Econ 797: Broad History of Exchange Rate Regimes. Arslan Razmi Fall 2016

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2 Econ 797: Broad History of Exchange Rate Regimes Arslan Razmi Fall 2016

3 Econ 797: Broad History of Exchange Rate Regimes 3 Miss Prism: Cecily, you will read your Political Economy in my absence. The chapter on the Fall of the Rupee you may omit. It is somewhat too sensational. Even these metallic problems have their melodramatic side. -Oscar Wilde, The Importance of Being Earnest Having behind us the commercial interests and the laboring interests and all the toiling masses, we shall answer their demands for a gold standard by saying to them, you shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold. William J. Bryan Cross of Euros - Kevin H. O Rourke and Alan M. Taylor, [1].

4 Econ 797: Broad History of Exchange Rate Regimes 4 1 Broad categories Fixed Either against a commodity (gold or silver) or against the n th currency (a currency board) Pure example would be dollarization or a currency union. Free floating or perfectly flexible Intermediate regimes (fixed but adjustable, managed floating, target zones, crawling peg, etc.)

5 Econ 797: Broad History of Exchange Rate Regimes 5 Taxonomy of choices. Source: [2]

6 Econ 797: Broad History of Exchange Rate Regimes 6 2 Historical progression Commodity money systems Napoleonic Wars-1870s: Bimetallic standard: Both gold and silver were used as money, accepted as means of payment. 1870s onwards - classic gold standard

7 Econ 797: Broad History of Exchange Rate Regimes The Gold Standard ( , ) 1 In theory a rules-based system Under a pure gold standard, different currency names would simply be different names for specified amounts of gold In practice, fractional reserve system with paper currency as the medium of exchange This impure system frees gold up for use as an ordinary commodity. paper easier to exchange and transact. Moreover The Central Bank promises to maintain the price of gold (i.e., redeem paper notes in exchange for a certain amount of gold). Each unit of currency is backed by an announced amount of Central Bank gold assets 1 This section borrows heavily from [3], ch. 4.

8 Econ 797: Broad History of Exchange Rate Regimes 8 Rules of the game: 1. The monetary authority promises to maintain convertibility at an announced price 2. No restrictions on imports or exports of gold by private citizens 3. Gold backing proportional to amount of currency 4. (implicit) If rule 1 is temporarily suspended convertibility is to be restored at the old parity as soon as possible.

9 Econ 797: Broad History of Exchange Rate Regimes 9 Talk a bit about the Hume specie flow mechanism...

10 Econ 797: Broad History of Exchange Rate Regimes 10 Given that the Central Bank targets the price of gold (P G ), how are currency prices of goods (P ) determined? We will (implausibly) assume fixed output (y) and distinguish between short-run (flow) analysis and long-run (stock) analysis. Two uses of gold: (1) monetary, (2) non-monetary (jewelry, etc.) Supply of gold given (at a level G 0 ) in the short-run but evolves over time (through new discoveries and depreciation in a closed economy; through the balance of payments in an open one)

11 Econ 797: Broad History of Exchange Rate Regimes 11 Demand for gold = Demand for monetary purposes (D M ) + Demand for non-monetary purposes (D N ). p = P G P D N = f ( ) ( ) p ; (+) y The monetary authorities promise to maintain a constant gold backing (λ), where (1) Demand for money: λ = P GD M M ; 0 < λ 1 M = P L(y) (2) Notice the absence of a portfolio motive. David Hume vs. Keynes, etc.

12 Econ 797: Broad History of Exchange Rate Regimes 12 Therefore, or, λ = pd M L(y) (3) D M = λl(y) p Thus, both D N and D M are negative functions of p. (4) D = D ( ) p; y, λ ; D p < 0, D y, D λ > 0 (5) Fixed stock of gold available in the short-run at: G = G 0 (6)

13 Econ 797: Broad History of Exchange Rate Regimes 13 Short-run equilibrium: or, D = D ( ) p; y, λ = G 0 p = p( + y, + λ, G) (7) With P G and λ fixed by policy, output given, and the supply of gold inelastic, P and hence p, are determined by the system. where, p y = D y D p, p λ = D λ D p, p G = 1 D p Note: Make sure that you can decribe the intuition underlying these and other partial signs.

14 Econ 797: Broad History of Exchange Rate Regimes 14 Over the longer run: In a closed economy, supply is a function of extraction effort, etc. g s = h (p, α) ; h p, h α > 0 (8) Non-Monetary gold depreciates at a rate δ, so that the volume lost each period is: g d = δd N (p; y) ; D Np < 0, D Ny > 0 (9) The quantity of gold will neither rise nor fall when P G P = ( P G ) P Here * refers to the steady-state level, not the foreign level

15 Econ 797: Broad History of Exchange Rate Regimes 15 Stock equilibrium In the steady state, the stock of gold should grow at a constant rate, i.e., new discoveries should exactly offset depreciation. Ġ = g s g d = h (p, α) δd N (p; y) = constant (10) or, writing the function implicitly in excess (flow) supply form: Or, substituting for p from equation (7): F (p, α, y) = 0 where F G < 0, F λ, F α > 0, F y 0. F (G; y, λ, α) = 0 (11)

16 Econ 797: Broad History of Exchange Rate Regimes 16 Partials in more detail: F G = p G (h p δd Np ) F λ = p λ (h p δd Np ) F α = h α F y = (h p δd Np )p y δd Ny Note: These are not equilibrium solutions that satisfy eq. (11), but rather partial effects on Ġ of changes in the relevant variables.

17 Econ 797: Broad History of Exchange Rate Regimes 17 What if the relative price of gold is momentarily above ( P G P )? The higher price causes extraction that exceeds wastage. Over time the stock of gold increases. Since the CB targets P G, money supply increases (i.e., the CB buys gold in exchange for money) The vertical gold supply curve shifts to the right. With more money chasing the same number of goods, P rises (i.e., p declines).

18 Econ 797: Broad History of Exchange Rate Regimes 18 h(p G /P) P G /P P G /P (P G /P) 0 D(P G /P ;y,λ) (P G /P) 0 (P G /P) * δf(p G /P ;y) G 0 G g * g 0 g The left and right panels present the SR and LR set-ups. The downward-sloping curve in the left panel derives from eq. (7). The two right panel curves derive from eqs. (8) and (9).

19 Econ 797: Broad History of Exchange Rate Regimes 19 Effects of macroeconomic shocks (1) Improved gold extraction technology ( α) (Spanish discovery of gold reserves in the Inca Empire) Curve shifts: From equation (7), p α = 0, D From equation (8), p α = h α h p < 0 h(.) From equation (9), p α = 0 δdn (.)

20 Econ 797: Broad History of Exchange Rate Regimes 20 New discoveries of gold

21 Econ 797: Broad History of Exchange Rate Regimes 21 Steady state solutions From equation (11), dg s dα = F α F g = h α > 0 s dg dα = F α F G = h α h p δd Np D p > 0 which, combined with equation (7) yields dp dα = p dg G dα = h α h p δd Np < 0

22 Econ 797: Broad History of Exchange Rate Regimes 22 h(p G /P) P G /P P G /P (P G /P) 1 (P G /P) 1 (P G /P) 0 D(P G /P ;y,λ) (P G /P) 0 δf(p G /P ;y) G 0 G 1 G g 2 g 2 g 1 g Shift in stock demand toward gold

23 Econ 797: Broad History of Exchange Rate Regimes 23

24 Econ 797: Broad History of Exchange Rate Regimes 24

25 Econ 797: Broad History of Exchange Rate Regimes 25 William Jennings Bryan and the cross of gold. The gold rush in California ( ) Gold supply later stabilizes. Few major discoveries between After 1870, a number of countries including the US adopted the gold standard Positive global gold demand shock In other words, goods price deflation

26 Econ 797: Broad History of Exchange Rate Regimes 26 This period coincides with (mostly) agriculture-based westward expansion of the US Farmers typically dependent on credit (i.e., debtors) Deflation meant that the real value of farmer debt rose causing financial hardship (redistribution of income from debtors to creditors) Contributed to the rise of the populist movement in the 1880s and 90s.

27 Econ 797: Broad History of Exchange Rate Regimes 27 Demanded remonetization of silver William Jennings Bryan (Democratic and Populist Party Presidential candidate in 1896) [W]e will answer their demand for a gold standard by saying to them: "You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind upon a cross of gold.

28 Econ 797: Broad History of Exchange Rate Regimes 28 Key twist: The Populists wanted silver monetized at price above its market price. Why? People will then buy silver from the market and sell it at the mint in exchange for money. With the passage of time, the US will effectively be on a silver standard. This will put upward pressure on the money supply and prices providing relief to debtors.

29 Econ 797: Broad History of Exchange Rate Regimes 29 With an open economy, the flow supply of gold becomes a function of the balance of payments (not covered here but easily analyzable in terms of balance of payments accounting and the CB s balance sheet). The Central Bank s Balance Sheet Net wealth from interest earn Assets Liabilities Government and nongovernment Currency in circulation securities Foreign exchange reserves (cash, bills, bonds, gold,etc.) Bank reserves ings, etc.

30 Econ 797: Broad History of Exchange Rate Regimes 30 Since gold flows resulting from trade imbalances lead to adjustments in price levels, movements in prices would tend to be cyclical rather than trending. The global relative price of goods is endogenously determined by the global demand for and supply of gold.

31 Econ 797: Broad History of Exchange Rate Regimes Inter-War period Return to gold standard expected What parities to set? Britain returned in 1925 at the pre-war parity level Keynes s opposition Unemployment and falling nominal wages (a phenomenon much less observed today thanks to unions, etc.)

32 Econ 797: Broad History of Exchange Rate Regimes 32 Several economic historians have noted that the gold standard contributed to prolonging, if not causing the Great Depression, and transmitting it across the world. The US devalued and abandoned the gold standard in 1933 as part of FDR s response to the Great Depression Other nations followed suit Eichengreen and others have shown that nations that left the Gold Standard recovered more vigorously from the Great Depression and resorted less often to protectionist measures Friedman termed the US regime between WWI and 1933 as being a pseudo gold standard since λ was not kept constant (it increased, putting deflationary pressure on US, and by repercussion, on ROW).

33 Econ 797: Broad History of Exchange Rate Regimes Bretton Woods, New Hampshire 1944 Fixed but adjustable exchange rates IMF overseeing exchange rate arrangements and short-term financing n 1 currencies fixed to the dollar. The n th currency fixed to gold ($35 per ounce) Relatively closed capital accounts in most countries

34 Econ 797: Broad History of Exchange Rate Regimes 34 The Triffin dilemma To maintain the BW system, US BP deficits required to provide liquidity to ROW But a deteriorating international asset position undermines confidence in the US ability to redeem dollars Speculation against the dollar Dollar covertibility suspended in 1971

35 Econ 797: Broad History of Exchange Rate Regimes The present non-system Floating exchange rates in most advanced economies outside of the Eurozone No foreign exchange intervention by CB EMS (setting up ERM) in 1979, Maastricht in 1991 and then the Eurozone in 1999.

36 Econ 797: Broad History of Exchange Rate Regimes 36 Mostly fixed or pegged in developing countries until the late 1990s Changed as a result of lessons learned from the Tequila crisis (1994), the Asian crisis ( ), Russia and Brazil (1999), and Turkey (2001?) Fear of appreciation and reserve accumulation

37 Econ 797: Broad History of Exchange Rate Regimes 37 1.The Eurozone crisis and the German-Italian One Year Bond Differential

38 Econ 797: Broad History of Exchange Rate Regimes 38

39 Econ 797: Broad History of Exchange Rate Regimes 39 Appendix This appendix formally treats the adjustment over time discussed in the lecture. Let s start by re-writing the equation for stock adjustment: Ġ = g s g d = h (p, α) δd N (p; y) = F (G; y, λ, α) (12) This is a first order non-linear differential equation. The fact that it is non-linear means that we can only analyze it qualitatively. Now recall that F G is negative. This means that the system is stable and the trajectories would look something like those shown in the figure below.

40 Econ 797: Broad History of Exchange Rate Regimes 40 The arrows confirm our initial conclusion that the system is stable. We could also analyze the system more explicitly but then we will have to linearize the equation. The proper way to do it would be to use a Taylor approximation so that our analysis is in terms of deviations from the steady state. Here I will take a short cut, and specify the following adjustment mechanism based on equation (12): Ġ = cg + α; c > 0 (13) where, as you know, c is the constant (exponential) growth rate of G while α represents exogenous influences on the supply of gold. Notice that, Ġ/ G < 0, so the system is dynamically stable, i.e., converges to G.

41 Econ 797: Broad History of Exchange Rate Regimes 41 2.The transition dynamics

42 Econ 797: Broad History of Exchange Rate Regimes 42 Suppose there is a new technological discovery at time t = 0 that makes it easier to extract gold (α rises). This shock shifts the AA locus up and Ġ rises to a value corresponding to point B in the figure.g gradually changes over time but is unchanged at that instant. To find the magnitude of this jump in Ġ, we can simply differentiate Ġ w.r.t. α, which in this case yields 1. The particular (or steady state) integral of equation (13) is given by, G = α/c. Thus an increase in α shifts the steady state value of G to the right. By how much? To find out, we need the answer to the question, how much should G change by in response to a unit change in α to maintain Ġ = 0? The answer is: dg dα = Ġ/ α Ġ/ G = 1 c > 0

43 Econ 797: Broad History of Exchange Rate Regimes 43 We had already carried out the steady state analysis in the main lecture, albeit for the non-linear case. Let s extend that analysis by looking at the behavior of the stock of gold look like over time? As you know from Econ 751, the solution to this differential equation takes the form: G = G + [G(0) G ]e ct (14) where G(0) is the value of G at the time of the shock (i.e., the initial value of G), and G(0) G (or, G(0) α/c) captures the initial deviation from the steady state gold stock. Also notice that, as t approaches infinity, the term in the square brackets becomes vanishingly small; the higher c is, the faster this happens).

44 Econ 797: Broad History of Exchange Rate Regimes 44 So, in sum, A supply shock takes the system from a point like A to a point like B, after which the stock of gold increases over time (and Ġ declines) until the system converges to the new steady state. With a low proportional rate of change of G, the system can be away from the steady state for a long time. Needless to say that, based on eq. (7) we could do a similar analysis of the time path of p.

45 Econ 797: Broad History of Exchange Rate Regimes 45 Exercises 1. Show that, under the Gold Standard, the nominal exchange rate between any two countries is simply the ratio of their gold prices. What feature of the system is required to ensure this outcome (clue: think of the rules of the gold standard)? 2. What is Gresham s Law? Can we apply it to modern day conditions (think, for example, of the black market for dollars in Venezuela). 3. Analyze the case under the Gold Standard where the Central Bank becomes more conservative ( λ). Be sure to think about both the short- and long-run implications and to show both your mathemtical and graphical results and to describe them in intuitive terms. What feature of the system drives these results? 4. Now suppose we relax the assumption of constant employment of resources and introduce price stickiness instead (i.e., assume p is fixed instead of y). How does this change your analysis in (3) above?

46 Econ 797: Broad History of Exchange Rate Regimes 46 [1] Kevin O Rourke and Alan Taylor. Cross of euros. Journal of Economic Perspectives, 27(3):167 92, [2] Max W. Corden. Too sensational: on the choice of exchange rate regimes. MIT Press, Cambridge, [3] Bennett McCallum. International Monetary Economics. Oxford University Press, New York, 1996.