The GS regulated the domestic countrys quantity and growth rate of money supply based on the amount of Gold backing. This standard ensured that the money supply and price levels dont vary much. Price-Specie-Flow Mechanism - This was the automatic BoP (Balance of Payment) adjustment process that used to take place in the Gold Standard. For example, suppose that productivity gains due to technological innovations, causes the price levels in USA to come down. This would make US goods cheap and thus improve its Current Account. Since other countries would want to consume US goods, there would be net inflow of gold into US economy. The inflow of Gold would cause the money supply to increase, thereby increasing the price levels in US, while in the trading partners countries the outflow of Gold would reduce the money supply there and thereby push the prices down. As a result of this, prices would be balance among countries according to their par exchange rates. Rules of the Game For the GS to work fully, the central banks were supposed to play by the rules of the game. This meant that if a country was running a BoP deficit, then it would allow a gold outflow until the ratio of its price level to that of its principal trading partners was restored to the par exchange rate. How would the price levels change in response to gold outflow/inflow? Well, the central bank would raise the interest rates in the view of declining gold reserves. The rise in rates would cause the inventory cost and other investment expenditure to decrease, which would cause the overall spending to decline and thus result in fall of price levels. Fixed Exchange Rate Regime Why do countries fix their currencies? a) Institute faith in the value of the currency. b) Provide credibility to policy stances and help anchor expectations. Why do FER regimes become unsustainable? a) If countries succeed in restraining inflation and restore confidence in the currency, then the consequence is that people want to own that currency. The inflow of capital exerts pressure on the domestic currency to appreciate. In order to maintain the fixed ER, the central bank builds reserves. The return on reserves is generally low, and the increased money supply that results as a consequence of the build up of reserves needs to be sterilized, which implies selling of G-Secs. The interest that the CB has to pay on these bonds is higher than the return it gets on the reserves. This difference is an implicit subsidy given by domestic economy to exporters who are benefiting from the efforts to prevent the currency from appreciating.
b) Accumulating reserves also causes nominal exchange rates to be suppressed. At the same time, the real exchange rate appreciates because inflation begins to creep higher. This happens regardless of whether money supply increases and is sterilised or not because an undervalued currency removes pressure on productivity improvement and also makes imports costlier. Domestic producers become inefficient or lose their incentive to become efficient. Domestic cost pressures rise and that is how inflation begins to creep higher.
c) Over time again, trade imbalances arise and the currency comes under pressure to be devalued or for the peg (fixed exchange rate) to be abandoned.
d) Another reason that fixed exchange rates become unviable and difficult to sustain is that the anchor currency economic cycles become divergent from that of the fixing country. Hence, following the monetary policy of the anchor country is no longer the right thing to do. But, the fixed exchange rate system demands that the fixing country shadows the monetary policy of the anchor country. Speculators can spot the unsuitability of this policy setting for the domestic economy and they attack the peg. Depending on their staying power, they can succeed in their bid to dismantle the peg.
Relationship between Fixed/Quasi Fixed ER System (called the Fixed ER Corridor), NEER and REER In order to shield their domestic currencies from the impact of surging capital inflow/outflows (from the developed companies), the EM CBs tend to limit appreciation of their currencies in good times by building up FX reserves. In the process they limit nominal appreciation of their currencies. But they, they will be unable to prevent the real appreciation because such build up of FX would cause the domestic money supply to rise, resulting in higher inflation. => Face NEER stability and REER appreciation. Such divergence could cause the currency to come under depreciation pressure sooner than later. Of course, in contrast, NEER stability or appreciation (overvaluation) combined with REER depreciation (or improvement in competitiveness) is a good thing for the economy because it shows that domestic inflation is lower than that of trade partners inflation rates, that domestic costs are being managed and that productivity trends are good in the economy.
Rules of the game International Gold Standard (1879-1913) a) Fix an official gold price or mint parity and there should free convertibility between domestic money and gold at that price. b) No CURA and CAPA restrictions c) Back national banknotes and coinage with gold reserves. d) In short-run liquidity crises, lend at high rates to the banks. e) If Rule 1 is suspended temporarily, restore convertibility asap (as soon as practicable) f) Allow the common price level to be endogenously determined by the worldwide demand/supply of gold. Rule 5 and use of Gold devices To cushion gold losses, the government may temporarily raise their buying price of gold. Provided Rule 5 was adhered to, the use of gold devices made it easier for governments to defend their gold stocks and stay close to their traditional mint parities. Since the people didnt extrapolate further increases in gold prices, thus the government could attract gold bullions from domestic or foreign residents with modest manipulations of the gold points. Rule 4 or the Bagehots Rule implies that in times of short run foreign/domestic drain of gold, the CB should extend large loans to the commercial banks. This means that the domestic assets of the CB would be actually increasing as its gold reserves declined This way the impact of gold loss on the domestic stocks of circulating bank notes was smoothened. Bretton Woods in 1945 the quest for national macroeconomic autonomy Post world war, there was clamour against the reestablishment of any common international monetary standard that would again limit the autonomy of national governments to determine their own monetary policies. The reason behind this philosophical change lies in the inter-war period. The abortive British attempt to re-establish an international gold standard from 1925-31 was seen as aggravating the Great Depression. Anticipating Britains return to her pre-war parity the pound appreciated by 10% vis-a-vis the dollar. In order to maintain the external parity, the Britain had to adopt tight monetary policies => industrial depression in the remainder of 1920s with high unemployment. Undervaluing sterling put greater pressure on other countries to deflate their economies => other countries soon devalued. The debacle mentioned above gave birth to the doctrine that instead of submitting to some international standard, nations should have sufficient flexibility in supporting their inflation and employment objectives. But to prevent the beggar thy neighbour policies of the late 1920s-early 1930s, exchange rates were to be sufficiently stable to permit the resumption of normal world trade. a) Fix foreign par value of the domestic currency in terms of gold or in terms of a currency tied to gold. b) In the short run, keep the ER within one percent of its par value, but leave its long term par value adjustable (with IMFs concurrence). c) Free CURA but CAPA controls can be put. d) Use national monies symmetrically in foreign transacting. e) Buffer short run BoP deficits by drawing on reserves. f) National macroeconomic autonomy: own price and employment objectives. Concomitant with the national macroeconomic autonomy, the Rule 2 here reverses the Rule 5 of Classical Gold Standard (Restorability), and Rule 3 corroborates by allowing for capital market segmentation/controls. Rule 5 (Bretton Woods) marked a shift from the monetary backing view of the exchange reserves (Rule 3 under International Gold Standard). It paralleled the shift away from a common external monetary standard where national money supply and price levels were endogenously determined. The Rules in the Bretton Woods Treaty aimed at treating all countries symmetrically a member country could approach the IMF independently and get its par value changed, the numeraire against which the value was to be determined was Gold (giving symmetric treatment to USD). Moreover, Rule 4 treated all national currencies more or less equally. Fixed Rate Dollar Standard (1950-1970) Despite the fact that the 1945 BWA wasnt amended until 1970s, yet the world monetary system had evolved into a Fixed Rate Dollar Standard. This is embodied in one set of rules for USA, and another set of rules for countries other than the USA. Countries other than the USA a) Fix a par value for the national currency with USD as the numeraire, and keep the ER within one percent of the value. b) Free CURA, CAPA control may be there but start liberalizing. c) USD as the intervention currency and build up reserves in USD d) Subordinate growth in domestic money supply to the fixed exchange rate and to the prevailing price inflation in the US. e) Offset losses in reserves by having the CB purchase domestic assets. United States f) Remain passive in the FX market: practice free trade with no ER and BoP targets. g) Keep the US Capital markets open h) Anchor the dollar price level for tradable goods Conceptual Rationale for the asymmetrical role of the United States The rules from f-h, resolved the redundancy problem - Only N-1 independent BoP instruments are needed in an N-country world because equilibrium in the balance of N-1 countries implies equilibrium in the balance of the Nth country. Because of the demonetization of gold in all private/official transacting, all N currencies in the Post WW2 system were independent fiat currencies. The amount of each currency was no longer determined by its monetary gold. Thus gold was no longer the Nth currency whose purchasing power determined the common price level. This required designating one countrys money to be the Nth currency. This currency would eschew the ER and BoP objectives, but it alone could exercise monetary independence to provide a nominal anchor. Why did the world adopt the Dollar Standard? The Marshall Plan was successful in the macroeconomic stabilization of Europe post World War 2. The MPs most important progeny the European Payments Union (EPU) - was established for clearing payments multilaterally within Europe using US Dollar as both the unit of account and means of settlement Thus each European CB found it convenient to maintain an exactly fixed dollar exchange parity. More importantly, the greater financial stability and the openness of the US compared favourably to the relative lack of confidence in the finances of other industrial economies. Floating Rate Dollar Standard (1950-1970) From March 1973 to Feb 1985, the governments followed rules of the game surprisingly similar to what they had seen before. Compare Box 3 and Box 4. Countries other than the USA a) Smooth near term fluctuations in dollar exchange rate without any par value. b) Free CURA, CAPA c) USD as the intervention currency and build up reserves in USD d) Partially adjust growth in domestic money supply to support major exchange interventions and reduce when money is weak against dollar and expand when it is strong. e) Set long run growth in the price level and money supply independently. United States f) Remain passive in the FX market: practice free trade with no ER and BoP targets. g) Keep the US Capital markets open h) Practice independent MP without trying to anchor any common price level. Because of the attempts by foreign CBs to smooth out fluctuations in dollar exchange rates, the collective world money became highly variable. This collective response also suggests why the business cycles were so synchronized. Plaza Accord 1985-1992 a) Set broad targets for DM/USD and Yen/USD of 12% (plus-minus) b) Adjust central rates if disparities in fundamentals disparity crop up. c) Intervene in concert to reverse short run trends in dollar exchange rate. d) Hold reserves symmetrically in each others currency e) Sterilize the immediate monetary impact of the interventions by not adjusting the short term interest rates. f)