topic 19.1

ALTERNATIVE INTERNATIONAL MONETARY STANDARDS

topic 19.1

THE GOLD STANDARD 1880-1914

Currencies had a fixed rate of excahnge with gold.

For example $20.67 = 1 ounce of gold

So all countries had in effect fixed their rates of exchange against other countries' currencies.

The benefit was price and exchange rate stability.

If a country tried to inflate its currency it would lose gold as people turned in their money for gold at the fixed rate. Since no country has unlimited gold reserves this prevented inflation.

A disadvanatge was that growth in the world gold supply determined the rate that money could grow. If too much gold was supplied there would be inflation, too little and there would be deflation.

After the first world war there were attempts to restablish this system, but they failed. A strict gold standard was not sustainable as countries tried to print more mony. Eventually even the US gave up on the gold standard.

topic 15.1

EXCHANGE RATES, INTEREST RATES, AND INTEREST PARITY

topic 15.1

INTEREST PARITY

Countries trade goods and services at a point in time. They also trade over time through buying and selling financial assets.

Under free trade with costless arbitrage the price of 'bonds' is constrained in a manner similar to that of goods. Just as traded goods should (in theory) conform to the 'law of one price', so too assets should exhibit parity conditions. Assets are actually a much better candidate for parity conditions than goods because they are homogeneous and easily traded, unlike goods which are neither.

The best known parity condition applies to international trade in bonds: 'interest rate parity'.

Assume there are two bonds, a US bond denominated in dollars and a UK bond denominated in pounds. Assume both are risk free.

Then

(1 + i)$ = (1 + i) pounds * (F/E)

where:

i$ and ipounds are the returns on the US and UK bonds
F and E are future and spot exchange rates ($/pounds)

To explain this - consider a US person with $1 to spend on a US one-year bond or a UK one-year bond. Absent any risk differences or transaction costs the investor should be indifferent between:

• investing in a US bond today or
• investing in a UK bond today with the necessary use of the exchange rate to convert dollars to pounds today (E), and then back the other way one year from now (F)

Another way to express the equation is:

i$ - ipound = (F-E)/E

In this example (F-E)/E is the 'forward premium'

The intuition here is that if US bonds paid a higher nominal interest rate than UK bonds then the higher expected US return must be offset by an expectation that the dollar will depreciate against the pound (F is higher than E).

If the forward premium is insufficient to cover exchange rate risk the traders will move into US bonds, driving the US bond price up and theUS bond expected return down (and the opposite for the UK bond) - this will drive the system toward parity.

There are reasons why interest rate parity may not hold: different risks between the bonds or the forward rate is not certain - it is an expected rate.

We can extend a similar analysis to equities.

The advantage of parity conditions is that they allow us to cut through the complexity of international finace to establish core fundamental relationships.

topic 17.2

THE MONETARY APPROACH TO THE BALANCE OF PAYMENTS

Topic 17.2

The MABP emphasizes the monetary aspects of the balance of payments.

The MABP is based on the idea that any balance of payments disequilibrium is based on monetary disequilibrium.

Monetary disequilibrium is an imbalance between the amount of money people wish to hold and the amount supplied by the monetary authorities.

So the determinants of money demand and money supply also determine the balance of payments.

David Hume understood the concept of the MABP.

The MABP is based on fixed exchange rates. If there is a disequilibrium money must move because the exchange rate cannot adjust. In economics, if prices are not allowed to adjust, then quantities must carry all the burden of adjusting to exogeneous shocks.