The International Monetary System

Fin 376 Topic 2.2 Prof Magee

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Topic 2.2 Highlights
1. US FED increases the US money supply (QE - quantitative easing),
lowering the value of the $ to stimulate exports & limit imports
2. 150 year history to 1973 of the international monetary system
Pre 1875 bimetallism (gold and silver) was unstable; gold
standard to 1914 stable; cant return to gold now (not enough)
WWI reparations caused WWII; Bretton Woods 1945-1973;
3. Floating FX rates 1973 to the present by all major currencies
a. Floating FX rates cause macro volatility in crises - money rushes out of
weak currencies and into strong ones like the US dollar.
b. But they are stabilizing in normal times because when a country
booms, its currency rises and higher export prices reduce its
export sales. Reverse process for a country in recession
c. QE quantitative easing by US & how it affects US trade
4. Asian crisis of 1997
5. Europe’s problems and QE Euro problems now
2-2
US FED QEs (Quantitative Easing) Stimulates US Exports
Increased Supply of $ from Microeconomics Explains QE
The FED buys Euros and sells
Price of the Dollar $, increasing $ so € / $ fall
€/$ Supply 1 .

Supply of US dollars rises

Supply 2 from S1 to S2 so price of $ fall
from €.88 to €.80
Demand
The € / $ FX rate $ falls
.88
Since € / $ is cheaper then the
Euro prices of US goods fall
.80
€/good = (€ / $) * ($ / good)
.

Thus Europeans buy

more US goods

Quantity of Dollars

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 150 Year History: International Monetary System
 Bimetallism: Before 1875 gold and silver
unstable because of Gresham’s Law
“bad money drives out good money”
 Classical Gold Standard: 1875-1914 - there was not
enough so gold – economic decline contributed to World War I
 1915-1940 WWI Reparations caused WWII
– Britain, France made Germany pay onerous reparations
– Germany bankrupt in early 1920s - unemployment 30%
– Bad economies bring forward autocratic leaders – Hitler
– WW II driven too by German industrialists – steel, IG Farben
(gasoline from coal),
– Japan latecomer – only war stimulated their economy
 Bretton Woods System: 1945-1972 fixed FX rate system
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 Pre-1875 Bimetallism Failed Because 2 Monies
(Gold and Silver) Are an Unstable System
 When price of gold rises, people hoard gold coins and
use silver ones for transactions in the market.
 Gresham’s Law Better Stated: people hoard good money
(gold) and get rid of bad money (silver) which drives
bad money silver into use in market transactions.
 People hoard gold (taking it out of out of circulation)
and buy good w silver. Having 2 monies is unstable.
 1980s Argentina printed too many pesos. People
hoarded $ and quoted rents etc in the stable US $.
 The ebb & flow of FX rates since 1973 is equilibrating –
when Europe weak, they invest in dollars so $ rises,
US goods get expensive, US exports US imports
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 International Trade Under the Gold Standard:
Price-Specie-Flow Mechanism, 1875-1914
 Suppose UK (shorthand for Britain) exports more to
France than it imports under the gold standard
 Large net exports from the UK causes its gold supply
and hence its money supply to rise. With fewer goods
(more are exported than imported) and more money,
prices rise in UK:
 Reverse logic leads to a lower price level in France.
 Increases in UK prices reduce the UK export surplus and
also decreases expensive UK imports from France
 This price mechanism eliminates the trade imbalances.
 Conservatives want return to gold standard to limit
inflation. But not enough gold to support world economy.
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 Bretton Woods System: 1945-1972
 Named for a 1944 meeting of 44 nations at
Bretton Woods, New Hampshire.
 The purpose was to design a post WWII
system to avoid the 1920’s inflation & the
Great Depression of 1930s plus its deflation
 The goal was to bring back exchange rate
stability but without the gold standard.
 The result was the creation of the IMF and
the World Bank, both lend to troubled
countries.
2-7
Flexible Foreign Exchange Rates : 1973 to Present
 The US started running out of gold reserves and had
to depreciate the dollar, August 15, 1971.
 In 1971 I calculated for the Nixon White House how a
temporary 10% tariff would reduce US imports
 John Connolly threatened the Minister of Belgium
 Gold was abandoned as an international reserve asset
 Emerging countries were given greater access to the
IMF, which was a quasi world bank.
 Floating FX rates adopted 1973 by major countries and
central banks were intervening in exchange markets to
depreciate their currencies and to reduce volatility.
2-8
 International Monetary System: 1990s - Present
 The European Economic Integration 1964, 1990
EEC, EFTA Europe united slowly out of free trade areas
US Canada Mexico slowly merging via NAFTA
 European Monetary Union and the Euro - post 1999
 Euro area 341 million today US is 327 million
 The Asian Currency Crisis 1997
– Excessive borrowing, floating FX rates, panic, capital flight
 Floating FX Rates cause volatility and instability –
money rushes out of weak countries and into strong ones But
 Floating FX rates restores equilibrium to weak countries
test question: explain to your neighbor how countries
that collapse are resurrected

2-9
 Value of the U.S. Dollar, 1973 through 2019
Foreign Currency Per US Dollar (Index)

Reagan
Volcker
Tight US
Money

Greenspan
Technology
Jamaica Plaza Subprime
Boom
Agreement Agreement Lending US
1995-2000
$ Creation
Quantitative
Europe’s Easing UK
Panic Europe Japan
Investing
In the US
2008-2009

Louvre
Accord
Great
Crash 2008

2-10
Origins of the Asian Currency Crisis
 Asia boomed and capital markets opened in the
1990s with large inflows of private capital
 Excessive borrowing led to an over-expansion in
the already booming Asian countries.
 Prices rose, making the countries less competitive
 Fixed exchange rates also encouraged unhedged
financial transactions and excessive risk taking.
 With higher prices, a slowdown in export growth
occurred & an inability to pay foreign creditors.
 Also, Japan’s was in recession and there was panic
yen selling as assets fled Japan.
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The Asian Currency Crisis of 1997

4-1997 12-1997

2-12
 Globalization Led to the Asian Crisis
 All Asia except the Japanese yen had their currencies
fixed by their govts relative to the dollar
 When excessive Asian over borrowing was realized,
money fled out of the countries, the Asian
governments ran out of $ and could not buy back
their currencies; panic ensued with panicking sellers
 First currency to collapse was the Thai bhat setting
off flight of capital from weaker Asian countries.
 This process was called “contagion” as the economic
illness spread rapidly across the region.
Read Money and the Meaning of Life pages 1-26 to 1-27
in Topic 1 and Niall Ferguson “pages 2-1 to 2-7 Topic 2
2-13
 Failures of the Euro:
 No country in the Euro can stimulate its economy by
printing money and lowering their FX rate.
– Less competitive countries are hurt more in a currency
union like the Euro. Germany wanted a strong Euro
– Weak Greece is stuck in Europe with a strong Euro
– The strong Euro plus Greece’s high unit labor costs
prevents it from exporting its goods both within Europe
and outside Europe
– Greece would be much better with its own currency
that it could depreciate & become competitive globally.
– Ex I-banker Martin Armstrong says that in history
collective economies like USSR (1990) failed. He says
Europe is the next to fall – too many social programs
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 How the European Central Bank Has
Stimulated Europe Exports & Reduced Imports
 Europe has lowered lowers its FX (foreign exchange rate)
rate to stimulate its exports and retard imports
 The Europe CB (central bank) cheapens Euros by selling
Euros & buying $ with them, thus dropping the $/€ rate,
making Europe’s exports cheaper in $ and other FXs
Cheaper Euros makes US want to buy more Euro goods
 When € is down, then €/$ are up so harder for Europe to
buy US goods because the $ is more expensive.
 Europe’s firms stimulated with less import competition
 Euro Central bank’s negative interest rates plus arbitrage
have driven down returns on real assets in Europe
2-15
European Central Bank Has Stimulated Europe’s Exports
Demand and Supply from Microeconomics Explains It
EC Bank dumps € onto
$ Price of the Euro S1 market and buys dollars
$/€ Euro Supply 1
Supply of Euros rises from
S2 S1 to S2
Demand Euro Supply 2
Dollar price of the € falls

$1.14 Since the $ / € is lower then

US $ / European goods fall

$1.00 $/good = ($ / €) * (€ / good)

US buys larger quantity

of Europe’s goods

Quantity of Euros

2-16