Chapter 18

The International Monetary System, 1870–1973

? Chapter Organization

Macroeconomic Policy Goals in an Open Economy

Internal Balance: Full Employment and Price-Level Stability External Balance: The Optimal Level of the Current Account

International Macroeconomic Policy under the Gold Standard, 1870–1914 Origins of the Gold Standard

External Balance under the Gold Standard The Price-Specie-Flow Mechanism

The Gold Standard “Rules of the Game”: Myth and Reality Box: Hume v. the Mercantilists

Internal Balance under the Gold Standard

Case Study: The Political Economy of Exchange Rate Regimes:

Conflict over America’s Monetary Standard During the 1890s The Interwar Years, 1918–1939 The Fleeting Return to Gold

International Economic Disintegration

Case Study: The International Gold Standard and the Great Depression The Bretton Woods System and the International Monetary Fund Goals and Structure of the IMF

Convertibility and the Expansion of Private Capital Flows Speculative Capital Flows and Crises

Analyzing Policy Options under the Bretton Woods System Maintaining Internal Balance Maintaining External Balance

Expenditure-Changing and Expenditure-Switching Policies The External-Balance Problem of the United States

Case Study: The Decline and Fall of the Bretton Woods System

Worldwide Inflation and the Transition to Floating Rates Summary

? Chapter Overview

This is the first of five international monetary policy chapters. These chapters

complement the preceding theory chapters in several ways. They provide the historical and institutional background students require to place their theoretical knowledge in a useful context. The chapters also allow students, through study of historical and current events, to sharpen their grasp of the theoretical models and to develop the intuition those models can provide. (Application of the theory to events of current interest will hopefully motivate students to return to earlier chapters and master points that may have been missed on the first pass.)

Chapter 18 chronicles the evolution of the international monetary system from the gold standard of

1870–1914, through the interwar years, and up to and including the post-World War II Bretton Woods regime that ended in March 1973. The central focus of the chapter is the manner in which each system addressed, or failed to address, the requirements of internal and external balance for its participants.

A country is in internal balance when its resources are fully employed and there is price level stability. External balance implies an optimal time path of the current account subject to its being balanced over the long run. Other factors have been important in the definition of external balance at various times, and these are discussed in the text. The basic definition of external balance as an appropriate

current-account level, however, seems to capture a goal that most policy-makers share regardless of the particular circumstances.

The price-specie-flow mechanism described by David Hume shows how the gold standard could ensure convergence to external balance. You may want to present the following model of the price-specie-flow mechanism. This model is based upon three equations: 1. The balance sheet of the central bank. At the most simple level, this is just

gold holdings equals the money supply: G ? M. 2. The quantity theory. With velocity and output assumed constant and both

normalized to 1, this yields the simple equation M ? P. 3. A balance of payments equation where the current account is a function of the

real exchange rate and there are no private capital flows: CA ? f(E ? P*/P) These equations can be combined in a figure like the one below. The 45? line

represents the quantity theory, and the vertical line is the price level where the real exchange rate results in a balanced current account. The economy moves along the 45? line back towards the equilibrium Point 0 whenever it is out of equilibrium. For example, the loss of four-fifths of a country’s gold would put that country at Point a with lower prices and a lower money supply. The resulting real exchange rate depreciation causes a current account surplus which restores money balances as the country proceeds up the 45? line from a to 0.