed or floating exchange rates
2.) Free or constrained capital mobility
Organizing principles
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How to proceed?
First, consider the implications of a fixed ER
regime for monetary policy.
Since nominal exchange rates are in part
determined by interest rate differentials, central
banks will have to change domestic interest rates
Organizing principles
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The HK dollar and USD as an example:
iHK  iUS
but under a fixed exchange rate regime
e
EHKD
/USD  EHKD /USD
EHKD /USD
Organizing principles
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Consider the conditions for equilibrium in the
HK money market:
the supply of real money balances =
the demand for real money balances
But uncovered interest parity implies that:
Organizing principles
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Now, notice everything is exogenously given:
the price level (P), liquidity preferences (L), the
nominal interest rate (i), and real income (Y).
Thus, the central bank of HK’s hands are
effectively tied in terms of monetary policy.
But what if they tried to decrease the supply of
HK dollars?
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And this is the very essence of the trilemma…
iHK
e
EHKD
/USD  EHKD /USD
 iUSA 
EHKD /USD
e
EHKD
/USD  EHKD /USD
EHKD /USD
iHK  iUSA
If HK tried to assert monetary policy autonomy,
last condition would be an inequality
Organizing principles
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So, what are the combinations of economic
policies available from the menu?
1.) A fixed ER regime, capital controls, and
monetary policy independence;
2.) A fixed ER regime, international capital
mobility, and monetary policy dependence
Organizing principles
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Putting it all together…
The cost-benefit analysis for why countries peg.
Benefits:
1.) greater trade and investment versus
Costs:
Organizing principles
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Organizing principles
As discussed previously, first wave of
globalization as a period of unprecedented—and
in some instances, unsurpassed—global flows.
Also witnessed rise of a symmetric international
monetary regime with no country at its center.
In 1910, adherents of GS accounted for at least
70% of all nations, global GDP, and global trade.
The rise and fall of the gold standard
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What explains the rise of the gold standard?
1.) contingency/luck
2.) financial orthodoxy; market’s seal of approval
3.) its effects on trade and capital flows working
in combination with network effects.
The rise and fall of the gold standard
Under GS, money supply was determined by the
stock of gold for all intents and purposes; central
banks only set mint prices of gold.
Price of gold in England, PE, set at £4.24/oz;
price of gold in France, PF, set at 107FF/oz.
Gold then acts at the numeraire good for the two:
mint prices imply a par exchange rate (Epar)
The rise and fall of the gold standard
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Arbitrage in international markets actually a
stabilizing influence by helping keep exchange
rates fixed; no need for government intervention.
Deviations in E from Epar as arbitrage
opportunities.
If E was 25FF/£ in Paris versus Epar= 25.23FF/£
in London…what should you do if you had one
ounce of gold in Paris?
The rise and fall of the gold standard
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As was suggested before, this was a fully
decentralized system with:
1.) no formal principles;
2.) no formal international treaties, and
3.) no lender-of-last resort (much less a central
bank in some countries; 1914/34 for NA).
The rise and fall of the gold standard
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Any trade imbalances were to be resolved
through the price-specie flow mechanism:
Implies monetary authorities are “hands-off”.
The rise and fall of the gold standard
With outbreak of WWI, countries suspend
convertibility of currencies; GS shut down.
But at its end, market participants along with
governments expect nations to get back on gold
once things return to normal.
One underappreciated issue (by policymakers):
differential rates of inflation meant that countries
The rise and fall of the gold standard
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The interwar period was characterized by the
resurrection of the gold standard through the
combination of:
1.) a desire to return to the pre-war level of
global economic integration; and
2.) a desire to reclaim national status and prestige
The rise and fall of the gold standard
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Even though this was still not a centralized
system, the period did mark:
1.) attempts to ease some of its constraints on Ms
2.) attempts to formalize its mechanisms;
3.) attempts to establish an international lenderof-last resort in the form of the BIS;
The rise and fall of the gold standard
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What explains this rapid fall of the resurrected
gold standard?
1.) a potential breakdown in the price-specie
flow mechanism:
2.) a definite change in political economy:
The rise and fall of the gold standard
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After WWII, general fear of currency instability
of the interwar…but also a mistrust of the gold
standard and its inflexibility.
General desire to rebuild international trading
system…but also acute political pressures for
active macroeconomic policy.
End result of “stability plus managed flexibility”:
The rise and fall of Bretton Woods
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Despite that this was a fully centralized system,
market participants viewed it as a non-credible
commitment on the part of governments.
So much so that divergences between official
ERs and (black/shadow) market rates were both
large and widespread.
The rise and fall of Bretton Woods
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But for all this, collapse of the Bretton Woods
system was a somewhat drawn-out process.
1.) capital controls of Bretton Woods era—
although initially effective—were more easily
evaded, and the trilemma reared its head again.
2.) The USD had become significantly
The rise and fall of Bretton Woods
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USD gold coverage plummeted in 1969/70 from
roughly 50% to 20%, due to inflation from
Vietnam War and the Great Society project.
What is more, the US began running persistent
trade deficits from 1971…the first time a trade
deficit was ran since 1893.
The rise and fall of Bretton Woods
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Development of global capital markets
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Leads to Smithsonian Agreement in 12/1971.
Raised dollar price of gold (from $35 to $38/oz)
and allowed for 2.25% trading bands as well.
However, this was not enough; imposed no
discipline on the US and was, thus, deemed
non-credible by markets.
The rise and fall of Bretton Woods
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Floating ER then as the only way to preserve MP
autonomy and co-exist with capital mobility.
But as slide 3 demonstrates, only slightly more
floating immediately after BW and substantially
less floating after 1980.
What explains decline of floating?
The rise and fall of Bretton Woods
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Notion of trilemma helps us how to think about
international monetary regimes; also provides us a
means to classify them in the past and present:
1.) Fixed exchange rates, capital controls, &
monetary policy independence (BW);
2.) Fixed exchange rates, no capital controls, &
monetary policy dependence (GS/interwar)
Conclusion
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