International payments
system and factor
movements
1
The Gold Standard
• While gold has been used as a store of value and as a
means of payment since ancient times, the international
gold standard proper dates only from the 1870s.
• It lasted until 1914, and then had a brief revival in the late
1920s.
• Until the late nineteenth century most countries were on a
bimetallic standard, interspersed with occasional periods of
inconvertible paper (as in the United States in the 1780s
and the 1862-78 period, or in Britain from 1797 to 1821).
• Some countries, such as China and Mexico, were on silver
alone and remained so into the 20th century.
• Holland and Belgium even switched from bimetallism to
silver alone in 1850 on the grounds (following the
California gold discoveries in 1848) that gold was too
unstable to provide the basis for the currency.
2
The Gold Standard
• The Process
– Government fixes the prices of its paper
currency to gold.
– The central bank backs all national bank notes
with and coinage with gold reserves
– The government allows free import and export
of gold.
– Prices and wages were fully flexible.
3
The Specie-Flow Mechanism
• This is the first general equilibrium adjustment
model in economics.
• It is based on simplified assumptions which
produce the sharp predictions
• Consider a world where
– prices are flexible
– all transactions take place with gold coins.
– there is a fixed supply of gold in the world.
– These coins are minted at a fixed parity in each
country.
• Fixed parity is the value of a country's currency in relation to
another currency to which it is fixed:
– no banks and no capital flows.
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• Capital flows describe the movement of money for the
purpose of investment, trade or business production.
• Capital flows occur within corporations in the form of
investment capital and capital spending on operations
and research & development.
• On a larger scale, governments direct capital flows
from tax receipts into programs and operations, and
through trade with other nations and currencies.
• Individual investors direct savings and investment
capital into securities like stocks, bonds and mutual
funds.
5
The Specie-Flow Mechanism
Whenever goods are exported a merchant
receives payment in gold.
Not wanting gold, the merchant takes this to the
mint and receives gold coins at the fixed parity.
To purchase imports a merchant pays with gold.
To get the gold the merchant takes coins to the
mint and sells them for gold at the fixed parity,
which is then used to pay for the imports.
The recipient in the foreign country takes the
gold to the mint and obtains coins.
6
The Specie-Flow Mechanism
• Consider country with a trade surplus.
This means that more gold is coming in to
the country than is leaving.
 Hence, the supply of gold coins in the
domestic economy is increasing.
With more circulating medium (specie)
the price level will increase.
(This follows from the assumption of price
flexibility and full employment).
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The Specie-Flow Mechanism
• The increase in domestic coinage increases
aggregate demand and pushes up prices.
But this reduces the competitiveness of exports
and increases the attractiveness of imports.
Hence, the flow of gold will be reversed until
prices return to their equilibrium levels
This is Hume’s specie-flow mechanism, which
explains the adjustment of price levels to shifts in
the money supply across countries.
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Advantages of the gold standards
1. Balanced trade
 Transactions took the form of merchandise
trade and balanced trade was regarded as
desirable.
2. Fiscal and monetary discipline
It does not allow the government to print
money to finance government deficits
Currency could only exchange for gold and
not treasury bills
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Disadvantages of the gold standards
1. Gold Supply and demand imbalance
 Gold discoveries could lead to inflation (California –
1848, Alaska – 1897)
 Deflation when gold discoveries do not keep up with
economic growth. (When central bank does not have
enough gold reserves to support an increase in money
supply – Industrial revolution
2. Political versus economic realities
 During wars
3. Possible adverse economic consequences
 Assumption of full price flexibility ( Do prices adjust
immediately?)
10
Demise of Gold Standard
• As a consequence of World War 1
• All nations either placed restrictions on gold
convertibility or issued non- convertible paper
money.
• Therefore people could not exchange paper
currency for gold at the central bank.
• Implied the central bank had insufficient gold
therefore the system collapsed.
• Many governments printed money to finance post
war expenditures and post war reconstruction
leading to inflation
11
The Bretton Woods System
• In July 1944, a conference took place at Bretton Woods in
New Hampshire to try to establish the pattern of post-war
international monetary transactions.
• The aim was to
– try to achieve free convertibility,
– improve international liquidity and
– avoid the economic nationalism which had characterized
the inter war period.
• The result was that two institutions were established:
– in 1946, the International Bank for Reconstruction and
Development (IBRD) also known as the World Bank
– in 1947 the International Monetary Fund.
12
Bretton Wood System
• The process of establishing after-war
arrangement was influenced by:
economic circumstances in the world at that
time
negative experiences from the interwar period:
• establish a complete arrangement and hence put a
stop to instabilities and economic nationalism
establish a stable
exchange rate
system
ensure additional
international
liquidity
set up a mechanism
for efficient elimination
of balance-ofpayments disequilibria
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Bretton Wood System
Great Britain
– new international currency
“bancor”, accepted as
equivalent to gold
– international clearing union
would guarantee automatic
elimination of balance-ofpayments disequilibria
– functioning of the system
similar to the functioning of
the gold standard, but
more flexible
USA
– restoration of the gold
exchange standard
– establishment of a special
fund, into which countries
would pay their financial
quota and from which they
could borrow in times of
temporary balance-ofpayments difficulties
– eradication of trade and
payment restrictions
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Basic elements of the System
1. Exchange Rates
– The US dollar was defined in terms of gold
– convertibility of dollars for gold at $35=1 ounce
– fixing the par value of each national currency in
terms of $
– exchange rate could fluctuate within a band of 1
percent above or below the par value
– possibility of changing the par value in case of
fundamental disequilibria
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Basic elements of the System
2. International Liquidity
• Establishment of the International Monetary Fund, based
on a quota and/or drawing rights system of all member
countries:
 Each nation was assigned a quota; each was to pay
25% of its quota in gold or $, and the remainder in its
own currency
 A member nation could borrow from the IMF to finance
temporary balance-of-payments deficits:
 Restrictions on the amount of borrowing from the
IMF
 conditioning
 International liquidity too small for normal functioning
of the world economy
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Basic elements of the System
3. Removal of restrictions on the current
account transactions
• Restrictions on international liquid capital flows were
explicitly permitted in the statute to allow nations to
protect their currencies against large destabilizing
international money flows
• Removal of all restrictions on the current account
transactions:
– a period of transition (article XIV of the IMF statute)
– This article allowed a member country to retain the
exchange controls that were in effect when the country
entered the IMF. Once a member country abolished its
exchange control, it could not re-impose controls
again without the IMF approval
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Basic elements of the System
4. Rare currency Principle
Bretton Woods system turned out to be immensely
asymmetrical, even though it was meant to be a
system in which both groups of countries are
responsible for the elimination of the balance-ofpayments disequilibria:
• rare currency principle:
–ongoing balance-of-payments surplus
–member nations could take discriminatory
action against imports of goods and
services from a nation with rare currency
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Basic elements of the System
5. Establishment of the IMF
Central goal of the IMF:
making a stable exchange rates system
come true
providing borrowing facilities for nations in
temporary balance-of-payments difficulties
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Functioning of the System From 1944 – 1959:
Period of the Dollar Shortage
 Reasons for the dollar shortage:
 Enormous world demand for American goods in
combination with very limited export possibilities
of other countries and their low foreign
exchange reserves
 Overcoming the dollar shortage problem:
 Marshall Plan (program of financial aid to
Europe, 1948)
 Trade and foreign exchange restrictions
20
Functioning of the System From 1944 – 1959:
Period of the Dollar Shortage
 Overcoming the dollar shortage problem:
 European Payments Union (1950)
 The EPU was a mechanism for multilateralizing the
bilateral agreements upon which intra-European
trade had been restarted after World War II.
 At the end of each month, each EPU country's net
balances with each other country were reported to
the Bank for International Settlements, the EPU's
financial agent, which cancelled offsetting claims.
 Remaining balances were consolidated, leaving
each country with claims on or liabilities to not
individual countries but the union as a whole.
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Functioning of the System From 1944 –
1959: Period of the Dollar Shortage
 Vital changes in the balance-of-payments position of
the USA and Europe:
 Improvement in economic growth and balance-ofpayments of Europe and Japan
 Worsening of the balance-of-payments of the USA
 Redistribution of foreign exchange reserves from the
USA into other parts of the world
 Role of the IMF in the 1950s:
 Passive role at solving the problems of the international
economic agreement
22
Functioning of the System From 1959 – 1971:
Period of the Dollar Glut
 Abolition of the European Payments Union and
restoration of convertibility of European currencies:
 exchange rates of the most important currencies
relatively stable
 all economically important countries removed
exchange restrictions for current account transactions
 macroeconomic stability, accompanied by high growth
rates of world trade
23
Functioning of the System From 1959 – 1971:
Period of the Dollar Glut
 Balance-of-payments adjustment problem:
 increasing balance-of-payments deficit in the
USA
 continuing balance-of-payments surpluses in
Germany and Japan
 nations with balance-of-payments deficit are
under more pressure than countries with
balance-of-payments surplus
 dollar devaluation impossible because of its
specific role in the Bretton Woods monetary
system
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Functioning of the System From 1959 – 1971:
Period of the Dollar Glut
 Problem of facilitating international liquidity and
problem of confidence into the system:
 Triffin dilemma –
 This is where short-term domestic and long-term
international economic objectives can conflict when a
currency is also a reserve currency
 The dollar could not survive as the world's reserve
currency without requiring the United States to run
ever-growing deficits.
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Measures of American authorities, focused on
reducing the balance-of-payments deficit
 Interest equalization tax
– A federal levy on the purchase price on foreign
stocks and bonds bought by Americans.
– It was established in 1963 and eliminated in 1974.
– It was designed to decrease the U.S. balance of
payments deficit by discouraging investment in
foreign securities and encouraging investment in
domestic securities.
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Measures of American authorities, focused on
reducing the balance-of-payments deficit
Federal Reserve System entered into a series
of currency swap agreements with central banks
of Western Europe, Canada, and Japan.
– Under these bilateral agreements, a foreign
central bank provided standby credit (in foreign
currency) to the Federal Reserve System in
return for an equal amount of standby credit (in
dollar).
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Collapse of the System
• Dollar not convertible for gold, reduction in American gold
exchange reserves and reduction in coverage of liquid
dollar liabilities of the USA with gold:
– speculative transfers from weak dollar into other
currencies
– negative consequences of sterilization of dollar inflows
in countries with strong currencies on inflation
– USA reneged on their obligation to buy and sell dollars
for gold at a fixed price of 35 USD = 1 ounce  de-iure
discontinuation of convertibility of $ for gold
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Final Assessment of the Functioning of
the Bretton Woods System
• Inappropriateness of the balance-of-payments
adjustment mechanism and large difficulties with
the functioning of the system of fixed, but
adjustable exchange rates
• Shortage of international liquidity and a built-in
systemic mistake in the form of the Triffin dillemma
• Importance of international cooperation for
successful functioning of the international
monetary system
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