International Monetary System Linda Young POLS 400 International Political Economy Wilson Hall – Room 1122 Fall 2005

International Monetary System

Linda YoungPOLS 400International Political EconomyWilson Hall – Room 1122

Fall 2005

Linda Young, POLS 400, International Political Economy

The International Monetary and Financial Systems

International monetary system: facilitate transactions

International financial systems: provide investment capital throughout the world

No integrated and operative international financial system until late 1960s due to controls by most countries

US dollar as basis – meant that the US could print more money when needed – other countries lacked that option

$ $


International Monetary and Financial Systems (con’t)

Exchange rate crises, debt crises, availability of capital are all important in understanding outcomes

Political outcomes – elections and other Economic outcomes

– volatility discourages investment

– impacts growth

– availability of credit (capital) critical


International Capital Flows

Motivation for huge increase

– reduced barriers

– investor diversification

– new financial instruments Categories

– foreign direct investment (less volatile, about ¼ total now)

• 10% or more of the publicly traded shared of an enterprise in another country

• establishment of a firm – lasting influence


• Portfolio (stocks and bonds) Cross border sales of bonds, money

market accounts, purchase of foreign equity securities, financial derivatives such as future contracts and options

Bank deposits bank loans, short term in nature

International Capital Flows (con’t)


Basic Concepts

Monetary transaction: converting money from one currency to another

Financial transaction: movement of capital from one country to another


Viewpoints

• Realists: States (largely) have independent currencies

– EU a real exception Increased financial flows due to encouragement of the

most powerful states who benefit from the current structure

• Liberals: growth of financial flows and interdependence means that states have difficulty in enacting policies to regulate economic activities


Your Finances

Keep track of your inflows and outflows Daily payments and receipts – checking account

– living within your means day-to-day Longer term borrowing, savings, investment in a different

form – capital and financial account

– wealthier or falling into debt What happens in one affects the other Income greater than expenses – transfer surplus from

checking (current account) to your capital and financial account

If expenses higher than income, then build up credit card or other debt

Surplus, deficit or equilibrium


Balance of Payments

Record of a country’s transactions with the rest of the world (ROW)– measures inflows and outflows to other countries in current dollars

Cat + KOt + ORTt = 0


CA: Current Account (your checking account)

Money Inflows: money received for exports of goods and services to foreign buyers, profit and interest received from US owned foreign assets and unilateral transfers from other nations

Money Outflows: money paid for imports of goods, services, profit and interests paid to the foreign owners of US assets and unilateral transfers to foreign persons

While income from a factory abroad would show up here, the investment to build the factory would be in the capital account

– Visible: commodity trade

– Invisible: shipping, TOURISM


KO: Capital Account (your savings)

Inflows: money received from foreign buyers of US bonds, stocks, real estate, patents or other assets

Outflows: money paid to foreign sellers for purchase of foreign bonds, stocks, real estate, patents or other assets

– All international asset transactions including those made by monetary authorities

• Private foreign investment and public grants and loans

– US residents buy German bonds (an outflow)

– German residents buy US assets (an inflow)

– Foreign direct investment (FDI) – a factory built in Canada

– Long-term portfolio investment (purchases of securities and bank loans)

– Short-term purchases of securities

• maturity less than one year


Relationship Between the Two

Back to personal finance analogy

Apply to nations?

With a surplus in the current account – transfer to capital account

Should people always have a surplus in their current account? – life cycle theory of savings


Balance of Payments (con’t)

Official Reserve Transactions (ORT)

Central bank transactions in the form of international reserve assets such as gold and major currencies – changes in foreign bank holdings of domestic assets and change in domestic central bank holdings of foreign assets

ORTs result from other transactions

Talk about this more in the context of exchange rates (ERs)

Cat + KOt = -ORTt


Current Account Deficits

When absorption > output Absorption as consumption includes business investment and

government spending Arguments for current account deficit Position of major countries Structural adjustment programs spring from changing the

balance between absorption and output

– Need to increase output, decrease absorption, or both (austerity programs)

• Increase output – tax incentives, wage controls, improved regulatory system

• Lowering absorption (consumption) raise taxes, reduce government transfers, increase interest rates


National Income Accounting

Y = Gross National Product (GNP): total value of all final goods and services produced by a country’s factors of production

C = Consumption: purchases by private sector for current wants

G = Government purchases: goods and services purchased by the public sector

I = Investment: part of current output used to increase in the capital stock and produce more output in future


In a closed economy, what is relationship between these variables?

Y = C + I + G

This equation is true by definition, we call it an identity

In a closed economy, each item produced is going to be utilized for something within the country

Y - C - G = I

S = I


In an open economy

Now goods can flow across national borders, so the goods produced within the US do not need to be utilized within the US

Y = C + I + G + EX - IM

Exports less imports can roughly be referred to as the current account

CA = EX - IMY = C + I + G + CAY - C - G = I + CAS = I + CA


New Way to Compute Current Accounts

Difference between national saving and investment

CA = S - I


US Current Account

Source: IMF


If the current account is in deficit –

Example: Suppose consumers in the US purchase a million Toyotas from Japan and give Toyota in Japan dollars in exchange. Japanese will use some of these dollars to buy Fords from the US, but suppose they only want half a million Fords. What will they do with the remaining dollars? They may use them to purchase real estate in the US or US government bonds which are government IOUs. In a sense, the US is borrowing from rest of world.

How is the U.S. paying for its imports in excess of exports?

It is selling off its assets, the wealth created by past production.


Is the increase in indebtedness bad?

CA negative as consumption high relative to output or

Investment spending is high

Or increase in government spending

CA = S – I = Y – C – G - I

Understanding the “Twin Deficits Hypothesis”

Y - C - I - G = CA

(Y - T) - C - I - (G - T) = CA

Define Yd = Y - T: disposable income

(Yd - C) + (T - G) - I = CA

Sp + Sg - I = CASp = Yd - CSg = T - G

Sp - def - I = CAthe government budget deficit: def = G - T

“All else constant,” a worsening budget deficit (def) will lead to a fall in the current account balance (CA)

Private saving and investment can also change and potentially cause current account deficits as well


US Current Account and Components

Source: IMF


Exchange Rates (ER)

Price of one currency for another currency

Who has been to Europe? More or less expensive than before?

How are exchange rates determined?

– Interest rates and investment returns: demand for dollars to purchase US securities and other interest bearing investments – if interest rates higher, greater demand for the dollar and thus the dollar appreciates

– So self-correcting and also influenced by policy

– What do the G-8 talk about?

Why are they volatile?


History and Types of Exchange Rates

• Gold standard (1870s to 1914): value of money fixed in terms of gold Dollar $35 and £14.5 per ounce of gold

– so exchange rate was $2.41 per £ Backed by British hegemony Sacrifice domestic goals for stability

US dollar ($) British pound (£)


Inter-War Period: Competitive Devaluations

• Britain unable to maintain the gold standard exchange regime

Competitive devaluations

Shift to floating exchange rates

Countries did not want to sacrifice domestic goals for currency stability


Bretton Woods – Post WWII

What do you want in an exchange rate regime?

– Stability and autonomy Stability if currencies pegged to a leader, or tied to a monetary

asset (gold) or coordination of economic policies by governments Currency pegged to gold or the US dollar Pegged exchange rates for stability, but also some flexibility of

adjustment

– Countries could revalue their currency under International Monetary Fund (IMF) guidance

– IMF to provide short-term loans for balance-of-payment problems and domestic problems from exchange-rate volatility

– Support for national control over movement of capital Why does this seem astonishing now????


US Dollar as Key International Monetary Fund to provide reserves for stabilization,

but the reserves of dollars held by member governments achieved this goal

Key role of dollar

– facilitated achievement of US political alliance

– its role as a currency of transaction facilitated trade

US right of “seiniorage” privilege

– print dollars to finance wars

– other countries unhappy about US privilege

– G-8 proposed to combat US hegemonic privilege but it ensconced it

– France converting US dollars to put pressure on the dollar


US Dollar as Key (con’t)

But has to pay interest to countries holding assets in its currency Has to maintain confidence in the currency

– banking system of the country benefits – economies of scale as reserves and transactions in its currency

US spent a lot of $$ to help allies and great society programs By Vietnam war could not redeem it all for $35/oz. and went off gold

standard

– US partners persuaded to hold overvalued US dollars


US had its first trade deficit in 1971

Declining competitiveness

Could not devalue currency(as it’s the reserve) to reduce trade deficit

Allowed the US to live beyond its means– then and NOW

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35

40

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1970 1975 1980 1985 1990 1995 2000

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Official Price of Saudi Light Refiner Acquisition Cost of Imported Crude Oil

World Oil Price Chronology: 1970-2003

Source: U.S. Department of Energy, Energy Information Administration, March 2004.


End of Fixed Exchange Rates

Nixon announced end of fixed exchange rates August 15, 1971

Other countries agreed to appreciate their currencies – why didn’t they want to?

1976 – flexible rates

Belief/hope that flexible rates would give governments more autonomy

Fear that without being linked to monetary asset inflation would result


New Monetary System

However, capital flows grew – dwarfed trade flows 25:1

Increased financial markets led to growth of multinational corporations (MNCs)

Size of capital flows led to exchange-rate volatility

125Trade FlowsCapital Flows

to

Floating Rates

Bretton Woods outlawed floating rates – most countries violated by 1973 – meeting to determine what to do

Free float – governments do not intervene in the value of their currency

Managed floating: members do intervene to prevent “excessive fluctuations”

Today: – US, Japan, Canada and some Least Developed

Countries float– EU countries manage and coordinate – the EURO (€)

• Isolate themselves from irresponsible US policies • Perhaps gain benefits from seiniorage

– Least Developed Countries frequently “peg” their currencies to a key currency or a basket

Shift to floating rates created a “crises of purpose” for the International Monetary Fund


Misalignment and Volatility

• Misalignment: long run, sustained by government policy

– China and its currency undervaluation

• Volatility due to massive flows of capital

– Negative consequences for growth

– Contributed to the new protectionism

• Alternatives found in regional relationships such as the EU

– Different than “dollarization”


Integration of Global Financial Markets

A country raises interest rates and attracts capital from other countries to benefit from the higher rate – causes a contraction in economic activity in the country from which the capital flowed

Reduced capacity for governments to achieve full employment, which undermines support for integration in the world economy


Contributed to Increasing Importance of Multinational Corporations

Single, globally integrated market for international business– take-overs; acquisitions and alliances

Reorganization of business

Triangle: Exchange Rates, Capital Flowsand Monetary Policy

Three variables – only twocan be accommodated

Source: Economic Report of the President, 2003, chapter 13

Free capital flows

Fixedexchange rate

Independent monetary policy

Free capital flows Fixed exchange rates

Independent monetary policy


Triangle Examples (con’t)

US has a flexible exchange rate and free flow of capital – interests rates set high by US Federal Reserve, so inflow of capital, currency appreciation

China pegs exchange rate to US $ – can operate independent monetary policy as restrictions on capital flows

Federal Reserve Building

Hong Kong has free capital flows and flexible exchange rate so cannot adjust interest rates


Reform the System?

Adjustment

Liquidity

– Need reserves to meet balance-of-payment difficulties caused by shocks (oil)

Confidence

Documents

International Monetary System Linda Young POLS 400 International Political Economy Wilson Hall – Room 1122 Fall 2005