Topic

10

International Trade and Finance: Problems and Policies

LEARNING OUTCOMES
By the end of this topic, you should be able to: 1. 2. 3. 4. Explain the Gold Standard and its limitation; Describe the Bretton Woods system and its limitation; Discuss the flexible exchange rate system; and Summarise the advantages and disadvantages of a flexible exchange rate system and a fixed exchange rate system.

INTRODUCTION

As we know, the world has operated under a number of different monetary systems since the beginning of the 20th century. In this topic, we will learn about the history of the most widely used international monetary systems, namely the Gold Standard and the Bretton Woods Systems. The Gold Standard, which was used up to 1914, had its own weaknesses and was eventually replaced by the Bretton Woods System in the 1940s after an international conference in Bretton Woods. We will also discuss the managed floating of exchange rates, which has evolved in the past few decades. Besides that, the advantages and disadvantages

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of both flexible and fixed exchange rates will also be examined at the end of this topic. Let us continue the lessons!

10.1

THE GOLD STANDARD

Have you ever heard about this standard? What does it stand for? Gold Standard is a formerly used international monetary system where the value of each currency was fixed in terms of gold. Under the Gold Standard, which operated from about 1870 to 1914, the external value of all currencies was maintained by fixing their prices in terms of gold. The Gold Standard was the major system of exchange rate determination at that time. This means that all currencies were exchanged at fixed ratios to gold and therefore exchange rate could be determined easily. To clearly understand, let us look at this example: One ounce of gold worth US$40 and the same ounce of gold also worth 5. This means that the same ounce of gold can be exchanged for US$40 US or 5. Based on this, the exchange rate between dollars and pounds was $40/5 or simply $8 to 1. However, in order for the system to be effective, the country had to be willing to buy and sell gold at the determined price. In other words, the countrys central bank had to preserve the official parity between its currency and gold by buying and/or selling gold at the official parity price; which was the price of each countrys currency in term of gold. Since the gold content of each countrys currency was known and fixed, the exchange rates between countries were also fixed. As long as a countrys balance of payments remained in balance, the economy would be in equilibrium as no gold would enter or leave the country. However, what if the citizens in country A bought more from country B? In this case, country As balance of payments would be in deficit and its stock of gold would decrease. On the other hand, country B would start to accumulate gold as exports would be greater than imports. The Gold Standard was not only a means of fixing exchange rates between countries but it also managed a countrys money supply automatically. This is because an inflow of gold into a country caused the countrys money supply to

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expand and conversely an outflow of gold caused the countrys money supply to contract. If gold were flowing form country A to country B, country Bs money supply would increase and country As money supply would decrease. When this happened, an increase in country Bs money supply would lower its interest rate and therefore stimulate aggregate demand. Consequently, the aggregate output and the price level would also increase. Higher prices in country B would discourage citizens in country A from buying goods from country B. Meanwhile, citizens in country B would import more goods from country A as they would have more income and face relatively lower import prices. In the end, we would see that changes in relative prices and income which resulted from the inflow and outflow of gold, would automatically come back into balance.

ACTIVITY 10.1
You may want to visit this website to gather more information about the Gold Standard at: http://www.britannica.com/EBchecked/topic/237431/gold-standard

10.2

PROBLEMS WITH THE GOLD STANDARD

What are the limitations of this standard? As stated by Case and Fair (1996), there are a few problems with the Gold Standard because a country had little control over its money supply. As mentioned earlier an inflow of gold would turn the balance of payments into a surplus and the money supply would expand. A country with a balance of payments deficit would then correct the problem by contracting its money supply. However, this would affect the economy as income and employment would decrease. In other words, a country could act to protect its gold reserves and this action would eventually prevent the adjustment mechanism from correcting the deficit. Besides that, the money supply of a country depends on the amount of gold available. Therefore, when major new gold fields were discovered, the worlds supply of gold increased, and therefore the price level and income increased. On the other hand, when no new gold was discovered, the price level and income decreased.

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EXERCISE 10.1
1. Discuss the role of the government in making the Gold Standard system effective. Explain the main problem of the Gold Standard system.

2.

10.3

BRETTON WOODS SYSTEM AND THE FIXED EXCHANGE RATES

Firstly, let us look at the definition of this system. Bretton Woods System is a system in which currencies were pegged to the US dollar and dollar was fixed at the rate of $35 per ounce of gold.

In July 1944, a group of economists met in Bretton Woods, New Hampshire to formulate a new exchange rate determination that could avoid the problems emerged in the Gold Standard. Out of this meeting, an adjustable-peg system of exchange rate, which was called the Bretton Woods System, was chosen. Under this system, the US dollar was tied to gold but all other currencies were tied to the dollar. Instead of pegging each currency directly to gold, all other currencies were fixed in terms of US dollar which was fixed at $35 per ounce of gold. It was also agreed that a new international monetary institution known as the International Monetary Fund (IMF) was created to play an important role in the operation of the international monetary system. As stated earlier, the Gold Standard gave rise to the problem of a countrys control over its money supply. The Bretton Woods System was developed to link between an imbalance in the balance of payments and a countrys money supply; that is, to reduce the role of gold in determining a countrys money supply. Under a pure fixed exchange rate system, governments would set a fixed rate at which their currencies will exchange for and then commit themselves to maintaining that rate. Governments then have to intervene, by buying or selling foreign exchange to manipulate the exchange rate and to keep currencies aligned at their established values.

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10.4

COLLAPSE OF THE BRETTON WOODS SYSTEM

The Bretton Woods system operated fairly well during the 1950s and 1960s. However, over time problems emerged. One of the problems was that the system was not symmetrical; where a country with a chronic balance of payments deficit would be obliged to devalue their currencies and to cut their deficits by contracting their economies. By taking these actions, prices and employments would increase. This would mean that a country was losing its stock of foreign currencies and therefore had to change its exchange rate. On the other hand, what would happen to those countries with a balance of payments surplus? Under the Bretton Woods system, countries with a balance of payment surplus were allowed accumulate reserves through intervention, where these countries were supposed to stimulate their economies and/or revalue their currencies to restore balance to their balance of payments, but they were not obliged to do so. The fixed exchange rate could be maintained easily as the country could buy any excess supply of foreign exchange with their own currency. Another problem of the Bretton Woods System was that all countries were fixed to the US dollar and the US government was obligated to exchange dollar for gold at a fixed price; meaning that as long as the USs balance of payments was balanced in the long run, the system would operate well. However, what happened in the mid 1960s? The US balance of payments was in deficit. As all countries demanded dollars to use for intervention, the US was not obligated to correct the imbalances. Therefore, no actions were taken, that is, there were no adjustments to the fiscal policy or monetary policy in order to correct the external imbalance. Over time, the foreign central banks were holding an increasing number of dollars. Those countries with balance of payments surplus had to buy US dollars and sell their domestic currencies to prevent their currencies from appreciating. Problems started to occur at the end of the 1960s where foreign central banks were holding a large amount of US dollars compared to the US stock of gold at the official price of $35 per ounce. In general, the collapse of the Bretton Woods System in the early 1970s was linked to the US balance of payments deficit. The announcement made by the US in August 1971 stated that it would no longer redeem dollars for gold ended. This marked the end of the Bretton Woods System.

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EXERCISE 10.2
Discuss the main problems of the Bretton Woods system that led to the breakdown of the system.

10.5

FLEXIBLE EXCHANGE RATE SYSTEM

Now we come to the flexible exchange rate system. What does it stand for? The flexible exchange rate is an exchange rate of which the value is determined by market forces without intervention from the central bank. The flexible exchange rate period officially began in 1973 after the breakdown of the Bretton Woods System. Under this system, demand and supply determine the exchange rates without any government intervention. The foreign exchange market will always clear and government can turn its attention to domestic problems such as inflation and unemployment and leave the balance of payments to adjust itself. With this movement from fixed/stable exchange rate to flexible exchange rate, it has been argued that the flexible exchange rates offered a superior alternative to fixed exchange rates in correcting the balance of payments disequilibrium. Theoretically, this system allows a nation to achieve internal balance easily and automatically. However, the degree of exchange rate volatility has been associated with high absolute levels of and great movement in other economic parameters such as inflation rate and interest rate. Therefore, there is also a discussion against flexible exchange rates, which argued that volatility in the foreign exchange market imposes a high real economic cost and this reduces the real international trade. Besides the volatility problem, the most important problem is misalignment which undermines economic performance in several ways, including generated austerity, adjustment costs, recession, deindustrialisation, inflation and protectionism.

10.5.1

Managed Floating Exchange Rate

With a managed floating exchange rate system, the central bank plays an important role in the foreign exchange market. The central bank does not have an explicit set value for the currency like in the fixed exchange rate system. At the same time, the central bank does not allow the market to freely determine the

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value of the currency like in the flexible exchange rate system. The central banks do not have to announce publicly the value for exchange rates that they have committed in advance to defend. Therefore, central banks are free to adjust their exchange rate targets as circumstances change. Sometimes, they leave the rate completely free to fluctuate and sometimes they intervene to alter the exchange rate from its free market value.

10.6

ADVANTAGES AND DISADVANTAGES OF FLEXIBLE EXCHANGE RATE SYSTEM

What are the advantages and disadvantages of flexible exchange rate system? Let us find out the answers in the next following subtopics.

10.6.1

Advantages of the Flexible Exchange Rate

As argued by the proponents of the flexible exchange rates system, there are four advantages of this regime. They are: (a) Under the flexible exchange rate system, a deficit or surplus in the nations balance of payments is automatically corrected by a depreciation or an appreciation of that nations currency. Therefore, no policy decisions or government intervention are needed to bring about adjustment in the balance of payments disequilibrium. This system can be derived fundamentally from the laws of supply and demand, where the competitive market establishes the price that equates quantity demanded with quatity supplied, and thus clears the market. Under the flexible exchange rate system, the balance of payments disequilibrium is theoretically corrected smoothly and continously, in contrast to the sudden erratic jumps under the Bretton Woods System. As the exchange rate moves in a smooth fashion, this would result in stabilising speculation, which prevents the exchange rate from overshooting the fundamental equlibrium value. The movement of the exchange rate is facilitated and smoothed by the actions of private speculators, which are based on their reading of current and prospective economic and policies developments. As a result of these actions, over-valued currencies will then be sold, thus reducing their values and under-valued currencies will be bought, thus pushing up their values. In any case, flexible exchange rates will eliminate the principle case of speculation such as large delayed discrete changes in exchange rate.

(b)

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(c)

The flexible exchange rate system overcomes the problem of asymmetrical adjustment since not only will the over-valued currencies depreciate but the under-valued currencies will appreciate. Therefore, the deflationary bias in the world economy can disappear. The flexible exchange rate system reduces and removes the need for payment policies such as protectionism. As a result, the full employment of the worlds resources will be used efficiently.

(d)

From the previous arguments, it has been argued that the flexible exchange rates will lead to market efficiency. In contrast, the fixed exchange rate system is inefficient as it may lead to policy mistakes and require the use of policies; therefore, purely internal economic objectives would be achieved.

10.6.2

Policy Advantages of the Flexible Exchange Rate

It is argued that the flexible exchange rate system provides greater autonomy of monetary policy where a nation is free to apply monetary policy for its domestic stabilisation purposes in order to achieve internal macroeconomic goals of employment, output, price stability and economic growth. The balance of payments may adjust either through fluctuations in the exchange rate, as discussed earlier, or through changes in internal economic variables and policies. Here, the fluctuation in the exchange rates is regarded as a substitute for unacceptable economic adjustments in the international adjustment process. A country can avoid the necessity of exposing domestic economic variables and policies to external influences by allowing the exchange rate itself to bear the burden of the international adjustment. For example, suppose that a foreign recession threatens the domestic economy through a fall in export demand. Under the flexible exchange rate regime, the exchange rate depreciates and this prevents the balance of trade from worsening by encouraging an increase in exports and a decrease in imports. Therefore, the monetary authorities are free from the balance of payments constraint and are able to pursue the goals of domestic stabilisation policies. The biggest contribution of flexible exchange rates is that it provides discretionary monetary independence rather than automatic insulation. It also gives freedom to the policy makers to set discretionary domestic policy without explicit concern over the balance of payment. In other words, under flexible exchange rates, a nation can let the exchange rate take care of the external balance

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and it can direct the macroeconomic policies toward the problem of internal balance alone. In the case of using fiscal policy to achieve internal balance under flexible exchange rate, it affects the exchange rate in two ways. When a nation expands its fiscal policy, through increasing government spending or reduces tax rates, the aggregate spending and national income increase. As a result, imports increase and this worsens the trade balance and weakens the domestic currency. At the same time, fiscal expansion increases the interest rates and the government borrows more. In the short run, high domestic interest rates attract capital from abroad. Thus, there are two opposing tendecies: an aggregate demand rise that weakens the domestic currency and capital inflow that strengthens it for a while. However, it appears more likely that the first effect would be stronger and longer lasting, since the second effect is offset by later outflows of interest and principle repayments on the attracted capital. As the overall result, fiscal policy probably causes the currency to depreciate, and therefore gives an extra trade base to domestic production. From the previous arguments, we can conclude that this system is generally more efficient and gives nations more flexibility in pursuing their own stabilisation policies. It also gives monetary authorities a greater control over the nations money supply for its domestic stabilisation purposes in trying to achieve internal macroeconomic goals of employment, output, price stability and economic growth.

10.6.3

Disadvantages of Flexible Exchange Rate

How about its disadvantages? The advantages of flexible exchange rates discussed previously are based on theory, and advocates of flexible exchange rates expected these advantages to occur in the real economy. However, after adopting the flexible exchange rate system, the outcome was different from what was expected. The experience that the world faced was not the same as predicted by theories of flexible rate. If we examine the worlds economic performance during the period from 1962 to 1972, when the Bretton Woods System operated and compare this period with performance since 1973 under the flexible exchange rates, we would find out that the economic performance had been almost unambigously inferior under the flexible exchange rate regime. A number of serious problems with flexible exchange rates are: (a) It is argued that the flexible exchange rate system is associated with volatility and misalignment. Opponents of flexible exchange rates then claimed that the worlds economic performance had worsened because of the adoption of this system. In case of volatility, two things can be inferred.

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Firstly, the volatility might mean that the fundamental equilibrium exchange rates are themselves volatile and that the nominal rates are not equal to the fundamental equilibrium exchange rate. It is also argued that, in general, factors that determine the fundamental equilibrium exchange rates such as productivity growth, terms of trade movement and changes in savings-investment, do not normally alter quickly and dramatically. While these factors can explain the slow movement in exchange rates, it is difficult to see how they could explain a high degree of volatility. Therefore, it can be concluded that for much of the time since 1973, there has been considerable misalignment of currencies. (b) The flexible exchange rate system also causes uncertainty for both investors and traders. Uncertainty caused by currency fluctuations discourages international trade and investment.

SELF-CHECK 10.1
How do you think a country with a flexible exchange rate would be protected from world economic fluctuations?

10.7

ADVANTAGES AND DISADVANTAGES OF FIXED EXCHANGE RATE SYSTEM

Do you know what the advantages and disadvantages of exchange rate system are? In this subtopic we will learn about the advantages and disadvantages of the fixed exchange rate system.

10.7.1

Advantages of Fixed Exchange Rate

There are two advantages of fixed exchange rate. They are: (a) Certainty is an advantage of the fixed exchange rate system. Under the fixed exchange rate system, international trade and investment becomes much less risky. Firms can forecast correctly, and therefore make profits, and international trade is encouraged. Foreign investment is also encouraged as firms are more willing to set up factories overseas if there is less uncertainty about exchange rate fluctuations.

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(b)

Fixed rates should eliminate destabilising speculation. If the exchange rate is fixed, there is no point in speculating. As there is no speculative pressure on the currency, the central bank would have to intervene less to maintain the rate.

10.7.2

Disadvantages of Fixed Exchange Rates

How about the disadvantages? There are four disadvantages of fixed exchange rate. They are: (a) There is no automatic adjustment in the balance of payments. With a fixed rate, the problem of disequilibrium in the balance of payments would have to be solved by a reduction in the level of aggregate demand. When demand falls, people consume fewer imports and the price level also falls, making the country more competitive. A large holding of foreign exchange reserves is required in a fixed exchange rate system. With fixed exchange rates, a government must hold large scale reserves of foreign currency to maintain the fixed rate and this involves opportunity cost. Loss of freedom in internal policy of a country. The needs of the exchange rate can dominate policy and this may not be best for the economy at that point. Interest rates and other policies may be set for the value of the exchange rate rather than the more important macro objectives of inflation and unemployment. Fixed rates are fundamentally unstable. Countries within a fixed rate mechanism often follow different economic policies, the result of which tends to be differing rates of inflation. This means that some countries will have low inflation and be very competitive and others will have high inflation and not be very competitive. The uncompetitive countries will be under severe pressure continually and may, ultimately, have to devalue their currency.

(b)

(c)

(d)

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x x x

This topic started with a discussion on the use of the Gold Standard as the main system of exchange rate determination before 1914. The Bretton Woods System was used after the collapse of the Gold Standard fixed exchange rate system in 1931. After the breakdown of the Bretton Woods System in 1971, a flexible exchange rate system officially begun in 1973 where demand and supply determine the exchange rates without any government intervention. Under managed floating rates, the government intervenes if foreign exchange rates are fluctuating more than the government desirable rates. The advantages of flexible exchange rates are that they allow a nation to achieve internal balance easily and automatically; they correct the balance of payments disequilibrium smoothly and continously; they overcome the problem of asymmetrical adjustments and they provide a greater autonomy of monetary policy. The disadvantages of flexible exchange rates are; volatility, misalignment and uncertainty. The advantages of fixed exchange rates are less risk and volatility, which encourages trade and investment and no speculation. The disadvantages of the fixed exchange rate are no automatic balance of payments adjustment, large holdings of foreign exchange reserves are required to maintain the fixed exchange rate, and loss of freedom in internal policy.

x x x

Bretton Woods System Fixed exchange rate Flexible exchange rate

Gold Standard System International Monetary Fund (IMF) Managed floating exchange rates