Miss Prism: Cecily, you will read your Political Economy
in my absence. The chapter on the Fall of the Rupee
you may omit. It is somewhat too sensational. Even
these metallic problems have their melodramatic side.
-Oscar Wilde, The Importance of Being Earnest
“Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer
their demands for a gold standard by saying to them, you
shall not press down upon the brow of labor this crown
of thorns. You shall not crucify mankind upon a cross of
gold.”
– William J. Bryan
“Cross of Euros”
- Kevin H. O’Rourke and Alan M. Taylor, Journal of Economic Perspectives, 27(3): 167-92, 2013.
1
Broad categories
Fixed
Either against a commodity (gold or silver) or against
the nth currency (a currrency board)
Free ‡oating or perfectly ‡exible
Intermediate regimes (…xed but adjustable, managed
‡oating, target zones, crawling peg, etc.)
2
2.1
Historical progression
1800-1914
Commodity money systems
Napoleonic Wars-1870s: Bimettalic standard: Both gold
and silver were used as money, accepted as means of
payment.
1870s onwards - classic gold standard
2.2
The Gold Standard (1870-1914, 19251931)
Under a pure gold standard, di¤erent currency names
would simply be di¤erent names for speci…ed amounts of
gold
In practice, fractional reserve system with paper currency
as the medium of exchange
This “impure” system frees gold up for use as an ordinary commodity. Moreover paper easier to exchange and
transact.
The Central Bank promises to maintain the price of gold
(i.e., redeem paper notes in exchange for a certain amount
of gold).
Each unit of currency is backed by an announced amount
of Central Bank gold assets
This section borrows heavily from McCallum (1996).
Rules of the game:
1. The monetary authority promises to maintain convertibility at an announced price
2. No restrictions on imports or exports of gold by private citizens
3. Gold backing proportional to amount of currency
Talk a bit about the Hume specie ‡ow mechanism
...
Given that the Central Bank targets the price of gold
(PG), how are currency prices of goods (P ) determined?
We will (implausibly) assume …xed output (y ) and distinguish between short-run (stock) analysis and long-run
(‡ow) analysis.
Two uses of gold: (1) monetary, (2) non-monetary (jewelry, etc.)
Supply of gold given (at a level G0) in the short-run but
evolves over time
Demand for gold = Demand for monetary purposes (GM )
+ Demand for non-monetary purposes (DN ).
p = PPG
DN = f
!
( ) (+)
(1)
p ; y
The monetary authorities promise to maintain a constant
gold backing ( ), where
=
PGDM
; 0<
M
1
Demand for money:
M = P L(y )
(2)
Notice the absence of a portfolio motive. David Hume
vs. Keynes, etc.
Therefore,
=
pDM
L(y )
(3)
or,
DM =
L(y )
p
Thus, both DN and GM are negative functions of p.
D = D p; y;
; Dp < 0; Dy ; D > 0
(4)
Fixed stock of gold available in the short-run at:
G = G0
(5)
Short-run equilibrium:
D = D p; y;
= G0
or,
+ +
p = p( y; ; G)
(6)
With PG and …xed by policy, output given, and the
supply of gold inelastic, P and hence p, are determined
by the system.
where,
@p
@y
=
Dy @p
Dp , @
=
D
@p
,
Dp @G
= D1p ,
Over the longer run:
In a closed economy, supply is a function of extraction
e¤ort, etc.
gs = h (p; ) ; hp; h > 0
(7)
Non-Monetary gold depreciates at a rate , so that the
volume lost each period is:
gd = DN (p; y ) ; DN p; DN y > 0
(8)
The quantity of gold will neither rise nor fall when PPG =
PG
P
Flow equilibrium
G_ = gs
gd = h (p; )
DN (p; y ) = constant (9)
or, writing the function implicitly in excess (‡ow) supply
form:
F (p; ; y ) = 0
Or, substituting for p from equation (6):
F (G; y; ; ) = 0
where FG < 0, F ; F > 0, Fy ? 0.
(10)
Partials i more detail:
FG = pG(hp
F = p (h p
DN p)
DN p)
F =h
Fy = hppy
DN y
What if the relative price of gold is momentarily above
PG
?
P
The higher price causes extraction that exceeds wastage.
Over time the stock of gold increases.
Since the CB targets PG, money supply increases
(i.e., the CB buys gold in exchange for money)
The vertical money supply curve shofts to the right.
With more money chasing the same number of goods,
P rises (i.e., p declines).
h(PG/P)
PG/P
PG/P
(PG/P)
(PG/P)
0
0
*
D(PG/P ;y,λ)
(PG/P)
δf(PG/P ;y)
0
G
G
*
g
0
g
g
E¤ects of macroeconomic shocks
(1) Improved gold extraction technology (" )
(Spanish discovery of gold reserves in the Inca Empire)
Curve shifts:
From equation (6), @@p
From equation (7), @@p
From equation (8), @@p
= 0,
D
=
h(:)
h <
hp
=0
DN (:)
0
New discoveries of gold
Steady state solutions
From equation (10),
dgs
d
=
F
Fgs
=h >0
dG
d
=
F
FG
=
h
pp (hp
DN p)
>0
which, combined with equation (6) yields
dp
d
@p dG
= @G
d =
h
Dp pp (hp
DN p)
<0
h(PG/P)
PG/P
PG/P
(PG/P)
1
(PG/P)
1
(PG/P)
0
(PG/P)
0
D(PG/P ;y,λ)
0
G
1
G
G
δf(PG/P ;y)
2
g
Shift in stock demand toward gold
2
g
1
g
g
With an open economy, the ‡ow supply of gold becomes
a function of the balance of payments
2.3
Inter-War period
Return to gold standard expected
What parities to set?
Britain returned in 1925 at the pre-war parity level
Keynes’s opposition
Unemployment and falling nominal wages (a phenomenon
much less observed today thanks to unions, etc.)
The US devalued and abandoned the gold standard in
1933 as part of FDR’s response to the Great Depression
Other nations followed suit
Eichengreen and others have shown that nations that
left the old Standard recovered more vigorously from the
Great Depression and resorted less often to protectionist
measures
Friedman termed the US regime between WWI and 1933
as being a “pseudo gold standard” since was not kept
constant (it increased, putting de‡ationary pressure on
US, and by repercussion, on ROW).
2.4
Bretton Woods, 1947-1971
New Hampshire 1944
Fixed but adjustable exchange rates
IMF overseeing exchange rate arrangements and shortterm …nancing
n 1 currencies …xed to the dollar. The nth currency
…xed to gold ($35 per ounce)
Relatively closed capital accounts in most countries
The Tri¢ n dilemma
To maintain the BW system, US BP de…cits required to
provide liquidity to ROW
But a deteriorating international asset position undermines con…dence in the US ability to redeem dollars
Speculation against the dollar
Dollar covertibility suspended in 1971
2.5
The present non-system
Floating exchange rates in most advanced economies outside of the Eurozone
No foreign exchange intervention by CB
EMS (setting up ERM) in 1979, Maastricht in 1991 and
then the Eurozone in 1999.
Mostly …xed or pegged in developing countries until the
late 1990s
Changed as a result of lessons learned from the Tequila
crisis (1994), the Asian crisis (1997-98), Russia and Brazil
(1999), and Turkey (2001?)
“Fear of appreciation” and reserve accumulation
Exercises
1. Show that, under the Gold Standard, the nominal
exchange rate between any two countries is simply
the ratio of their gold prices. What feature of the
system is required to ensure this outcome?
2. What is Gresham’s Law? Can we apply it to modern day conditions (think, for example, of the black
market for dollars in Venezuela).
3. Analyze the case under the Gold Standard where the
Central Bank becomes more conservative (" ). Be
sure to think about both the short- and long-run implications and to show both your mathemtical and
graphical results and to describe them in intuitive
terms. What feature of the system drives these results?
4. Now suppose we relax the assumption of constant
employment of resources and introduce price stickiness instead (i.e., assume p is …xed instead of y ).
How does this change your analysis in (2) above?