AM08 Int Fin II

Questions for the Final

Q 1. After World Ward I, with depletion of gold reserves at Central Banks, European economies faced a choice between favoring global trade versus favoring domestic economy. Explain what this choice was, and what policy would favor one, and what policy would favor the other. Explain why European Economies chose to try to return to the gold standard, causing massive domestic suffering, instead of making the other choice of abandoning gold, and favoring domestic economies.

Answer 1: After WWI the European domestic economies were in ruins and in order to built up their economies governments focused on domestic economies rather than international trade. Thus they were left with a a choice or shall we say number of choices which was called Trilemma of monetary policy. This theory states that a country can choose to do two out of three things if the choices are:

1. Independent Monetary Policy

2. Pegged/Stable Exchange Rates

3. Free International Capital Mobility

If the state wants independent Monetary policy then the country will want to fix its domestic economy and thus the monetary policy will be used for domestic economy and not pegging the exchange rate. This means that the ratio of money to gold reserves will vary. This will happen because the government will not try to peg the exchange rate by keeping the money supply to maintain the exchange rate rather the money supply will be increased or decreased in the domestic economy counter cyclically depending upon boom and recession. This idea was presented by Keynes who said that a right amount of money is needed to drive the economy and too much money causes inflation and too less money causes recession. Therefore if it is a democratic political system then exchange rate will be flexible but there will be international capital mobility.

Now suppose that we want to have stable or pegged exchange rates then the monetary policy will be used to keep the exchange rates fixed and it will not be used for domestic economy. Then the first choice is sacrificed for the remaining two options.

If international capital mobility is to be restricted, then we can have a stable exchange rate and also a monetary policy which addresses the problems of the domestic economy. This is because when international capital mobility is not restricted then due to flexible exchange rate the rate will fluctuate with varying gold content backing the currency. Thus when the currency will appreciate due to high gold content backing then the foreigners will buy the currency and when it will depreciate they will sell it. This will cause massive fluctuations and might cause crises in the domestic economy. Therefore in order to prevent this buying and selling of currency, capital controls are implemented in order to have a stable exchange rate.

The European economies tried to go back to the gold standard because they linked the prewar prosperity with the gold standard and they thought that if they did that the prewar prosperity will return. However due to war efforts the gold that these countries had was seriously depleted and their economies were in ruins. Secondly they had to impose capital controls because now the CBs of the countries were focusing on domestic economy and not stabilizing the exchange rate. Thus when capital controls were not imposed the financiers used to sell the currency when it depreciated making it even more weaker. This restricted the CB’s effort to manage the domestic economy in a coherent way. Therefore capital controls were imposed by weaker economies because their domestic economies suffered from international capital mobility in the post war era. One point to be noted is that this pegging of exchange rate benefitted the elite financiers who wanted a stable exchange rate for their capital flows but was detrimental for the domestic economy. Secondly gold standard is bad for the economy and fractional reserve system is better suited for the domestic economy.

2. Explain, as clearly as you can, why the international trading system is an artificial set of rules, which is created by consensus. There is no "natural trading system". After breakdown of gold standard, Bretton-Woods was an attempt to create a new trading system. This new system was called the Gold-Exchange Standard - it was based on dollars which could be exchanged for gold, instead of gold itself. Explain why this system emerged, instead of the alternative, based on Keynes ideas about creating an N+! currency (the bancor, called SDR by IMF) which would be used for trade. Explain why this system favors the USA, while the bancor would have been a more neutral and symmetric system.

Answer 2: The international trading system is artificial because it is created by consensus of the trading countries who determine their value of the currency via exchange rate system. The gold system was backed by gold system in which currency can be exchanged by gold. However this system had limitations because the limited amount of supply of gold couldn’t compete with the growing demand of the trading that was occurring between the countries. Thus after WWI when the CBs focused on the domestic economies and didn’t stabilize the exchange rate and also capital controls were imposed which caused the breakdown of the gold system.

Another consensus was made in which only central banks can ask for the conversion of foreign currency to gold in order to correct the imbalances of trade. Secondly gold generally didn't back the currency anymore. This was called the Bretton Wood system an in this system it was thought that since dollar was a strong currency and was backed by gold then the foreign currency was exchanged to dollar or dollar denominated bonds (on which interest could be earned) in order to meet the reserve requirement for gold for a stable exchange rate. This system weakened the link between the currency and value of gold. It was seen that the value of gold deviated significantly from the prices at which CBs traded with currencies of each other and of gold. However IMF was created to monitor this system and provide liquidity through special drawing rights to needed countries but IMF didn’t had the political power to enforce its rules.

This system favors USA because USA is able to buy real resources with its dollars which are equivalent to gold. Thus USA can print up as much dollar as it wants without any repercussions. USA has even blocked many efforts which were designed to make the international monetary system more equitable.

Q 3. Explain the impact of expectations about Central Bank behavior on the outcomes of policy decisions. Show example of how the same policy had different effects in pre-War era, because Central Banks were committed to international trade, and in the post War era, where Central banks were committed to the domestic economy.

Answer 3: In the prewar era, a stable exchange rate was the highest priority of the central bank. Thus the CB didn’t let the currency become weak. Whenever that happened they used to take measures like raising the interest rates in order to strengthen the currency and keep the exchange rate stable. The financial speculators knew this and they would take advantage of this and would buy the weak currency because they knew that its value will rise and secondly they knew that the interest rate will rise as well. Thus capital inflows moved the currency back to it pegged or equilibrium position. However this was not the case in postwar era where the CB’s main aim was to help the domestic economy and not to stabilize the exchange rate. Thus the CB would let the currency depreciate rather than to harm the domestic economy. Therefore in the post war era when the currency depreciated, the financial speculators didn’t buy it rather they sold it due the fear of further depreciation. They also thought that the CB will not intervene and will not take measures to make the currency strong again. Thus this caused destabilizing capital flow which was totally opposite of prewar era.