POLI 12D: International Relations Sections 1, 6 Spring 2017 TA: Clara Suong Chapter 9 International Monetary Relations
9 INTERNATIONAL MONETARY RELATIONS
Core of the Analysis National Monetary Order Fixed Exchange Rate Floating Exchange Rate International Monetary Order Commodity Standard (e.g. classical gold standard) Commodity- backed Paper Standard (e.g. Bretton Woods system) National Paper Currency Standard There are often domestic conflicts over the best currency policy. Because exchange rates represent the relative value of currencies, there are incentives to cooperate for mutual gain. International monetary institutions can facilitate cooperation in international monetary policy.
What Are Exchange Rates, and Why Do they Matter? Exchange rate: the price of a national currency relative to other national currencies. The exchange rate can go up and down E.g., when the dollar goes up in value against some other currency it is said to appreciate or strengthen. If the dollar s value goes down against that of another currency, it is said to weaken, depreciate, or to be devalued. The exchange rate is very important to a country s international economic relations. E.g., when a country s currency appreciates, its products are more expensive for others to buy
How Are Currency Values Determined? The exchange rate goes up and down in response to change in supply and demand. Exchange rates represent the price of a currency Foreigners considering investing in a country weigh relative interest rates. Higher interest rates make it more profitable for people to put (or keep) their money in a country
What Are Exchange Rates, and Why Do they Matter? Governments raise and lower interest rates as a part of their monetary policy. Governments aim to affect macroeconomic conditions by manipulating monetary policy Macroeconomic conditions include unemployment, inflation, and overall economic growth. The most common manipulation involves interest rates. Lower interest rates make it easier for people to borrow, allowing the economy to expand Higher interest rates make it harder to borrow, restraining demand Government policy can have a powerful impact on a currency s value.
Allowing the Exchange Rate to Change Should a government fix the exchange rate or let it float? Fixed exchange rate: A government promises to keep the national currency at a constant value (measured in another currency or a precious metal such as gold) The period of the classical gold standard: From about 1870 to 1914, many governments promised to exchange their currency for gold at an established rate Floating exchange rate: A currency s value fluctuates freely, driven by markets or other factors
Allowing the Exchange Rate to Change
Allowing the Exchange Rate to Change The Bretton Woods monetary system followed the gold standard and prevailed from 1945 to 1973. Bretton Woods was a system of fixed but adjustable rates (an adjustable peg): Required governments to fix currency values for relatively long periods but permitted them to alter them if and when desirable
Who Cares about Exchange Rates, and Why? Governments must decide whether currencies should be fixed, floating, or in between. Fixed exchange rates provide stability and facilitate international trade and investment. But fixed rates reduce or eliminate a government s ability to have its own independent monetary policy Floating exchange rates offer more freedom to pursue one s own monetary policy. The government does not have to keep the exchange rate fixed However, floating exchange rates can make international trade and investment much more difficult.
Consumers and Businesses Consumers and businesses whose economic activities are entirely domestic are likely to favor a floating exchange rate. They want the government to be able to manipulate the national economy freely Interests may also clash over a currency s desirable value.
Consumers and Businesses A strong exchange rate allows consumers to buy more of the world s products. But it also makes domestic goods more expensive to foreigners From 1981 to 1985, the US dollar appreciated by more than 50%. Increased purchasing power but led to serious problems in American manufacturing industries
Consumers and Businesses A weak currency has less purchasing power, making domestic consumers worse off. Prices of foreign goods rise, contributing to inflation A government s exchange rate policies depend on the structure of its economy, interest groups and the political system.
Can There Be World Money without World Government? National monetary order: Provides predictability in the value of money and in the price of goods International monetary order: Provides predictability in currency values across borders
Question Holding everything else being constant, would American consumers prefer the U.S. dollar to be strong or weak against other currencies? (Hint: compare amount of foreign goods they can buy in each case)
International Monetary Regimes International monetary regime: An arrangement that is widely accepted to govern relations among currencies and that is shared by most countries in the world economy These regimes help facilitate international economic exchange.
International Monetary Regimes Two principal features: Clarify whether currency values are expected to be fixed or floating (or mixed) Establish a common base or benchmark to which currencies can be compared Three kinds of benchmarks: Commodity standard Commodity- backed paper standard National paper currency standard
International Monetary Regimes Commodity standard: A good with inherent value is the basic monetary unit (e.g., gold or silver coins) Commodity- backed paper standard: National governments issue paper currency with a fixed value in terms of gold A national paper currency standard: Currency is backed only by the commitments of its issuing governments to support it Today, most international exchange is measured and conducted with the dollar and the euro.
International Monetary Cooperation and Conflict A successful international monetary regime depends on interactions among the governments of the world s major economies. National governments face incentives to both cooperate and to enter into conflict.
The Gold Standard (1870s 1914) The stability of the classical gold standard relied on close ties among the three leading financial powers: Britain, France and Germany. General agreement that the gold standard was beneficial sustained it for many decades. The gold standard was very controversial in the US because it made exports less competitive. Nonetheless, there was enough domestic support to sustain the gold standard from 1870 to 1914. After the Great Depression, governments tried floating- rate systems based on paper national currencies. This probably contributed to the collapse of the international economy in the 1930s. The system caused volatility and instability
The Bretton Woods System (1945 1973) After WWII, Britain led the way in designing the Bretton Woods monetary system. It was organized around the dollar, which was tied to gold at a fixed rate of $35 per ounce Like the gold standard, the Bretton Woods system relied on collaboration among its members. Under this system, the International Monetary Fund was created. Charged with overseeing currency relations and providing support to countries in need of short- term assistance By the early 1970s, the US was no longer willing to keep the dollar fixed to gold.
Today s International Monetary System Today s system is based on floating exchange rates among a few major currencies. In particular, the US, Japan, Germany and Britain It does not depend on explicit commitments to fixed exchange rates. But it requires the major national governments to work together, especially in times of crisis Exchange rates still fluctuate quite widely. Without an established global monetary system, some countries have developed regional monetary systems to stabilize exchange rates among groups of countries.
Regional Monetary Arrangements: The Euro Pursued after the collapse of the Bretton Woods monetary system by the European Union (EU). At first, fixing EU exchange rates meant pegging them to the German currency, the Deutsche mark. But in 1991, Germany raised its interest rates very high, causing many EU members to defect The next plan was for the European Central Bank (ECB) to establish the euro. Germany agreed: The ECB was to be based in Frankfurt, Germany Germany wanted less currency volatility in Europe The euro was connected to many different cooperative projects by the EU
Regional Monetary Arrangements: The Euro The euro was adopted as Europe s circulating currency in 2002. Britain and Sweden remain outside of the monetary union Many countries attempt to stabilize their exchange rates through regional currency unions.
What Happens When Currencies Collapse? Fears that a government cannot maintain an exchange rate can create a panic. A typical currency crisis: A government is committed to a fixed exchange rate but faces pressure to devalue the currency This creates unease about the credibility of the government s commitment
Effects on Government The government is torn: Either keep the current exchange rate where it is or allow the currency s value to drop Eventually, the currency is devalued. The burden of foreign currency debt rises, many go bankrupt, and a recession typically follows
International Repercussions Contagion: uncertainty about one country can feed uncertainties about others. Currency crises often create broader financial and economic difficulties.
Case Study: Europe Most EU countries had pegged their currency to the Deutsche mark. In 1991, the German central bank raised interest rates to prevent inflation after the eastern and western parts of the country were unified European governments had to either continue their membership in the Deutsche mark bloc, or get out and avoid a recession. In the end, the peg was too costly, and governments began devaluing their currency. Despite the failure, plans for the euro began. There was agreement on the need to limit the negative effects of currency crises
Case Study: Mexico The Mexican government wanted to hold the peso steady against the US dollar. But in 1994, the government struggled to maintain its commitment to the peso The government was ultimately forced to devalue its currency, throwing the country into a financial panic. The crisis affected all of Latin America
Case Study: East Asia In 1997, East Asian economies were booming. But inflation was rising and banks were taking on more and more debt Investors began to expect devaluations and started selling off East Asian currencies. Within weeks, currencies collapsed: Malaysia dropped 40%, Thailand dropped 50%, and Indonesia dropped 80%
Containing Currency Crises All major governments have a common interest in containing these crises. But there is conflict over how to distribute the cost of providing this public good The IMF and other international institutions support governments going through a crisis. Cooperation among national governments can mitigate the international impact of currency crises. But critics argue that taxpayers should not be forced to bail out foolish investors and overextended governments.
Conclusion: Currencies, Conflict, and Cooperation The exchange rate s impact differs among groups, firms, regions and individuals. An international monetary regime is a public good. Everyone benefits from its existence But governments have incentives to free ride and not pay its costs Some argue that we may be heading towards a world of regional currency blocs. The future of these arrangements depends on the interests governments have in developing them.
Group Discussion https://www.youtube.com/watch?v=ulqicn0 YNmw What do the dinner party and the menu mentioned in the video stand for? The video focuses on drawbacks of multiple countries having a common currency. What are the benefits of having a common currency?