CHAPTER 9:

INTERNATIONAL
MONETARY
REGIMES IN
HISTORY

Paul Sharp and Cambridge University Press

 WHY IS AN INTERNATIONAL MONETARY
SYSTEM NECESSARY?
An international monetary system means currencies can
be converted and facilitates international trade
Otherwise trade restricted to balanced bilateral trade
E.g. if Denmark wants 10 billion kroner worth of goods from
Norway, but Norway only wants 5 billion kroner of goods from
Denmark, then trade is restricted to 5 billion kroner
Cannot fully realize gains from trade and specialization
Also means domestic savings = domestic investment
Foreign investment impossible

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 HOW DO POLICYMAKERS CHOOSE THE
INTERNATIONAL MONETARY REGIME?
Was long believed that commodity currencies and fixed
exchange rates were necessary
Today fiat currencies and floating exchange rates
dominate
Choice depends on the shifting priorities of
policymakers!
Available choices have been termed the open economy
trilemma
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 THREE DESIRABLE POLICY GOALS
1. Fixed exchange rates
Less uncertainty for international traders
2. Unrestricted capital mobility
More trade and foreign investment
3. Monetary autonomy
Use of interest rate as macroeconomic tool

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 THE TRILEMMA
Pick two policy goals, any two but only two!
1. Fixed exchange rates and unrestricted capital mobility
Monetary policy cannot be used
2. Fixed exchange rates and monetary autonomy
Capital controls must be imposed
3. Unrestricted capital mobility and monetary autonomy
Exchange rate uncertainty for international traders

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 WHY CANT YOU COMBINE ALL THREE
POLICY GOALS?
With unrestricted capital mobility and fixed exchange
rates monetary policy is limited!
Why? Arbitrage
An attempt to e.g. lower interest rates lowers the return
to domestic capital
Assets will move out of the country
Downward pressure on the exchange rate
Central bank must raise interest rates again!
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 HISTORY OF INTERNATIONAL MONETARY
REGIMES IN A NUTSHELL
From second half of 19th century to First World War
Fixed exchange rates and unrestricted capital mobility
International Gold Standard
From Second World War until 1970s
Fixed exchange rates and capital controls
Bretton Woods System
From 1970s until today
Floating exchange rates and unrestricted capital mobility
Post-Bretton Woods System
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THE OPEN ECONOMY TRILEMMA

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THE INTERNATIONAL GOLD STANDARD
C. 1870-1914
Gold used as money since ancient times
Gold Standard as an institution has origins in Britains
Resumption Act of 1819
Spread through Europe, replacing bimetallism, based on
gold and silver
Implied fixed exchange rate, and some countries also
introduced monetary unions
Latin Monetary Union of 1865
Scandinavian Monetary Union of 1875 Paul Sharp and Cambridge University Press
 RULES OF THE GAME OF THE
INTERNATIONAL GOLD STANDARD
Most important rules:
1. The currency should be freely convertible to gold at a
set price or mint parity
2. There should be no barriers to capital and gold flows
between countries
3. Money should be convertible on request to gold, and
thus backed by gold reserves

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 WHY WAS THE GOLD STANDARD A
FIXED EXCHANGE RATE SYSTEM?
E.g. US mint parity $20.646 / ounce; UK 4.252 / ounce
Exchange rate must be 20.646 / 4.252 = $4.856/
Any other exchange rate gives the possibility of
arbitrage (given rules 1-3)
Currency traders would be able to convert the cheap
currency to gold, exchange the gold for the expensive
currency and make a profit on the forex markets
In reality small deviations possible due to gold points
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DEVIATIONS FROM THE RULES OF THE
GAME
Most governments took a laissez faire attitude towards
economic policy
1752: Hume described price-specie-flow mechanism
Gold standard automatically ensures balance of payments
equilibrium: if one country has a current account deficit, it will
lose gold, forcing prices to decrease, causing exports to increase
and restoring equilibrium
In practice: central banks more concerned about losing
gold than gaining it, so sterilized gold inflows
I.e. did not increase the money supply Paul Sharp and Cambridge University Press
 SO WHY DID THE GOLD STANDARD
LAST SO LONG?
Commitment: Deviations from parity followed by return
to original parity
Confidence: People believed exchange rates would
remain fixed, so speculation was stabilizing
Symmetry: No one country had an overwhelming
influence on the price level

Paul Sharp and Cambridge University Press

 DETERMINANTS OF THE PRICE LEVEL
UNDER THE GOLD STANDARD
Global money supply determined by supply of gold
Inflation rates uniform among members
Prices fluctuated over shorter periods due to demand and
supply of gold, e.g. stochastic shocks to gold production
E.g. long deflation period 1875-95 after many countries joined
the gold standard
Then inflation after a new method of extracting gold from ore
was discovered
Especially deflation is damaging!
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 THE INTERWAR YEARS
Gold standard suspended during First World War,
governments financed war expenditure and
reconstruction by issuing bonds and printing money
inflation
To restore gold standard, deflation was necessary
For some countries impossible, e.g. Germany
experienced hyperinflation of 3.25 million % / month!
UK restored parity in 1925, France devalued to 25% of
pre-war parity Paul Sharp and Cambridge University Press
THE GOLD STANDARD AND THE GREAT
DEPRESSION
By 1929 US trying to slow overheated economy through
monetary contraction, France ending an inflationary
period with return to gold, both sterilizing inflows
US and France ended up holding 70% of world supply of gold
massive deflation needed in other countries
Then Wall Street Crash of 1929 and Great Depression
Banks failed because liquidity not available when countries
were trying to protect their gold reserves
UK forced off gold in 1931, US 1933, France 1936
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 HOW DID THE GOLD STANDARD
PROLONG THE GREAT DEPRESSION?
Countries which left the gold standard early could
devalue their currencies, avoid deflation
Devaluation meant that exports became more
competitive
Inflation reduced product wages and real interest rates
Monetary policy became available to policymakers
Many now believe the gold standard prolonged the Great
Depression for those countries which left later
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CONTRASTING FORTUNES: GDP/CAPITA
OF FRANCE AND THE UK 1920-39

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 THE BRETTON WOODS SYSTEM
Reaction to the Great Depression was disastrous:
protectionism increased, capital flows restricted,
countries became more autarkic, world trade declined,
fascism emerged
In 1944 in Bretton Woods, 44 countries signed Articles
of Agreement of the International Monetary Fund
Designed a system with fixed exchange rates, but with
more monetary policy flexibility
capital controls
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 DOLLAR EXCHANGE STANDARD
The dollar was fixed against the price of gold: $35 /
ounce
Member countries held reserves in gold or dollar assets.
Could sell dollars to the Federal Reserve for gold at the
official price
All currencies fixed in value against the dollar,
giving N-1 exchange rates

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 FLEXIBILITY UNDER THE BRETTON
WOODS SYSTEM
Capital controls: convertibility only required on the
current account and not the capital account
Interwar experience led many to believe that speculation was
the cause of instability
IMF controlled pool of currencies which could be used
to stabilize countries experiencing current account
deficits (with supervision)
If fundamental disequilibrium (not defined) countries
could de- or revalue their exchange rates
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 DOWNFALL OF THE BRETTON WOODS
SYSTEM
Could avoid capital restrictions by speculating on the
current account: leads and lags
If thought country in fundamental disequilibrium they
would speculate against the fixed exchange rate
All countries forced to maintain exchange rate, but not
the US. With expansion of welfare spending and the
Vietnam War, inflation took off. Lack of symmetry
Other countries not prepared to import inflation, and US could
not maintain value of dollar against gold
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 THE WORLD OF FLOATING EXCHANGE
RATES
Emerged by accident, fixed exchange rates had always
been considered to be necessary
Prices diverged after Bretton Woods collapse, countries
lost interest since floating exchange rates proved to be
compatible with increasing world trade
Emergence of regional fixed exchange rates systems, but
usually short lived
After collapse of Exchange Rate Mechanism in 1992,
EU implemented common currency: the euro
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 THE OPTIMAL CURRENCY AREA
CRITERIA
OCA criteria give conditions under which countries
might agree to form a currency union
Q: When does it make sense to have a common monetary
policy?
A: When asymmetric shocks are less likely
Economic criteria: Labour mobility, similar structure of
trade, openness to trade
Political criteria: Countries should put common interests
before national interests fiscal transfers given shocks
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 THE EUROZONE CRISIS IN THE LIGHT
OF THE HISTORICAL EXPERIENCE
Note the primacy of political motives
European Economic and Monetary Union (EMU) differs
from previous monetary unions since combines a single
currency with a single central bank: the ECB
2007/8 financial crisis was an asymmetric shock
How could the ECB set monetary policy for countries in very
different economic situations?
Badly affected countries forced to implement austerity
measures, need deflation (compare to Great Depression)
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THE EUROZONE CRISIS IN FIGURES: AN
OPTIMAL CURRENCY AREA?

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EXCHANGE RATE SYSTEMS

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 SUMMARY
A gradual realization that fixed exchange rates were not
necessary for a well-functioning world economy
The rise of domestic policy goals made monetary policy
more desirable
Globalization made capital controls difficult to
implement
In modern times, fixed exchange rates are made to be
broken!
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SUGGESTIONS FOR FURTHER READING

Paul Sharp and Cambridge University Press

SUGGESTIONS FOR FURTHER READING

Paul Sharp and Cambridge University Press