Monday, November 21, 2005

Bretton Woods System of International Finance

Since this is my blog, I believe I will put my book report here!
Actually this is my International Finance assignment...

Assignment One
Session Five 2005

a. Outline the reasons for the collapse of the Bretton Woods System of International Finance.
To avoid the problems of balance of payments with gold as being the medium of transactions, the world implemented the Bretton Woods System (BWS) or defined as an adjustable peg system. The two main reasons for the break down of the BWS were due to lack of adequate adjustment mechanisms and lack of liquidity.

The United States currency became the “gold standard” as the currency was convertible to gold at the exchange rate of $35.00 per ounce of gold. But to maintain the levels of reserves other countries had to run a surplus and the US to run a deficit. And if the US was to implement policies to curb its deficit it would stifle world trade leading to stagnant and shrinking economic growth with deflationary pressures. As confidence in the system waned, the ratio of US reserves to liquid liabilities became too low and something had to be done to adjust this.

The bad money (overvalued asset) drove out good money (undervalued asset). Gresham’s Law was proven right when gold was driven out by dollars. The composition of world official international reserves changed from 90.7% gold and 9.3% currencies in 1980 currencies until 1970 was 40.1% gold, 48.3% currencies and 11.6% in IMF positions and Special Drawing Rights ( 494).

Since confidence of the BWS system was based on the free exchange of dollars for gold, the US could not adjust the exchange rate of dollars for gold. Since the US inflation was about 40% accumulative, thus gold should have also risen of the same amount. But the US was unwilling or unable politically to pursue deflationary policies.

Neither debtor nor surplus countries were willing to adjust their currencies. Debtor nations felt devaluation was a sign of national weakness while surplus nations did not want to adjust the economy away from the export of tradable goods. While debtor nations had the option of the ‘scarce currency clause’ to penalize surplus countries this option was never used. This probably was considered a sign of weakness also.

These factors lead to the enviable position of the US being able to consistently out consume what it produced also referred to as the Seigniorage Problem (gains from creating new money( 491)). And thusly many nations became jealous of the reserve currency status of the US dollar including Italy and France. After President Charles de Gaulle espoused the virtues of gold, France led the march to demand gold for dollar claims and thus reducing gold reserves held by the US. This in turn led the two tier approach to gold pricing on March 17, 1968.

Another reason the adjustable peg system failed is of the “one way speculative gamble”. The speculators seeing a rise in the deficit of a counties balance of payments could surmise that the currency would need to be devalued eventually. By speculating in the futures markets by selling short, he would have little chance of loosing since the currency is pegged. But he would reap high profits if the currency would be devalued. His only downside would be transaction fees and a slight gap between the forward rate and the spot rate. And as put by a foreign exchange specialist, “In those days we could make money just by following the crowd (1. pages 401-403).” In one way the speculative attacks added stability by hastening the transition to the new equilibrium.

b. Explain the effects on UK interest rates…
I will be assuming that the risks exposed to both markets are the same. Thus not factoring the US and UK experienced external shocks to the system through 9-11 and 7-7 dated incidents, as well as any other shocks to the systems. I will also assume no transaction costs as well as any factors of taxation that may affect decisions in this perfect market.
PPP holds that the expected rate of inflation (UK) increasing 2% per year will cause the ₤ to depreciate by 2% per year more than the current rate. And the US $ would appreciate by the reciprocal. Current spot market exchanges would not change since price levels have not changed in the short term. Since the spot market in the future will change, forward exchange rates will be arbitraged until it meets the expected rate of depreciation less the time value of money.

c. Why do the levels and movements of exchange rates differ from the absolute and relative PPP?
Absolute PPP states that prices will tend to equalize prices across countries, while relative PPP considers only the rates of changes in price levels or broadly defined as the inflation rate. Since there are many distorting effects on the absolute PPP which includes but not limited to transportation costs, tariffs, imperfect information, imperfect markets, and protectionism measures, relative PPP may be a better guide to knowing which direction exchange rates will head with all other things being constant. (2.)
Absolute PPP is defined as exchange rate equals ($/₤) = (price level in US)/ (price level in UK). Relative PPP is defined as a change in exchange rates ($/₤) = (change in US price levels)/ (change in UK price levels).

d. Describe and explain the effects which a reduction in Government expenditure would have…
I will assume that the government in the question is more biased on domestic consumption and imports little, unlike the expenditures by China for Boeing’s 737 planes. A reduction in government expenditure will reduce income by the multiplier effect of change in G/(s+m). Because the sum of marginal propensity to save plus the marginal propensity to import is less than one since some of the change in income is the result of less domestic consumption. As a result of a drop in income imports will drop while export being exogenous will stay the same CA=X (same)-M↓. If we relax the assumption that exports are exogenous, the multiplier would be the same direction but less, because the marginal propensity to import in the other country is less than one. As the other countries income falls and consume less of imports the first countries exports will decrease also. And of course if trade wars break out then nothing is guaranteed.

a. If the reduction in government spending was accompanied by a reduction in taxes, then the reduction in government spending would be offset by increased disposable income by consumers. But this increases the leakages in the system by increased savings and more imports on the first round. Thus the multiplier effect of higher disposable income would not overcome the negative effect of the government expenditure multiplier, and still have a reduction in total income. This lower income results in lower imports but since the marginal propensity to import is higher in consumers than the bias for government domestic purchases, then imports will increase. With available information I could not say which effect would be greater and thus no conclusion of the changes in the current account balance.

b. Just like reduction in taxation, reduction in the borrowing by government does not show a clear pattern of reducing the CA balance. There is one more link in this that the consumers were not faced with, and that is even if more funds are now available for either investment or increased consumption does not mean that either will happen and not to the extent that extra monies become available. Consumers may decide to move the savings to other investments. Banks may hold excess reserves. And business may not wish to invest at the current economic climate even if the banks do reduce the interest rates.

d. Use the elasticities and absorption approaches to explain why devaluation may not improve a country’s balance of payments.
I will assume no Giffen Goods or negative elasticities. Since devaluation affects only the price levels of export goods in other countries and the import prices, then the sum of elasticities of exports plus imports must be greater than one for devaluation to be effective. That for a given increase in prices for imports and exports must produce greater percentage changes in quantities than the percentage changes in prices. Either the increased price level for imports cuts back more or decreased price level of exports increases more.

Over the long run elasticities tend to increase. The markets have time to adjust to market signals to lead to substitutions or increase consumption in lower priced items. These effects create a J-curve that at first worsens the CA but after time the CA becomes positive. Small countries face infinite elastic curves as being price takers and as such would always benefit from devaluation.

The absorption approach assumes that for national income to raise that the country must be short of full employment. But from the experience of the US with rates believed to be below full employment for sustained periods of time, we should wonder if there is a definite concept of full employment. While I can see that not all labor can be substituted, we can see that indeed the labor can change in geographic as well as jobs categories in a relatively short time frame.

If a change in income that results from devaluation increases more than the marginal propensity to absorb, then devaluation will result in an improved current account balance. But if marginal propensity to absorb (defined as the sum of consumption, investment and government expenditures) is greater than the income change then the current account balance will worsen.

The absorption approach is more flexible in looking at the income effect of devaluation and looks at what policies can be implemented to achieve the best desired output.

1. Peter Lindert, (1986) International Economics, Eighth Edition, Richard D. Irwin, INC.
2. Keith Pilbeam, (1998) International Finance, Palgrave

Links of interest:

Marshall-Lerner Condition
Basic Exchange Rate Theories-CIES
Purchasing Power Parity


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