1. GOLD
(A) Why were capital flows stabilizing during the gold standard era and why do they tend to be destabilizing now? Explain these terms.
During the gold standard era, the standard unit of exchange was a predetermined weight of gold. The unit was equivalent and could be exchanged with a specific quantity of gold. Capital flows refers to the movement of capital from richer economies to flow to economies. Capital flows were stable due to the fact that there was a stable exchange rate system. Most of the countries were pegged and adopted capital controls or had pervasive capital controls (as in the case of the Bretton Woods period). However, the modern era is marked with unstable capital flows because of the existence of mixed policy regimes.
(B) Why is the gold standard considered to be a pre-Keynesian financial regime?
The gold standard is considered to be a pre-Keynesian financial regime because of two main reasons: the exclusion of bank credit and the existence of perfect competition. Gold was considered to be very precious and banks strived to maintain a minimum reserve. The banks restricted lending because it would increase the supply of banknotes in the economy and reduce the quantity of gold in bank custodies. This is explained by increased demand for gold in exchange for notes. There existed perfect competition as the success of domestic economies heavily relied on competition for markets and precious metals. This is demonstrated by Britain’s desire to emerge as the largest empire in the world. It explored around the African continent in search for gold and silver.
(C) Explain how international shipments of gold (arbitrage) were supposed to enforce the mint parity (i.e., explain Hume’s price-specie-flow mechanism). Why did so little gold actually cross borders?
Mint parity is the exchange rate between two currencies that is automatically fixed by the ratio of the gold content between the two currencies. A surplus balance of payment causes an inflow of gold into a country reducing its exports as its goods become relatively expensive in the foreign market. Imports become cheaper resulting in an increase in imports. Subsequently, there is a gradual decrease in the balance of payment surplus towards the mint parity. In the case of a deficit there will an outflow of gold leading to reduced notes and prices. Exports eventually increase and imports reduce. This reduces the deficit towards the mint parity. Low quantities of gold actually cross borders due to administrative measures imposed by an economy. The authority may suspend conversion of gold with currency or fix the rate to be equal to the mint parity.
2. Why do Eichengreen and Temin (2010) compare the euro zone to the gold standard and to the global imbalances surrounding the US and China?
Eichengreen and Temin (2010) made the comparison because the three sides presented countries that were operating on deficit constraints. The countries included Germany (gold standard), Greece (euro zone), and US (trade imbalances). They faced challenges of budget deficit, running budgets and current account deficits and financing them by borrowing abroad. In the early 19th century, the policies of gold sterilization by the US and aggravated the policies of Germany. The latter was in surplus and refused to expand causing the latter to be in deficit and contract. The US refused to offer financial aid thus aggravating Germany’s extent of contraction. The same process is currently taking place where Greece (in a deficit) is trading with Germany (with a strong surplus).
3. Why would a country adopt capital controls on financial outflows? On financial inflows?
Capital account restrictions compensate for financial markets imperfections through an improved disclosure and superior prudential standards to the imposition of controls on global capital flows. Capital controls also help in reconciling conflicting policy objectives when the exchange rate is fixed or heavily managed by preserving the autonomy of monetary policy. This directs the policy towards domestic objectives and reduces pressure on the exchange rate. Capital controls further support policies on financial repression in an effort to help the government access cheaper financing to surplus the budget and finance priority projects.
4. Explain how fixed or pegged exchange rates encounter a conflict between internal and external balance. Do floating rates resolve this conflict? Refer to the history of the managed float among the triad countries since 1973 in your answer. Are national economic sovereignty and free capital flows incompatible? Is the goal of national economic sovereignty outdated in a globalized world?
A fixed exchange encounters external and internal balance conflict because it is difficult to keep a strong currency relative to currencies in other economies. The other economies may be using floating rates that adjust automatic. Floating exchange rates resolve the conflict by enabling the country to get rid of any balance of payments crisis and reduce the impact of shocks and foreign business cycles. Singapore, Indonesia and Malaysia coped with open capital accounts making them promote expansion, diversifying exports and reducing levels of inflation. National economic sovereignty and free capital flows are compatible because a free capital flows enable a country to produce what it has decided due to easy access to capital resources necessary for production. However, economic sovereignty is not outdated because countries decide to produce where they enjoy a competitive advantage in the global market
5. BRETTON WOODS
(A) Why were the designers of the Bretton Woods system desperate to avoid prolonged deflationary macro adjustment? Why did the creators of BW want a compromise between fixed and floating exchange rates? How did the structure of the Bretton Woods system reflect concern about the conflict between internal and external balance? Be specific.
Prolonged deflationary macro adjustments would lead to budget surplus. An economy will be injecting fewer funds than it will be withdrawing through taxes leading to a fall in economic activity and aggregate demand. A compromise between fixed and floating exchange lead to greater stability and certainty and also increased volatility in foreign exchange. The structure of the Bretton Woods system reflected the concern about the conflict between internal and external balance by forming the International Monetary Fund. It would offer loans to supplement economies with low reserves and a deficit in the current account.
(B) Doesn’t a fixed exchange rate regime, especially a system with an adjustable peg, invite speculative attacks (Pugel one-way speculative gamble)? Discuss the US experience in the 1960s to early 1970s as an example.
A fixed exchange rate regime with an adjustable peg invites speculative attacks because it does allow for the devaluing of currency when a trade deficit occurs and a revaluation in the case of a surplus. The US expected not to experience much risks of losing money by moving money away from its strong economy towards England where the pound needed to be revalued. Investors thought that the dollar was being overvalued and opted to invest in England.
(C) Explain the Triffin dilemma and how the events of the 1960s demonstrated the problem. Could the US and other participating countries have prevented the collapse of the BW regime or was it simply too flawed? If so, how? Explain.
Triffin dilemma is an economic observation in a situation where a national currency is used as an international reserve currency, leading to a conflict of interest between the short-term domestic and long-term economic objectives. The country faces huge trade deficits in an effort to supply the world with enough currency to enable it meet world demand for foreign exchange reserves. In 1960, the dollar was overvalued as shown by the price of an ounce of gold in dollars. An ounce of gold was being exchanged at $40 in London as compared to $35 in the US. The BW regime could not be prevented because the US had overspent on in strengthening its army, the Marshall plan and imports. It was required to operate a current account deficit and surplus simultaneously. This proved to be an impossible task.
(D) Why did the Bretton Woods financial system collapse? What lessons would you draw?
The main reasons for the collapse of the Bretton Woods financial system include its rigidity, US spending on the Vietnam War and social programs, and the divergence of national responses. A lesson drawn from the system is that it presented an instance of conflict of interest between national regulations with international regulation. The system was disrupted by extreme policies created by the US. It also shows that many countries could not allow misuse of power by any other economy. The system was also not open to economic change due to its rigidity.
(E) Explain the impossible or unholy trinity.
It is impossible to have a fixed exchange rate, free movement of capital and an independent monetary policy. It is based on IS/LM models and a finding that governments that have tried to pursue the three goals have always failed. The theory became formal when capital controls broke down in several countries and there was a conflict between fixed exchange rates and monetary autonomy. Many examples show many countries with loose capital controls, which result in a rigid exchange rate and less policies on monetary autonomy.
6. According to the impossible trinity, floating exchange rates would permit free capital flows and independent monetary policy devoted to internal balance. Would you amend this analysis in light of the experiences with the triad float?
Singapore, Malaysia and Indonesia have succeeded in stabilizing exchange rate at competitive levels and also enjoyed monetary independence with an open capital account. For instance, Singapore had abolished all exchange controls by 1978 in an effort to strengthen its role as a financial centre. Capital controls could not be effective in Singapore since the country’s financial centers included Indonesia and Malaysia. Singapore was able to reconcile openness with a stable growing money supply, low inflation, and stable real exchange rates.
7. Why were floating exchange rates (acting as shock absorbers) positively regarded in the 1960s? Why were they expected to work better than fixed or pegged rates? Discuss two of the serious problems that have arisen with the triad float. Does a floating regime require macro adjustments by participating countries? What is a managed float?
Floating exchange rates would protect a country from economic problems experienced in another country due to its flexible rates. They were expected to work better than fixed rates because fixed rates had become incompatible with a relatively independent monetary policy. A floating regime does not require macro adjustments because they are determined the forces of demand and supply in the foreign exchange market. A managed float arises when the central bank intervenes with a floating exchange rate. The bank provides money if the exchange rates are dropping to restore it.
8. Was the European single currency a mistake? How does Greece’s membership in the euro zone limit its options going forward? What is its likely future? Explain carefully.
The European single currency is a mistake because the heterogeneity nature of the European Union is an obstacle to the e mergence and smooth operation of the monetary union. Member countries are endowed with different factors of production. Effects of external change will be different on different economies. Greece is a small economy and is incapable of assuming the obligations of its membership in the short time period and playing an active role in ensuring success of the process of integration in the long run.
9. The US$ was depreciating during the later years of the Bretton Woods international financial regime, and the US$ has been depreciating for much of this decade. Are the reasons the same? Explain carefully.
The US dollar depreciated in both periods due to the same reason of increased spending and credit financing. In the late periods of the Bretton Woods regime, the US was spending much on the Marshall plan, strengthening its army and purchasing large quantities of foreign goods. This led to a budget deficit that was financed by loans borrowed abroad. In recent times, Americans are spending so much money on credit and making huge investments in real estate and other activities. This has led to a reduction in the circulation of real money. Eventually, the dollar weakens and increases the cost of imports.
10. Could we avoid huge swings in exchange rates if the triad countries tried harder to coordinate macro policies? Is more coordination likely? Desirable?
Coordination of macro policies would avoid huge swings in exchange rates because the underdeveloped economies would adopt fiscal expansion policies and the developed nations would adopt fiscal contraction policies. This would lead to small deviations in exchange rates as monetary expansions increases result in net exports and a reduction in foreign output by a relative amount. Coordination is likely because triad countries are less developed and their coordinating activities would attract a third economy such as the US. They are desirable because the triad country would benefit more than developed economies.
