ECN 440 Lecture Notes - Brady Bonds, Wharton School Of The University Of Pennsylvania, Robert J. Shiller

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3 Feb 2013
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Bretton Woods System (1946-1971)
1944: Bretton Woods conference (44 countries)
Creation of the IMF and the World Bank
Each country set a fixed value of its currency in terms of the US$ (par values), and the US$ fixed
its value in terms of gold (1 ounce of gold = US$35)
Official exchange rate was determined by the par values of the two currencies.
If 0.5 Pound = US$1; 200 Yen = US$1; then this implies 0.5 Pound = 200 Yen or 1 Pound
to 400 Yen
Convertibility of US$ into gold on demand: limited to US Federal Reserve and other
member central banks (not to general public)
Four serious problems in the 1920s and 1930s:
Worldwide depression
Collapse of world trade
Collapse of the international monetary system
Collapse of international lending
Founding principles of the Bretton Woods institutions:
Trade should be open in all countries
Nations should not discriminate against other nations
Countries should not limit the buying and selling of currency when its purpose is to pay for
imports
Exchange rates should be fixed but with possibility of periodic adjustment
UK: John Keynes
US: Harry White
Keynes saw the international institution as a kind of world central bank which could create
money on its own and thus give countries financial support
An international lender of last resort
Largely independent so that no political influence could be exercised over its decision-
making
White advocated the provision of financial assistance from member countries’ contributions
A tighter grip on the policy of the country receiving the credit
Central banks held international reserves in convertible currencies (US$-denominated assets)
The aim of the system was to strike a balance between the objective of stable exchange rates
and domestic macroeconomic goals
To reduce the likelihood of competitive devaluations
To reduce the likelihood of exchange controls and other trade restrictions
To reduce the high cost of adjusting for payment imbalances in the form of
unemployment and recession
Bretton Woods System - Adjustment Mechanism
A system of adjustable pegged exchange rates (Dollar Standard):
there were about 10 major realignments between 1946 and 1971
Each member country contributes reserve assets according to a quota system to finance
temporary balance of payments disequilibria
The U.S. (reserve-currency country):
cannot revalue or devalue its currency against other currencies
Can finance its external deficits by issuing liabilities on itself
How Bretton Woods Worked
Exchange rates adjusted only when experiencing a ‘fundamental disequilibrium’ (large
persistent deficits in balance of payments)
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Loans from IMF to cover loss in international reserves
IMF encourages contractionary monetary / fiscal policies
Recession
Devaluation only if IMF loans are not sufficient
No tools for surplus countries
U.S. could not devalue currency
Adjustment mechanism: Central bank intervention in the FX markets
For example: there was an excess supply of francs relative to the US$, the value of francs fell
(depreciation)
To support the par value of francs, the Bank of France bought francs and sold US$ until there
was no more excess supply
Collapse of the Bretton Woods System
Market price of gold: rising
rising demand for gold in postwar era
supply not increasing enough to meet the higher demand
US’s liabilities to foreigners (particularly in the 1960s): rising
(1950-70: US$39 billion)
US’s gold reserves: falling
(1949-1960: $8 billion)
Collapse of the Bretton Woods System
US: persistent external deficits
1971: US$30 billion
Many factors:
military and economic aids (Vietnam War in the 1960s)
fiscal deficits
inflationary pressures
private capital outflows
rising productivity of trading partners (Germany, Japan),
Expectation of major devaluation of the US$
Speculative attacks on the US$
Collapse of the Bretton Woods System
Smithsonian Agreement in 1971: US$ devaluation against gold, from US$35 per ounce to US$38
per ounce (later changed to US$42 per ounce), but failed to save the system
1971: Nixon closed the US gold window
1971: Germany floated the German mark
1972: UK floated the Pound
1973: Japan and other European countries floated their currencies
The IMF
Founded in 1945 at the Bretton Woods meetings between the Allies in July 1944
187 members (2010): IMF is the central monetary institution in today’s international economy
Funding comes from member quotas, or “deposits”
depend on member’s size and status
determine member’s voting weight
determine the member’s access to loans
The IMF: Functions
Prevent crisis in the system by promoting sound macroeconomic policy, which includes:
Balanced expansion of trade
Stable exchange rates
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Avoidance of competitive devaluations
Orderly corrections of Balance of Payments problems (trade deficits)
The IMF Conditionality
Financial crisis
Occurs when a country runs out of foreign exchange reservesa major currency or gold
that can be used to pay for imports and international borrowings
Members can borrow against IMF quotas in the event of financial crisis
IMF conditionality: requirement for the borrowing member to carry out economic reforms in
exchange for a loan
Key features of IMF lending
Conditional on policies to correct balance of payments problems
IMF funds will be deposited in the Central bank of the borrowing country, cannot be used to
finance projects
loans may be disbursed over periods as short as six months and as long as four years, with
repayment period ranges from three to seven years (10 years for low-income countries)
all but the low-income developing countries pay market-related interest rates and service
charges, plus a refundable commitment fee
Low-income countries borrowing under the Poverty Reduction and Growth Facility pay a
concessional fixed interest rate of 1/2 percent a year
Financial Liberalization
Latin American debt crises in the 1980s
Global Information Revolution and International Finance
Explosion of information technologies parallel the explosion of international finance
Both money and documentation are moved by information technologies at a faster speed
1947: invention of the transistor
1960s: integrated circuits
1970s: fax machines
1980s: personal computers
1990s: internet
Global Information Revolution and International Finance
Question: Does the improvement in communication technology create better-informed
investment behaviour and more stable financial market?
Answer: YES and NO
Chancellor:
“The wider availability of financial information has tended to attract impulsive new players to
the speculative game.”
“In the era of global 24-hour trading, money didn’t sleep, nor did those who pursued it.”
The Rise of Economic Liberalism
By early 1970s, Keynesian economics was under sustained attack
Milton Friedman (University of Chicago): Free Market ideology (laissez-faire)
He argued that the market was fundamentally a self-correcting mechanism
Government attempts to interfere with market operation were doomed to failure
All government intervention, however well-intentioned, had harmful side effects
Friedman: Great Depression was not caused by speculators but by a sharp contraction of the
money supply due to the monetary policy of the Fed
Friedman: against capital controls and fixed exchange rates, in favour of floating exchange rates
and free movement of capital
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