International Monetary Exchange in Theory

Lecture 11 – Tuesday, 18 October 2011J A Morrison 1

Satirical Cartoon of John Law’s Mississippi Scheme (Paris, 1720)

We’re at another turning point in the course…

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PS 0304 Int’l Pol Econ• Unit 1: Studying the Global Economy

– Topic 1: Introductory– Topic 2: Perspectives on IPE– Topic 3: Explaining Foreign Economic Policy

• Unit 2: Trading Goods & Services– Topic 4: Trade in Theory– Topic 5: Trade in Practice

• Unit 3: The International Monetary System– Topic 6: The IMS in Theory– Topic 7: The IMS in Practice

• Unit 4: Migration• Unit 5: Special Topics in IPE 3

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Lec 11: Money in Theory

I. Introductory: Money is HardII. The Basics of Monetary

Exchange

III.The International ConnectionIV.Exchange Rate Politics

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Lec 11: Money in Theory

I. Introductory: Money is HardII. The Basics of Monetary

Exchange

• The International Connection• Exchange Rate Politics

5

Before we launch into the specifics of international

monetary exchange, let’s step back to consider international

monetary exchange in the context of international trade.

How does money compare to trade?

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Simply put, money is hard…

Money is hard for us—the academicians—to understand.

And it is hard for policymakers to control.

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Money is Hard for Us

• Less familiar than trade• More abstract than trade & migration• Money has changed more over time

– Variation in policies: fixed versus flexible• akin to change in trade policy: liberal

versus managed

– But money itself might be different: commodity currency is governed by different rules than is fiat currency

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Money is Hard for Policymakers

• More difficult to understand• Imprecise, blunt instruments• Money is more mobile more

difficult to control• Severe market constraints: attacks,

competition, counterfeiting, contagion, &c.

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So, the international monetary system is more difficult for

policymakers to manage than is trade.

But, arguably, the stakes are higher…

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Money Matters• The downside risk is greater

– Collapse of trade: ouch!– Currency collapse catastrophic!

• All interests are affected– Some groups rely relatively little on trade– Everyone uses money tighter coupling with

macroeconomic effects

• Damage is harder to repair– Violating a trade agreement causes upset– States spend decades trying to repair

reputations after currency disorders

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Here’s our plan…

We’ll proceed as we did for trade: first theory, then empirics.

Be prepared that money will be challenging. I’ll do my best to

unpack the key terms and concepts. But you might have to

turn things up a notch.

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I. Introductory: Money is HardII. The Basics of Monetary

Exchange

• The International Connection• Exchange Rate Politics

13

Lec 11: Money in Theory

II. BASICS OF MONETARY EXCHANGE

1. Background on Money• Monetary Systems

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It’s easy to understand why we trade goods & services:

the benefits of specialization are readily

apparent.

Understanding the invention and use of money,

however, is less immediately obvious. 15

Money serves three functions…

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(1) Medium of Exchange

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• Money resolves “double coincidence of wants problem”

Individual Has Wants

John A Fedora Air Jordans

Adam Air Jordans A Sweater Vest

Maynard A Sweater Vest A Fedora

What are the chances that you’ll encounter someone who has what you want and wants what you have?

Hint: < Finding True Love

Money evolves as a means to resolve this problem.

Individuals accept a common good with certain characteristics (high value

to bulk ratio, divisible, durable, uniform in quality) that becomes the common

medium of exchange. 18

(2) Store of Value

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• Money allows individuals to convert perishables into more durable goods

• This allows:– Storing value between transactions– Saving by hoarding cash

(3) Unit of Account

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• Money provides a standard relationship between various g&s in the economy

Using a standard unit simplifies accounting and transactions immensely

Non-standard Unit Standard Unit

1 Blazer = 2 Air Jordans Blazer = $200

2 Blazers = 5 Fedoras Air Jordans = $100

4 Air Jordans = 5 Fedoras

Fedora = $80

II. BASICS OF MONETARY EXCHANGE

1. Background on Money• Monetary Systems

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Across history, nations have chosen a wide variety of materials

to serve as money.

The ancient Greeks used cattle, some Native Americans used

wampum, and the early Chinese used cowry shells.

Today, most countries use “paper” currency, which is usually made

from cotton and/or linen. 22

For most of history, in most places, markets came to rely on specie--minted, precious metal

coins.

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We can organize monetary systems according to the various

values of the money…

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The Values of Money• Intrinsic Value: market value of the

currency’s constituent material when used for non-monetary purposes– E.g. gold coin sold as material for jewelry

• Exchange Value: market value of the currency when used as currency in trade– E.g. gold coin used to purchase jewelry

• Extrinsic/Nominal Value: “official” value and/or units– E.g. “1 shilling,” “1 dollar” 25

Monetary systems can be grouped along a continuum according to

the gap between the intrinsic and the exchange values of the

currency.

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Types of Monetary Systems

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Monetary System Type

Intrinsic Value

Exchange Value

Gap Examples

Commodity Money

Relatively High

High Narrow or None

England in 1690s; Chinese Cowry Shells

Fiat Money Relatively Low

High Very Large USD today; Euro today

Seigniorage• Historical Origin: charge at mint to

convert raw material into currency– Also called “brassage” or “coinage”

• Modern Usage: “the excess of the nominal value of a currency over its cost of production” (Cohen, Future of Money, 18)

• Implications:– Revenue source for state– Creates incentive to counterfeit—(the

unauthorized creation of currency)

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Seigniorage and Monetary Systems

• Commodity Money– High seigniorage might be viewed as

revenue source (e.g. 18th C France)– Low or no seigniorage would subsidize

exports and encourage capital inflows (e.g. 18th C Britain)

• Fiat Money– Seigniorage is necessarily high;

seigniorage creates the difference of value between intrinsic and exchange values

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The historical trend is clearly away from commodity money and toward fiat

money.

Policymakers generally prefer fiat money because (1) they gain increased revenue from seigniorage; and (2) the market imposes fewer constraints on

monetary policy when using fiat money.

But the power to “print” money is frequently abused. Some economists,

like FA Hayek, appreciated the discipline imposed by commodity money systems.30

I. Introductory: Money is HardII. The Basics of Monetary

Exchange

III.The International Connection• Exchange Rate Politics

31

Lec 11: Money in Theory

III. THE INTERNATIONAL CONNECTION

1. The Nth Currency2. Exchange Rate Regimes• The Balance of Payments

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The same logic that impels the development of a common medium of

exchange within economies impels the adoption of international media of

exchange between economies.

Such a currency is sometimes called the Nth

Currency.33

Gold & silver previously performed this role.

After WWII, the US dollar was the preeminent Nth

Currency.

Today, the dollar faces competition from the Euro, the Yen, and the Renminbi. 34

“The United States would be mistaken to take for granted the

dollar’s place as the world’s predominant reserve currency…

Looking forward, there will increasingly be other options to

the dollar.”

-- World Bank President Robert B. Zoellick (26 Sept 2009)

(Source: NYT 28 Sept 2009)

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Why would foreign states move away from holding the dollar in reserve and

using the dollar in international exchanges?

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Because the dollar doesn’t perform the

functions of money as well as it used to!

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The Dollar’s Declining Role

• Medium of Exchange– US share of total GATT/WTO Member

GDP• 1948: ~65%• 2001: ~38%

(Source: Barton, et al, p 13)

• Store of Value– Market price of gold (per ounce) in $US

• 1945: $35/ounce• 14 Oct 2009: $1063/ounce• 11 Oct 2010: $1348/ounce

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The Falling Value of the USD

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III. THE INTERNATIONAL CONNECTION

1. The Nth Currency2. Exchange Rate Regimes• The Balance of Payments

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How do states determine their relationships to the Nth Currency, whatever it

might be?

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Through their exchange rate regimes.

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An exchange rate (ER) is the specific valuation between domestic currency and a

foreign/international currency/commodity.

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British Pounds (GBP) per Dollar (USD)

A state’s exchange rate regime is the set of rules

that determine the relationship (including

valuation) between domestic currency and

foreign currencies, the Nth currency, and/or key

commodities.44

(For now, we assume governments enjoy monetary sovereignty, the

ability to control the market value of their currencies.)

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How States Regulate the Value of the Currency

• Intervention in Foreign Exchange (Forex) Market– Buy/sell reserves of domestic currency, foreign

currency, and/or a key commodity to directly affect market prices

• Adjust Quantity via Monetary Policy– Open Market Operations– Fractional Reserve Rate– Discount Rate (Interest Rate)

• By Proclamation and/or Price Controls– “What was previously worth $1 shall now be worth

$5.”– “Grain shall not be sold for less than $5 per bushel.”– “One Pound shall not be traded for more or less

than $4.86.”46

States can regulate the value of the currency vis-à-

vis:

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- Foreign currency(ies)- Key commodity(ies)- The overall national price level

Is it possible to fix a currency with respect to several things

simultaneously?

Not usually.

Different parts of the economy grow at different rates.

Maintaining stability with respect to one generally precludes stability with respect to the

others.

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Pick a Price, Any Single Price

• Assume Different Rates of Growth– World supply of gold: 2%– US GDP: 3%– British GDP: 1%

• What should be rate of increase of US dollars?– Stable gold price: 2%– Stable overall price level: 3%– Stable ER vis-à-vis pound: 1%

Stability can only be maintained along one dimension at a time

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Exchange rate regimes exist along a continuum: to what extent does the state use

its monetary sovereignty to maintain a stable exchange

rate in the market?

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Exchange Rate Regimes

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Intervention to Maintain Stability

Names of ER Regime Examples

High Fixed; Pegged GB on Gold Standard; Hong Kong Dollar

High Intervention with Periodic Adjustment

Fixed-but-Adjustable; Crawling Peg

Mexico in 1990s; Some Gold Standard Countries; China

Low or None Flexible; Floating; Free Float

US Dollar; Yen; GBP; Euro

-- We’ll sometimes simplify things, talking here in terms of regimes that are “fixed” and those that are and “flexible/adjustable.”

NOTE: the de facto fluctuations in market value may not always align with

the de jure regime…

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Government management sometimes fails to achieve its

goal…

“Fixed” ER regimes do not always generate stable market

ERs.

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And sometimes states claim to have “flexible” ERs but, in reality, regulate them such

that their market values remain stable.

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Mexico & Switzerland in the 1990s

Country De Jure (Official) ER Regime

Market ER Trends

Mexico Fixed vis-à-vis the dollar

Volatility; de facto float

Switzerland Flexible Stability; de facto peg vis-à-vis the dollar

55Grieco & Ikenberry, 62.

So, again, note that the regime is determined by

what the monetary authority actually does, not

what it promises to do.

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III. THE INTERNATIONAL CONNECTION

1. The Nth Currency2. Exchange Rate Regimes• The Balance of Payments

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Bunsen, I thought we were done with

the balance of payments!!!Well, Dewb, I

thought you could use a refresher...

Remember that the balance of payments (BoP)

reconciles all of a country’s financial transactions with

the world.

This includes trade, remittances, investment,

loans, &c.59

You should also remember that the ER regime

determines, in part, how balance in the BoP is

maintained.

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BoP Adjustment under Flexible ER Regime

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How do states achieve balance while keeping the

ER fixed?

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Remember this slide?

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Lecture 6: Balance of Payments (Slide #38)

Reconciling the Balance of Payments with Fixed ER

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1. Adjustment of Reserves2. Adjustment of Internal Prices &

Incomes 3. Exchange Rate (ER) Adjustment4. Exchange Controls

1. Capital Controls: Limit convertibility2. Commercial Policy

1. Adjustment of Reserves

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2. Macroeconomic Adjustment

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4.1 Capital Controls

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4.2 Commercial Policy

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I. Introductory: Money is HardII. The Basics of Monetary

Exchange

III.The International Connection• Exchange Rate Politics

69

Lec 11: Money in Theory

Note that the title of this section comes from Jeff Frieden’s piece.

We know from scholars like Frieden & Cohen that states’ choices about their exchange rates are intensely political.

So, we can draw on our theories of political economy to understand the political underpinnings of the international monetary system. 70

Systemic Theories: Distribution of Power

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• Charles Kindleberger (1973)• International Monetary System

requires stabilization– Serve as lender of last resort– Provide liquidity

• Hegemonic Stability Theory: hegemon is willing and able to stabilize the system

Domestic Interests

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• Jeff Frieden (1988); J. Lawrence Broz (1997)

• Like trade, exchange rate policy helps & hurts economic interests

• Interest groups will form coalitions to lobby for the policies that serve them

Domestic Institutions

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• Karl Polanyi (1973)• Institutions mediate influence of

lobbying groups• E.g. Gold Standard

– GS benefits wealthy at the expense of the poor

– 19th C: workers were disorganized and unrepresented tolerate GS

– 20th C: empowered workers bring end to GS

Policymakers’ Ideas

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• Keynes • Gold standard rested on the theory

that it maximized public good– Golden handcuffs restrained perfidious

politicians– Employment would take care of itself

• Abandoning GS required changing people’s minds!