Brief answers to problems and questions for review 1. The official parity price was the rate of exchange between gold and the domestic currency. A balance of payments deficit would cause a slight depreciation in the dollar. This would cause traders to buy gold at the fixed price with cheaper dollars. Gold would start flowing out of the country and the money supply would drop. The reverse would occur in the case of a surplus. Deficits and surpluses were automatically correcting because of the fixed price. 2. In this case traders would use the cheaper dollars to buy gold. Gold would start flowing out of the US. This would cause the domestic money supply to drop. The ensuing drop in prices and real GDP would correct the balance of payments deficit. 3. The gold standard was not only a means of fixing exchange rates between countries, but it was a system that automatically managed a country’s money supply. If a country had a balance of payments imbalance at the current fixed exchange rate, the gold standard system would automatically set into motion an adjustment process to correct the imbalance. For example, suppose that a country had a balance of payments deficit at the current fixed exchange rate. This imbalance in the foreign exchange market would be corrected by gold outflows from the country to the rest of the world. This exportation of gold would cause a decline in the country’s monetary base and money supply. Domestic interest rates would increase and aggregate demand would decline causing a decrease in real GDP and the price level. 4. An external surplus resulted in an inflow of gold. This inflow would automatically cause an increase in the money supply. This would quickly correct the balance of payments surplus by increasing aggregate demand causing an increase in real GDP and the price level. 5. With the gold standard, a balance of payments deficit (surplus) would lead to outflows (inflows) of gold. A change in the amount of gold would lead to a change in the money supply. If the money supply changes then there would be an effect on aggregate demand. 6. The regulation of the money supply in a gold standard is automatic. A country with a balance of payments deficit would have a falling money supply and a surplus would mean a rising money supply. There is no need for a monetary authority if the country is willing to accept the fluctuations in real GDP that the system may cause. 7. A gold standard insures that inflation cannot become a long run problem. A balance of payments surplus may cause a temporary increase in the price level. However, the surplus will lead to an increase in aggregate demand that will cause an increase in real GDP and the price level. These increases will reduce aggregate demand and eventually stabilize the price level. 8. The Bretton Woods system was more precisely called the gold-exchange standard. In this system the US dollar was tied to gold but all other currencies were tied to the dollar. In turn, the price of gold was defined in terms of the US dollar at $35 per ounce. In addition, the US would stand ready to exchange dollars for gold, or vice versa, at the stated price without restrictions or limitations. This requirement allowed the system to retain at least a small part of the old link to gold. Second, all other currencies were fixed in terms of the © 2015 W. Charles Sawyer and Richard L. Sprinkle US dollar. The Bretton Woods system was essentially a US dollar standard, with the dollar linked to gold. Because all currencies were fixed to the dollar, they also were fixed in relation to one another. 9. Because all currencies were fixed to the US dollar, they also were fixed in relation to one another. The international monetary system seemed ideal in that exchange rates were fixed and governments were now free to pursue a monetary policy consistent with internal balance, i.e., intervention coupled with sterilization. It would no longer be necessary for a country to sacrifice internal balance considerations to maintain its external balance. The problem is that it is logically impossible for all countries to have a balanced balance of payments in both the short and long run. At best, one would hope that countries would have balance of payments deficits over some periods of time and surpluses in others. This long-run balancing was quite important for sustaining this international monetary system. In order to maintain a fixed exchange rate, it was necessary for governments to actively intervene in the foreign exchange market. In some cases, governments would have to buy their own currency or sell foreign exchange (dollars) to prevent the currency from depreciating. In other cases, they would have to buy foreign exchange (dollars) or sell their own currency in order to prevent the currency from appreciating. In order to sell foreign exchange, it is necessary for the government to have a readily available supply. This selling of foreign exchange would occur when the country had a balance of payments deficit. The necessary reserves of foreign exchange to sell needs to be created in a previous period when the country had a balance of payments surplus and was accumulating foreign exchange. It was important for countries to pursue internal policies that would ensure that the balance of payments “balanced” in the long run. However, if the imbalances were persistent, then it would be difficult for the country to “finance” the balance of payments deficit using only previously accumulated reserves. If the country kept pursuing policies that were inconsistent with internal and external balance, then at some point the country might have no choice but to devalue the currency. 10. During the 1950s and 1960s, the Bretton Woods system worked fairly well. However, there were two problems that developed. The first problem was that it was not symmetrical. The International Monetary Fund (IMF) could force a country with a chronic balance of payments deficit to pursue more restrictive monetary and fiscal policies that would eventually correct the problem. However, the system as designed allowed countries with a balance of payments surplus to accumulate reserves through intervention and then sterilize the effect of this intervention on the domestic economy. As a result, the Bretton Woods system had no real way to deal with chronic surpluses. A second and more serious problem developed. All currencies were fixed to the dollar and the US government was obligated to exchange dollars for gold at a fixed price. This worked well as long as the US balance of payments was essentially balanced in the long run. However, beginning in the mid-1960s, the US developed persistent balance of payments deficits. Over time, this left foreign central banks holding an increasing number of dollars. Surplus countries had to buy dollars and sell their domestic currencies to prevent their currencies from appreciating. By the end of the 1960s, an obvious problem had emerged. Foreign central banks were holding an amount of dollars that was larger than the US stock of gold at the official price of $35 per ounce. The US was faced with a choice of: (1) changing its macroeconomic policies to reduce or eliminate its external deficit; (2) have foreign central banks demand gold in exchange for the dollars they were holding; or (3) devalue the dollar and let the dollar float against gold and the other currencies. The US chose the latter option. The announcement by the US in August of © 2015 W. Charles Sawyer and Richard L. Sprinkle 1971 that it would no longer redeem dollars for gold effectively ended the Bretton Woods system. 11. The embodiment of the Bretton Woods system was the IMF. The IMF’s initial business was to oversee the reconstruction of the world’s international payments system. However, the Articles of Agreement also provided for the creation of a pool of international reserves that countries with temporary deficits could draw on. A country could borrow up to a fourth of its quota at any time without any conditions. As a country attempted to borrow more reserves from the IMF to finance a deficit, the IMF would begin to impose “conditions” on this borrowing. The conditions imposed were that the borrowing government had to pursue monetary and fiscal policies that were consistent with long-run external balance. This invariably meant tighter monetary and/or fiscal policies. Once a country had exhausted its own reserves, there was a limit to its ability to pursue inconsistent policies indefinitely. 12. In the Bretton Woods system a country with a balance of payments deficit might seek to borrow from the IMF. However, this borrowing frequently came with conditions. The conditions were usually changes in macroeconomic policy that would eventually reduce the deficit. However, a country with a surplus had no need to borrow from the IMF. As such, the IMF had no mechanism to force countries with surpluses to take steps to reduce the surplus. 13. A country borrowing from the IMF is subject to conditionality. This means that there are conditions placed on the country for borrowing. These conditions usually are in the form of tighter monetary and fiscal policy which would reduce the balance of payments deficit and eventually reduce the country’s need to borrow. Conditionality is structured in such a way that the more a country borrows from the IMF, the tougher the conditions become. 14. An IMF-mandated austerity program normally would involve both tighter monetary and fiscal policy. The tighter monetary policy would take the form of higher interest rates and a reduction in the rate of growth of the money supply. A tighter fiscal policy would take the form of higher taxes and lower government spending. The result of these policies would mean a leftward shift of the aggregate demand curve. This results in a lower price level and a lower level of real GDP. 15. In the Bretton Woods system, all currencies were fixed to the US dollar. During the 1960s the US began running large current account deficits. What this meant was that there was an increasing amount of dollars being held outside of the US. For the system to work, it was necessary for the US to be ready to redeem dollars for gold. At some point it became obvious that the amount of dollars outstanding was larger than the US gold stock. Either the US needed to pursue policies to reduce the deficit or devalue the dollar. The subsequent devaluation of the dollar effectively ended the Bretton Woods system. 16. Under a clean float option, the government essentially has left the exchange rate alone and let market forces determine the value of the currency in international markets. Adopting a clean float policy is the same thing as deciding that internal balance is substantially more important than external balance. A major benefit is that the government sets monetary and fiscal policy to achieve acceptable levels of economic growth and inflation. The resulting mix of monetary and fiscal policies then determines the value of the exchange rate and also what the current and capital account balances will © 2015 W. Charles Sawyer and Richard L. Sprinkle be. However, a clean float is not a costless choice. Under a clean float, monetary policy becomes very effective and fiscal policy is much less so. In addition, it is quite possible that the policy mixes can lead to an exchange rate that in the short run may be far away from purchasing power parity causing large impacts for some sectors of the economy. The macroeconomic policy mix could easily lead to a substantial real appreciation of the currency, causing hardship on the tradable goods portion of the economy. The tradeoff is one of overall internal balance versus potential hardship for certain parts of the economy. 17. A country may decide to peg its exchange rate by setting the nominal value of the exchange rate against that of another currency. In most cases, a simple peg will invariably be to the currency of a larger country that is a major trading partner and/or where crossborder financial flows are large. However, one must keep in mind that the exchange rate has been fixed against one other currency and that the exchange rate is not pegged against all currencies. If the currency that it is being pegged against is itself floating, the value of a country’s currency is still changing. In addition, a nominal peg still allows the real value of the exchange rate to change substantially unless inflation rates and interest rates between the two countries are similar. A second option is to fix the country’s currency against a basket of currencies. This will eliminate some of the problems of fixing the exchange rate against a single currency. If the domestic currency depreciates against one currency in the basket, it may appreciate against another currency. In the long run, this system may yield a more stable exchange rate than fixing the currency against a single foreign currency. There are two practical problems with such a system. First, the construction of the basket is not at all clear. Second, there is the issue of whether the government should announce which currencies are being used in the basket. Finally, such a system is more difficult for participants in private markets to handle. In this case, the government is committed to maintaining a fixed exchange rate against the basket and not any specific currency creating uncertainty for specific transactions. 18. Businesses genuinely dislike the current system of floating exchange rates as exchangerate volatility greatly increases the risk of doing business in both the short run and the long run. In the short run, firms are forced to either take on the risk of exchange-rate volatility or try to protect themselves from it by hedging in the foreign-exchange market. One strategy is just to ignore the volatility and hope that the losses and the gains are roughly equal in the long run. The current volatility of exchange rates also makes it difficult to plan long-run types of business activity. Should a firm invest in expanding plant and equipment in the home country or invest in new capacity overseas (FDI)? In making these judgments the firm needs to consider the evolution of the relevant exchange rate over longer periods of time. If the current exchange rate is away from its long-run value and the firm does not perceive this, it can make a costly mistake. The bottom line is that the current exchange-rate environment puts businesses in the position of having to implicitly forecast exchange rates whether they want to or not. Even if the firm is not thinking much about exchange rates, doing so usually amounts to a forecast that the exchange rate will not change. In the current system, fluctuating exchange rates impose a significant externality on the world economy. Volatile exchange rates make international trade and investment more risky. Activities that entail more risk command a higher rate of return. In part this is because risk is just another type of cost. To justify the higher costs, economic agents engaging in international trade need a higher rate of return to justify the higher costs. Since volatile exchange rates make international trade and investment more risky, fluctuating exchange rates also implicitly make international trade more costly. With higher risk and costs, you would expect to have less of any type of activity. The © 2015 W. Charles Sawyer and Richard L. Sprinkle same is true of international trade. A big, though usually unrecognized cost, of volatile exchange rates is that they lower the total volume of international trade and investment. 19. Figure 19.3 shows several of the central issues associated with any international monetary system and plots the gold standard, the Bretton Woods system, a pegged exchange rate system, and a clean float. On the horizontal axis, the degree of cooperation among countries is shown. Moving to the left, countries increasingly do not cooperate with one another and become more independent. At the limit, each country pursues whatever set of fiscal and monetary policies it deems appropriate given the country’s state of internal balance. Moving to the right, countries would increasingly cooperate with one another. This cooperation may be necessary to smooth or enhance the international monetary system’s operation. However, cooperation means that countries are willing to occasionally sacrifice internal balance considerations in order to achieve some level of exchange-rate stability. The vertical axis plots the degree to which the international monetary system has some agreed upon set of rules. At the top of the axis is an international system with rigid rules. At the bottom of the axis is a situation where countries exercise a lot of discretion. In this case, each country is more or less free to do as it pleases. 20. Such a system would presumably include a movement toward more stable exchange rates. The US position is a useful starting point. Any movement toward more stable exchange rates would include at least one of two things: more rules and/or more cooperation. A move in the rules direction back to the gold standard would probably prove to be unacceptable because of the loss of monetary policy. What might emerge is a move from the US position to one of more cooperation. This might occur when the policy mix needed to stabilize exchange rates matches the policy mix necessary for internal balance. The current system, if it can be called that, is clearly messy and carries some costs for both the private and public sectors. However, given the preferences of most governments for autonomy in fiscal and monetary policy, it may be all that is feasible at this point. © 2015 W. Charles Sawyer and Richard L. Sprinkle