International Macroeconomics

Theory and Policy

Victor Argy

• Publisher: Routledge
• Year: 2013
• Print ISBN: 9780415098229
• eBook ISBN: 9781134961764
• Topic: Business
• Subtopic: Business General
• Index: Business

International Macroeconomics: Theory and Policy offers phenomenal coverage across the entire subject of international macroeconoimics in an open economy context. The book has four objectives:
* to describe the evolution of and experiences with global exchange rate regimes
* to introduce the reader to a rigorous analysis of open economy models
* to apply the model framework to address key policy issues
* to review individual country experiences of macro policy

Part I

GLOBAL EXCHANGE RATE REGIMES

In the last hundred years or so the industrial world has seen four principal types of international monetary regimes: first, the gold standard regime, which operated between 1880 and 1914 and again between 1925 and 1931; second, the managed float regime, which operated between 1918 and 1925 and again from 1973 to date; third, the IMF (Bretton Woods) type regime which functioned between 1946 and 1973; fourth, a collective exchange rate arrangement such as that embodied in the European Monetary System (EMS), which came into operation in 1979.

These four regimes are distinguishable, principally, by their differing prescriptions on exchange rates and the adjustment mechanism. At one extreme, in the gold standard regime exchange rates are permanently fixed and adjustment occurs by allowing deficits/surpluses to act on the volume of money. At the other extreme – the managed float regime – exchange rates are principally determined by market forces; in turn these changes in exchange rates serve to equilibrate the demand and supply for foreign exchange. The IMF regime represents, in intention, the intermediate case. It allows exchange rate flexibility in the long term to correct fundamental disequilibria but, at the same time, there is an obligation on participant countries to maintain the exchange rate fixed within a narrow band in the short term. The EMS is also an intermediate regime; amongst participating countries, the exchange rate principles parallel those of the IMF; at the same time member currencies jointly float vis-à-vis the main currencies outside the EMS.

These four regimes are described in some detail in the first four chapters of the book.

Part II will develop, in detail, the theme that the effects of monetary and fiscal policies depend not only on the exchange rate regime in operation but also, critically, on the degree of capital mobility. It is important, therefore, before we embark on such analyses to describe the evolution in the degree of financial interdependence amongst industrial countries. Chapter 5 in Part I addresses this theme. We show how, beginning in the late 1950s, there has been a gradual progress in the direction of greater financial integration. In today’s world, with very few exceptions, there are few remaining barriers to the movement of capital.

1

The gold standard regime

INTRODUCTION

Although it is now over sixty years since the gold standard regime has been in operation it continues to appeal to and to cast a spell over many economists, some very distinguished, and policy-makers.

As noted in the introduction a gold standard regime was in place on two occasions: between 1880 and 1914 and again between 1925 and 1931.

In this chapter we propose to spell out the general principles underlying the gold standard, to explain briefly its workings on the two occasions and to outline why it ultimately broke down in 1931. (For general references see Meade (1951), Yeager (1976), Ford (1962), Moggridge (1972), Brown (1940), Hawtrey (1931) and Kindleberger (1973).)

GOLD STANDARD RULES

The gold standard regime has conventionally been associated with three rules of the game. The first rule is that in each participating country the price of the domestic currency must be fixed in terms of gold. The second rule is that there must be a free import and export of gold. The third rule is that the surplus country, which is gaining gold, should allow its volume of money to increase while the deficit country, which is losing gold, should allow its volume of money to fall.

The first two rules together ensure that exchange rates between participating countries are fixed within fairly narrow limits. With the price of any two currencies fixed in terms of gold the implied exchange rate between the two currencies is also fixed and any significant deviation from this fixed rate will be rapidly eliminated by arbitrage operations.

Suppose, for example, that the two currencies concerned are the US dollar and the franc and suppose that $40 exchange for an ounce of gold in the USA while 160 francs exchange for an ounce of gold in France. This fixes the bilateral exchange rate at 4 francs to $1. Suppose, too, to begin with, that arbitrage (i.e. the converting and shipping of gold) is costless. Now consider the case where France is running a deficit. The excess demand for the dollar cannot produce an exchange rate such that more than 4 francs would sell for $1. At that rate no one would want to sell francs because it would be cheaper to sell francs for gold, ship the gold to the USA and convert the gold there into US dollars. In other words, traders could get more US dollars per franc by transacting in gold than by selling francs for dollars in the foreign exchange market. By the same token if France were in surplus the exchange rate could not be such that fewer than 4 francs would sell for $1; for, in that case, no one would want to sell US dollars at that rate since it would be cheaper to convert US dollars into gold, ship the gold to France and convert it into francs at the official rate.

In reality, of course, there are costs associated with the buying and shipping of gold (e.g. a service charge by the central authority, a shipping charge, insurance costs and a loss of interest during transit). This means that deviations from the implicit exchange rate are quite possible so long as these deviations are equal to or less than the costs of transacting in gold. Suppose that these costs amount, roughly, to 5 per cent; then the exchange rate could fluctuate within the range of, say, $1 for 3.8–4.2 francs (the so-called gold points) without any shipment of gold. The rate of $1 for 3.8 francs is, from the point of view of France, its gold import point while the rate of $1 for 4.2 francs is its gold export point. In other words, if the French franc is weak and the exchange rate is being pushed beyond 4.2 francs to the dollar, France will lose gold to the USA, while if the US dollar is weak and the exchange rate is being pressed below 3.8 francs to the dollar the USA will lose gold to France.

The third rule, requiring the volume of money to be linked in each participating country to balance of payments developments, provided an ‘automatic’ mechanism of adjustment which ensured that, ultimately, any balance of payments disequilibria would be corrected. There are several potential mechanisms by which changes in the money supply serve to correct the disequilibria. One mechanism is through the variations in the interest rate which induce corrective movements of capital; for example, the surplus country would lower its interest rate while the deficit country would raise its interest rate and capital would flow from the former to the latter. Another mechanism, through the goods markets, operates more slowly. Deflation and inflation of the money supplies will lead to relative changes in prices and/or real output that will correct the imbalances. The adjustment through prices is associated with the classical price-specie flow mechanism while the adjustment through output is associated with (later) Keynesian thinking.

The precise operation of the three rules will vary depending on the institutional arrangements. Consider, first, a primitive monetary system represented by a gold specie standard, where money is made up only of gold coins with a fixed gold content and the national mint will always supply gold by melting down gold coins or coin gold supplied to it by the public. In these conditions adjustment is simple and automatic. The exchange rate cannot move outside the gold points; gold will flow out (after being melted down) at the gold export point and will flow in at the gold import point.

Next consider the simplest gold bullion standard where money is made up of notes only, which are themselves backed 100 per cent by gold. In this case the outcomes and method of adjustment are effectively the same. For example, instead of melting coins for payment notes are presented for conversion into gold. Suppose, however, that notes in circulation are not backed 100 per cent by gold but, initially, by, say, only 50 per cent gold and there is no legal reserve requirement. The balance of the backing is assumed to be in loans to the private sector (commercial banks are assumed, at this point, to be non-existent). The central bank balance sheet in its simplest form would now have the note issue in its liabilities (say 100 units) and half of that (50 units) as loans and the other half (50 units) as gold in its assets. Now suppose that a payment of 5 units needs to be made overseas. Notes and gold will now both drop by 5 units and so gold reserves will have fallen by 10 per cent while the volume of money will have fallen by only 5 per cent. Partial backing, therefore, may weaken the corrective mechanism of the gold standard and threaten the reserve position. The smaller this backing the greater the danger that the corrective mechanism might not work before reserves are severely depleted. By contrast, with 100 per cent backing the corrective process cannot fail since the volume of money cannot be reduced 100 per cent.

Suppose, now, that a legal reserve ratio of the order of 40 per cent is imposed while the central bank, de facto, holds 50 per cent. (It is necessary to hold excess reserves if the strict letter of the law is not going to be broken since with notes and gold falling by equal amounts the reserve ratio falls.) Clearly, to restore the reserve ratio of 50 per cent a reduction in gold of 10 per cent must be associated with a reduction in notes of 10 per cent as well and hence loans, in our example, must also fall by 10 per cent. The reduction in gold will then also be associated with a reduction in the domestic assets of the central bank. How much of this process is automatic and how much is discretionary depends, of course, on the legal reserve requirement and the margin of excess reserves.

Now consider the case where commercial banks exist and suppose that money is made up of notes as well as bank deposits. (To place this in historical perspective, in Britain the proportion of money held in the form of demand deposits had increased from some 35 per cent in 1885 to some 60 per cent in 1913.) The non-bank private sector now holds notes as well as deposits while the banks hold, say, a proportion of their deposit liabilities as deposits with the central bank. In turn the central bank has domestic assets as well as gold. Now central bank reserve ratios may apply only to the note liability or may extend as well to the deposit liabilities or may be different for the two forms of liabilities. Clearly, in this more complicated system the possible slippages are greater; how the total volume of money will respond to a change in gold reserves will clearly depend not only on central bank legal reserve requirements but also on cash/deposit and notes/deposit conventions by commercial banks and the private sector respectively. The adjustment will now be automatic, proportionate and predictable only so long as the relevant ratios (of the commercial banks, central banks and private sectors) are all rigidly defined and exactly observed.

Suppose, finally, that the system in force is a gold exchange standard, where one country’s currency (the reserve currency) is held as ‘reserves’ by the rest of the world while the reserve currency itself is backed by gold. To take the simplest case, if central banks hold their foreign exchange as deposits with the commercial banks in the reserve currency country, settlement of disequilibria may be effected by changes in the ownership of deposits with the commercial banks without any change in the total volume of their deposits or in their cash reserves. For example, if sterling were the reserve currency, a British deficit might be financed by the switch in the ownership of a deposit from, say, a British resident to a foreign central bank. In this case there would be no automatic adjustment. There would also be an asymmetry in that the full burden of adjustment would now fall on the rest of the world. The automaticity of a gold standard regime in this case (with a reserve currency) would be further weakened. (See on this also Chapter 13.)

THE FIRST GOLD STANDARD PERIOD 1880–1914

Although by 1819–21 Britain was already on a full-fledged gold standard, it was not until about 1880 that most of the industrial world joined Britain in meeting the conditions of the gold standard. This regime was to endure until the outbreak of the First World War.

How is it possible to account for the survival of the gold standard fixed rate regime over a thirty-five-year period? Several reasons may be advanced. First, the world economy was relatively stable: there were no major wars or disturbances; governments and their budgets were relatively small and hence were not a volatile element in the economy; monetary conditions and the financial environment tended to be relatively stable; the period was distinguished by powerful long-term expansionist influences while, more important, output growth was relatively steady. Second, economic cycles of participating countries were highly synchronised, thus averting the emergence of large disequilibria. Third, it is likely, as Triffin (1964) has argued, that substantial discrepancies in cost competitiveness were not allowed to surface because participating countries exercised ex ante constraint in the conduct of their monetary policies.

Fourth, sterling’s dominant role at the centre of the world financial scene considerably facilitated the workings of the gold standard system. For almost every year in the thirty-five years of the gold standard Britain had a current account surplus. Indeed her basic economic strength is evidenced by the fact that these surpluses actually grew over the time period. This surplus tended to fluctuate by only small margins over economic cycles and this meant that Britain’s task became essentially one of tailoring her lending overseas to the fluctuations in her current account; this she managed with considerable success. This is so despite the fact that Britain had relatively meagre international reserves. For example, if we take the ratio of reserves to imports as a very rough measure of a country’s reserve adequacy, Bloomfield (1959) found that the UK’s ratio was very low in a sample of ten countries. Also, although Britain’s sterling liabilities to foreigners exceeded her gold holdings (by 1913 they were over twice as much) sterling was never under speculative attack in those years.

Fifth, the adjustment mechanism appeared to have worked relatively painlessly and without undue strain on the system. In general, an outflow (inflow) of gold tended to be associated with an increase (decrease) in the central bank discount rate. In turn, these variations in the discount rate acted to correct the external position. For the UK at least, the central bank rate mechanism worked so quickly and effectively that any changes did not have to be sustained for too long. Much of the evidence now suggests that the adjustment came about largely through changes in the flow of capital which was particularly sensitive to changes in the UK bank rate (Bloomfield 1959; Ford 1962). Economic activity and employment, it appears, were only marginally affected by the bank rate. The effects on relative prices, to the extent that they occurred, would have been considerably delayed and, with early reversals of policies, dispersed over time. Indeed the evidence suggests that movements in price levels were predominantly in the same rather than in the opposite direction in participating countries.

Sixth, and finally, over the period as a whole the supplies of gold accruing to central authorities were adequate to meet the needs of the regime. Ford (1962), in summarising the role of monetary gold stocks in this period, asserts: ‘the main role of the increasing gold supplies was to facilitate the workings of the international payments system, so that as trade and payment flows expanded the system was never permanently braked by sharply rising interest rates through shortage of cash …’ (pp. 24–7).

THE SECOND GOLD STANDARD PERIOD 1925–1931

Background

The dislocation of the war had made it impossible to return immediately to the gold standard. Its enormous success, however, in the pre-war years and the absence of clearly defined alternatives left no doubt in the minds of policy-makers and the financial community about the desirability of a return to the gold standard as soon as conditions rendered it appropriate. This attitude is most clearly reflected in the views of the UK’s Cunliffe Committee set up in January 1918 to examine currency issues in the years after the war. Its report presented a glowing picture of the workings of the pre-war gold standard and concluded that the objective of policy was to restore the gold standard along traditional lines at pre-war parity as soon as feasible.

In the years immediately following the war exchange rates for the major c...

Table of contents

• Front Cover
• Title Page
• Copyright
• Contents
• List of figures
• List of tables
• Acknowledgements
• General introduction
• Part I Global exchange rate regimes
• Part II Open economy models – comparative statics analysis
• Part III Open economy models – dynamic analysis
• Part IV New Classical themes
• Part V A general framework
• Part VI Models of exchange rates
• Part VII Policy design
• Part VIII Case studies of macro policy
• Notes
• References
• Index