Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-1CHAPTER15InternationalEconomicPolicyCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-2Questions•Howhastheworldorganizeditsinternationalmonetarysystem?•Whatisafixedexchangeratesystem?•Whatisafloatingexchangeratesystem?•Whatarethecostsandbenefitsoffixedexchangeratesvis-à-visfloatingexchangerates?Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-3Questions•Whydomostcountriestodayhavefloatingexchangerates?•WhyhaswesternEuroperecentlycreateda“monetaryunion”--anirrevocablecommitmenttofixedexchangerateswithinwesternEurope?•Whatwerethecausesofthethreemajorcurrencycrisesofthe1990s?Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-4TheGoldStandard•BeforeWorldWarI,nearlyalloftheworldeconomywasonthegoldstandard–agovernmentwoulddefineaunitofitscurrencyasworthaparticularamountofgold–thecurrencywasconvertible•couldbeconvertedintogoldfreely–thecurrency’spriceintermsofgoldwasitsparityCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-5Figure15.2-GrowthoftheGoldStandardCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-6TheGoldStandard•Whentwocountrieswereonthegoldstandard,theirnominalexchangeratewasfixedattheratiooftheirgoldparities–atWorldWarIIparities•theU.S.dollarwasequalto1/35ofanounceofgold•theBritishpoundsterlingwassettoequal1/15.58333ouncesofgold•theexchangerateofthedollarforthepoundwas£1.00=$2.40Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-7TheGoldStandard•Exampleofcurrencyarbitrage–theU.S.governmentiswillingtobuygoldat$35perounce–theBritishgovernmentiswillingtobuygoldat£15.58333perounce–thepoundtradesfor$2.64(10%higherthantheratioofthegoldparities-$2.40)Copyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-8TheGoldStandard•Someonewithanounceofgoldcould–tradeittotheBritishTreasuryfor£15.58333–tradethosepoundsfordollarsintheforeignexchangemarketandget$38.50–tradethe$38.50totheU.S.Treasuryfor1.1ouncesofgold–repeattheprocessasquicklyaspossible,makinga10%profiteachtimethecircleiscompletedCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-9Figure15.1-HowtoProfitintheForeign-ExchangeMarketCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-10WeaknessesoftheGoldStandard•Thegoldstandardtendedtobedeflationary–undersomecircumstances,itpushedcountriestoraisetheirinterestrateswhichreducedoutputandincreasedunemployment–itneverprovidedacountervailingpushtoothercountriestolowertheirinterestratesCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-11WeaknessesoftheGoldStandard•Iftheexchangerateisfloating,foreigners’domesticcurrencyearningsmustbeusedtobuyexportsortoinvestinthehomecountry•Theexchangeratemovesupordowninresponsetothesupplyanddemandforforeignexchangeinordertomakeitso0NFINXCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-12WeaknessesoftheGoldStandard•Underagoldstandard,foreign-currencyearningscanalsobeusedtopurchasegoldfromtheforeigncountry’sTreasury0FG-NFINX•Ifacountry’snetexportsplusnetforeigninvestmentarelessthanzero,itsTreasurywillfinditselflosinggold–thecountry’sgoldreservesshrinkCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-13WeaknessesoftheGoldStandard•Ifacountry’sgoldreservesareshrinking,ithasachoice–abandonthefixedexchangeratesystem–makeitmoreattractiveforforeignerstoinvestbyraisingdomesticinterestrates•putscontractionarypressureontheeconomy•CountriesgaininggoldfacenoincentivetolowerinterestratesinordertostayonthegoldstandardCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-14CollapseoftheGoldStandard•ThegoldstandardwassuspendedduringWorldWarI•Afterthewarended,politiciansandcentralbankerssoughttorestoreit–theybelieveditwasanimportantstepinrestoringprosperity•AftertheGreatDepressionbegan,thegoldstandardbrokeapartCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-15CollapseoftheGoldStandard•Fourfactorsmadethegoldstandardalesssecuremonetarysystem–everyoneknewthatgovernmentscouldabandontheirgoldparitiesinanemergency–everyoneknewthatgovernmentsweretryingtokeepinterestrateslowenoughtoproducefullemploymentCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-16CollapseoftheGoldStandard•Fourfactorsmadethegoldstandardalesssecuremonetarysystem–afterWorldWarI,countriesheldtheirreservesinforeigncurrenciesratherthangold–thepost-warsurpluseconomiesdidnotlowerinterestratesasgoldflowedinCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-17CollapseoftheGoldStandard•Assoonasarecessionhit,governmentsfoundthemselvesunderpressuretoraiseinterestratesandloweroutput–couldeitherstayonthegoldstandardandfaceadeepdepressionorabandonthegoldstandard–thefurthercountriesmovedawayfromtheirgold-standardrates,thefastertheyrecoveredfromtheGreatDepressionCopyright©2002byTheMcGraw-HillCompanies,Inc.Allrightsreserved.15-18Figure15.3-EconomicPerformanceandDegreeofExchangeRateDepreciationDuringtheGreatDepressionCopyright©2002byTheMcGraw-HillCompanies,Inc.