Chapter 18 The International Monetary System,1870- 197312/4/20142Chapter Organization Macroeconomic Policy Goals in an Open Economy International Macroeconomic Policy Under the Gold Standard, 1870-1914 The Interwar Years, 1918-1939 The Bretton Woods System and the International Monetary Fund Internal and External Balance Under the Bretton Woods System Analyzing Policy Options Under the Bretton Woods System12/4/20143 The External Balance Problem of the United States Worldwide Inflation and the Transition to Floating Rates SummaryChapter Organization12/4/20144Introduction The interdependence of open national economies has made it more difficult for governments to achieve full employment and price stability. The channels of interdependence depend on the monetary and exchange rate arrangements. This chapter examines the evolution of the international monetary system and how it influenced macroeconomic policy.12/4/20145Macroeconomic Policy Goals in an Open Economy In open economies, policymakers are motivated by two goals: Internal balanceInternal balanceInternal balanceInternal balance It requires the full employment of a countrys resources and domestic price level stability. External balanceExternal balanceExternal balanceExternal balance It is attained when a countrys current account is neither so deeply in deficit nor so strongly in surplus.12/4/20146 Internal Balance: Full Employment and Price-Level Stability Under-and overemployment lead to price level movements that reduce the economys efficiency. To avoid price-level instability, the government must: Prevent substantial movements in aggregate demand relative to its full-employment level. Ensure that the domestic money supply does not grow too quickly or too slowly.Macroeconomic Policy Goals in an Open Economy12/4/20147Macroeconomic Policy Goals in an Open Economy External Balance: The Optimal Level of the Current Account External balance has no full employment or stable prices to apply to an economys external transactions. An economys trade can cause macroeconomic problems depending on several factors: The economys particular circumstances Conditions in the outside world The institutional arrangements governing its economic relations with foreign countries12/4/20148 Problems with Excessive Current Account Problems with Excessive Current Account Problems with Excessive Current Account Problems with Excessive Current Account Deficits:Deficits:Deficits:Deficits: They sometimes represent temporarily high consumption resulting from misguided government policies. They can undermine foreign investors confidence and contribute to a lending crisis.Macroeconomic Policy Goals in an Open Economy12/4/20149Macroeconomic Policy Goals in an Open Economy Problems with Excessive Current Account Problems with Excessive Current Account Problems with Excessive Current Account Problems with Excessive Current Account Surpluses:Surpluses:Surpluses:Surpluses: They imply lower investment in domestic plant and equipment. They can create potential problems for creditors to collect their money. They may be inconvenient for political reasons.12/4/201410 Several factors might lead policymakers to prefer that domestic saving be devoted to higher levels of domestic investment and lower levels of foreign investment: It may be easier to tax It may reduce domestic unemployment. It can have beneficial technological spillover effectsMacroeconomic Policy Goals in an Open Economy12/4/201411International Macroeconomic Policy Under the Gold Standard, 1870-1914 Origins of the Gold Standard The gold standard had its origin in the use of gold coins as a medium of exchange, unit of account, and store of value. The Resumption Act (1819) marks the first adoption of a true gold standard. It simultaneously repealed long-standing restrictions on the export of gold coins and bullion from Britain. The U.S. Gold Standard Act of 1900 institutionalized the dollar-gold link.12/4/201412International Macroeconomic Policy Under the Gold Standard, 1870-1914 External Balance Under the Gold Standard Central banks Their primary responsibility was to preserve the official parity between their currency and gold. They adopted policies that pushed the nonreserve component of the financial account surplus (or deficit) into line with the total current plus capital account deficit (or surplus). A country is in balance of payments equilibriumbalance of payments equilibriumbalance of payments equilibriumbalance of payments equilibrium when the sum of its current, capital, and nonreserve financial accounts equals zero. Many governments took a laissez-faire attitude toward the current account.12/4/201413International Macroeconomic Policy Under the Gold Standard, 1870-1914 The Price-Specie-Flow Mechanism The most important powerful automatic mechanism that cont