Exchange Rate Regimes
Lecture 13

1. Gold standard - central banks convert their currency to gold on demand
   1. History
      • Greeks and Romans
      • 1876 to 1913
   2. The central banks would set an exchange rate of their currency to gold
   3. Example is below:

400 U.S. dollars = 1 ounce of gold.

1,000 Japanese yen = 1 ounce of gold.

800 British pounds = 1 ounce of gold

2. If the central bank in the U.S. wants a money supply of $4 million, it has to buy and hold 10,000 ounces of gold ( = $4 million / 400).
   1. The gold standard has fixed exchange rates
   2. Example:

1 ounce of gold = $400 = 1,000 yen = 800 pounds

$1 = 2.5 yens = 2 pounds

3. The U.S. has a payments deficit with Japan
   1. current account + financial account < 0
   2. U.S. dollars flow out of the United States and into Japan
   3. Japan has surplus of U.S. dollars, so U.S. central bank exchanges gold for dollars
   4. Gold flows from the United States to Japan
      • The U.S. central bank has less gold, so it has to decrease the money supply
      • Remember - the money supply is tied to the amount of gold the government is holding.
      • When the money supply decreases, prices in the economy will decrease
      • Creates deflation (i.e. negative inflation)
        • U.S. products become cheaper compared to other countries, so U.S. export increase
        • The lower U.S. prices cause foreign products to become more expensive, so U.S. imports decrease
        • The balance-of-payments deficit returns to zero
   5. The exact opposite will occur in Japan
4. The gold standard has two benefits
   1. High inflation rates were rare under the gold standard
      • Central banks have little control over the money supply
      • If a central bank wants to increase the money supply, the central bank has to buy gold.
      • The inflation rate averaged less than 1% in U.S. under the gold standard.
   2. The exchange rate risk is zero, which fosters trade and investment
5. The gold standard has two problems
   1. The central bank has little power to influence the money supply
      • Monetary policy is weak
      • During the 2008 Financial Crisis, the Fed granted $2 trillion for emergency loans to banks
      • Difficult to do under a gold standard
   2. If one country experiences a recession, then the recession can easily spread to other countries (other regimes also have this problem)
6. Countries left the gold standard before the outbreak of World War I

1. Founded after World War II from 1945 to 1971
2. Bretton Woods, New Hampshire
3. The United States gov. promised to convert U.S. dollars into gold
   1. Official exchange rate, $35 = 1 ounce of gold
   2. U.S. government held the world's gold
   3. Europe bought military supplies from U.S. using gold
   4. Illegal for Americans to hold gold until the 1970s
4. The other countries fixed their exchange rates with the U.S. dollar
   1. The U.S. dollar became the international reserve currency
   2. Flexible gold standard
   3. Countries could adjust their exchanges rates relative to the U.S. dollar
5. The Bretton Woods system created two institutions
   1. International Monetary Fund (IMF) - created to enhance stability in international payments and promote international trade
      • IMF is the lender of the last resort
      • Granted loans to countries that experienced balance-of-payment deficits
        • More money is leaving the country than amount entering
      • IMF collects and standardizes international economic data
      • A country wants to join the IMF
        • IMF uses a formula
        • One-fourth of the capital is gold
        • Three-fourths is the country’s own currency
        • IMF has financial capital; it has gold and a pool of foreign currencies
      • Example
        • Britain has a payments deficit and borrows from the IMF
        • Britain needs U.S. dollars, so the British give pounds and receive dollars from the IMF to finance its payments deficit
        • U.S. dollars decrease and pounds increase in the IMF’s currency pool
        • Britain pays back the loan (with interest) to the IMF in an acceptable currency and Britain gets its pounds back
      • IMF created Special Drawing Rights (SDRs) in 1969
        • Belief of gold shortage and other reserve assets; originally a SDR was priced in a weight of gold
        • IMF disburses newly created SDRs to members
        • IMF issued 204 billion SDRs by 2010 (approximately worth $308 billion)
        • SDR value is equaled to a basket of currencies, the Euro, British pound, Japanese Yen, and U.S. dollar
        • Countries can use SDRs to obtain foreign currencies from the IMF
        • IMF considers SDRs as a credit instrument
        • SDR defined as "unit of account," which is a function of money and has an exchange rate with the four currencies
      • The U.S. Treasury receives new SDRs
        • Treasury issues certificates that are claims to the SDRs
        • Treasury sells these certificates to the Federal Reserve
        • The Federal Reserve assets increase, causing the money supply to increase
   2. World Bank - grants long-term loans to developing countries
      • The loans are for economic development and help to build a country's infrastructure, such as highways, bridges, power plants, and water supply systems
      • World Bank sells bonds and receives donations
6. President Nixon ended the Bretton Woods System in 1971
   1. Balance-of-payment deficits (i.e. trade deficits) would cause gold to leave the U.S.
   2. World Bank and IMF still live on

1. Governments use a variety controls and measures
   1. Gov. imposes controls and standards on that country's currency and how it can be exchanged with other currencies
   2. Gov. imposes controls on imports and exports of products
   3. Gov. imposes control on international investment
2. Types
   1. Free float ( or clean float) - a flexible exchange rate system
      • Supply and demand in the foreign exchange markets determine the exchange rates
      • No gov. interference
      • Very rare
   2. Managed float - government intervenes in the foreign exchange market in order to achieve its policy goals 
      • Dirty float - if you are pessimistic; managed float if you are optimistic
      • Gov. keeps its currency too strong or too weak
      • Gov. does allow currency to move
      • Problem
        • If investors believe a country's currency will depreciate, then investors enter the market to buy derivative contracts
        • Investors can overwhelm a government, and then government may devalue its currency
        • Self-fulfilling prophecy
   3. Pegged Exchange Rates - a country sets its currency exchange rate with another currency, usually the U.S. dollar
      1. Countries
         • United Arab Emirates, $1 = 3 Dirhams (pre 2008) and $1 = 3.67 (post 2008)
         • Bahamas, Barbados, and Bosnia and Herzegovina
      2. Gov. has to intervene to maintain that exchange rate
         • Some countries refuse to do this
         • Uzbekistan and some African countries
         • Black markets form for their currencies
         • The black markets reflect the true market value
         • The official gov. value tends to be over valued and its central bank is increasing the money supply
         • Gov. uses a pegged exchange rate to keep inflation in check from expanding money supply
   4. Dollarization - a country uses the U.S. dollar as its currency
      1. Countries
         • Panama since 1907
         • Ecuador since 2000
         • Guam, Marshall Islands, U.S. Virgin Islands, and Puerto Rico
      2. Benefits
         • Integrate economy with United States
         • Tie inflation rate to the United States
         • Remove exchange rate stability
      3. Problems
         • No monetary policy
         • No seignorage - gov. creates profit from printing money
           • Example - a $100 bill costs $0.50 to make
         • Severely limits a central bank

1. Source of wealth, power, and economic growth
2. Hegemon has three advantages
   1. Industrial and agricultural production
   2. A strong financial system
   3. Dominates international trade
3. Three modern hegemonies
   1. The United Provinces (Holland) 18th century
   2. Great Britain 19th century
   3. United States after WWII
4. International markets are public goods
   1. Free trade
   2. Peace and security
   3. Balance of powers
   4. System of international payments (money system)
   5. Also creates international institutions
5. Public goods are costly to provide
   1. Free-riders - individuals and nations benefit from the international system without paying for it
   2. Hegemon provides the international public goods, even taking free riders into account.
   3. Hegemon benefits outweighs the cost
6. When a hegemon arises, the world economy tends to grow and prosper
   1. Stimulates wealth creation from markets
   2. U.S. supports a system of free trade
   3. After WWII, U.S. was the largest industrial producer
   4. European factories were in ruins
   5. U.S. greatly benefited from free trade
   6. Helped established the Bretton Woods System
7. Costs of hegemony tend to rise and weaken the hegemon's base of wealth and power.
   1. If the hegemon fails, the public goods disappear
   2. The world economy stagnates or declines
   3. Interesting theory - a rich and powerful nation gains control after a world war
      1. Hegemon falls into decline
      2. Harmonious relationships break down, and then war follows
      3. A new hegemon rises
8. U.S. is a selfish hegemon
   1. U.S. dollar is international currency
   2. Abuse the system
   3. U.S. runs up large international debts
   4. Pays for debt by printing dollars
   5. Other nations hold the U.S. dollars as wealth
   6. Other debtor nations cannot do this
   7. Other nations buy U.S. federal gov. securities