The International Monetary System

The International Monetary System Lecture 18: 14 April 2011J A Morrison English Shillings, Minted 1664

Lec 18: The International Monetary System • Building Blocks • Constraints & Opportunities • History • Politics

I. BUILDING BLOCKS • Background on Money • Exchange Rate Regimes • The Balance of Payments

It’s easy to understand why we trade goods & services: the benefits of specialization are readily apparent.Understanding the invention and use of money, however, is less immediately accessible.

Money serves three functions…

(1) Medium of Exchange • Money resolves “double coincidence of wants problem” •  What are the chances that you’ll encounter someone who has want you want and wants what you have? • Hint: < Finding True Love

Money evolves as a means to resolve this problem. Individuals accept a common good with certain characteristics (high value to bulk ratio, divisible, durable, uniform in quality) that becomes the common medium of exchange.

(2) Store of Value • Money also allows individuals to convert perishables into more durable goods • This allows: • Storing value between transactions • Saving by hoarding cash

(3) Unit of Account • Money also provides a standard relationship between various g&s in the economy •  Using a standard unit simplifies accounting and calculations immensely

The same logic that impels the development of a common medium of exchange within economies impels the adoption of international media of exchange between economies.

Gold & silver used to perform this role. Today, several “major” currencies do: the US dollar, the Euro, and the Yen.Such a currency is sometimes called the Nth Currency.

How, though, do states determine their relationships to such currencies? Answer: through their exchange rate regimes.

An exchange rate(ER) is the specific valuation between domestic currency and foreign/international currency.

A state’s exchange rate regime is the set of rules that determine the relationship (including valuation) between domestic currency and foreign or international currencies.

We assume governments enjoy monetary sovereignty, the ability to control the value of domestic currency.(This is generally done by regulating the quantity of domestic currency in circulation.)

States can regulate the value of the currency vis-à-vis: • Foreign currency(ies) • Key commodity(ies) • The overall national price level Note: Fixity with respect to one thing generally requires flexibility with respect to the others!

Exchange Rate Regimes

Government intervention sometimes fails to achieve its goal.“Fixed” ERs do not always generate stable market ERs. From Greico & Ikenberry

The balance of payments (BoP) reconciles all of a country’s financial transactions with the world.This includes trade, remittances, investment, loans, &c.

Balance of Payments Current Account Trade in G&S Income Receipts Unilateral Transfers Capital Account Direct Investment Securities Purchases Checking Accounts Balance of Payments Current Account = Current Receipts – Current Expenditures Capital Account = Capital Inflows – Capital Outflows

Just as with your personal BoP, the national BoP must ultimately balance (by design).If you buy more than you sell, you must finance this with loans.This is how the US finances its current account deficit (borrowing & investment).

The ER regime determines, in part, how balance in the BoP is maintained.

Reconciling BoP under Adjustable ER Regime

Reconciling the Balance of Payments with Fixed ER • Adjustment of Reserves • Adjustment of Internal Prices & Incomes • Exchange Controls • Capital Controls: Limit convertibility • Commercial Policy

Reconciling the Balance of Payments with Fixed ER Our focus here. • Adjustment of Reserves • Adjustment of Internal Prices & Incomes • Exchange Controls • Capital Controls: Limit convertibility • Commercial Policy

Reconciling BoP under Fixed ER Regime via Reserves

The ER regime helps to determines whether these adjustments happen through the market (change in exchange rate) or through intervention by the monetary authority.

Recall our framework for thinking about IPE: States face a dilemma between integration and insulation.This applies directly to states’ management of their relationships to the international monetary system.

By maintaining stable exchange rates, states can lower the costs of moving between domestic and foreign currencies.States can eliminate these costs altogether by simply adopting foreign currencies.

These policies bring the benefits of openness: • Increased trade and specialization • Access to foreign markets • Freedom to spend and invest where one pleases

But they come at some costs: • Exposure to foreign shocks & disruptions • Loss of policy autonomy Let’s unpack this latter one…

We said that a state can regulate its money supply (and hence value) towards various ends.If it regulates it towards the end of maintaining a stable exchange rate, it might do so at the expense of instability of the domestic price level.

Fixed ER  Loss of Monetary Policy Autonomy • US fixes the dollar to the price of gold • E.g. $35 = 1 oz of gold • If the quantity of gold increases at 1% per year, then the US must (roughly) increase the stock of dollars at 1% per year • BUT perhaps the whole US economy grows at 2% per year  US prices will fall. The US has sacrificed domestic price stability for ER stability.

Stability in 1 ER  Instability in other ERs • Swiss attempt to maintain ER stability with the US dollar • BUT the US dollar is not stable vis-à-vis the Euro  Swiss Franc fluctuates vis-à-vis the Euro

States have attempted to develop various mechanisms to reduce the rate of trade-off here, to achieve greater openness at less loss of policy autonomy.

The two perennial contenders: capital controls and trade management.The former targets the capital account. The latter targets the current account.

Balance of Payments Current Account Trade in G&S Income Receipts Unilateral Transfers Capital Account Direct Investment Securities Purchases Checking Accounts Managing the Balance of Payments Trade Management Capital Controls

Capital Controls • Capital Controls: Restrictions on the exchange of foreign and domestic currency • Types • Administrative: Prohibitions on ownership, investment, &c. • Market-based: Multiple ERs; Taxes on international capital movements (Tobin Tax) • Efficacy • Viewed as ineffective in long run • Presently working in China & India

By restricting the flow of capital, capital controls allow states to maintain “official” (and perhaps even market) exchange rates without having to subordinate monetary policy exclusively to maintain the ER.

Trade Management • Trade Management: Intervention designed to influence prices and capital flows generated by trade • Types • Protectionism: Limit consumption of foreign goods • Encouragement: Stimulate exports • Efficacy • Can be effective if deployed properly • Creates incentives for special interest capture • Comes at high cost—benefits of free trade

By managing trade, states can manipulate some of the forces that determine price levels and international capital flows. This grants states increased monetary policy autonomy.

Summary • Constraints and Opportunities: • If states want to retain some policy autonomy, they must insulate their monetary system along at least one dimension • The Key Question for Policymakers: • What combination of policies provides the greatest amount of openness at the lowest cost of policy autonomy?

So, there is more than one way to strike a balance between integration and insulation.Across time, we see wide variation in the combinations of policies adopted by states.

Balances Chosen between Integration and Insulation

As social scientists, our immediate question is: how do we explain this cross-temporal and cross-sectional variation?

The International Monetary System