No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Fifteen: Issues in International Economics 375 The gold standard was (incorrectly in my view) blamed for exacerbating the Great Depression, and countries established a fixed exchange rate regime after WWII. Under this agreement, called the Bretton Woods Agreement (since it was agreed to in Bretton Woods, NH), each participating country fixed its exchange rate against the dollar, and the U.S. agreed to redeem (from governments, not citizens) dollars for gold at a ratio of $35/oz. Fixed exchange rates greatly facilitate international trade (similar to a gold standard), but since they are fixed, all the countries involved must conduct similar monetary policies. For example, when the U.S. had greater rates of inflation to support both “Great Society” social spending and the VietnamWar, the differential monetary policies led to a large outflow of gold from the U.S. This unsustainable outflow led President Nixon to close the “gold window” in 1971, abrogating the U.S. promise to redeem dollars for gold at a fixed rate. After the breakdown of the fixed exchange rate regime of Bretton Woods, the world entered into mostly flexible exchange rates where currencies are allowed to freely fluctuate and traders must consider not just the current exchange rate but how the values of currencies will change over the relevant contractual time frame. While uncertainties of future exchange rates make international trade more difficult, entrepreneurs have developed sophisticated futures markets and financial derivatives to hedge (offset) risk. A variant of fixed exchange rates during the flexible exchange rate era (post-1973) is dollarization. Some countries that historically inflated their currency egregiously have surrendered their ability to conduct an independent monetary policy and pegged their currency directly to the dollar, such as what Argentina did in the 1990s with its currency board. Other countries simply abandoned any currency and used dollars directly; Panama and El Salvador are examples of this. While the U.S. monetary policy was believed to be very stable, countries that pegged to the dollar in one way or another could benefit by giving market participants (especially foreigners) confidence that the real value of their investments in that country would not be expropriated through inflation. PURCHASING POWER PARITY With flexible exchange rates, how do market participants “know” what the rate should be? Well, hopefully you’ve learned by now that no one market participant “knows” anything, but rather the knowledge of all market participants come to be embedded in market prices as the market process unfolds. Exchange rates should be thought In the long run, the exchange rate of any currency is primarily driven by trade requirements (goods and services that are imported and exported). In the short run, however, the exchange rate is primarily driven by financial flows between countries. Fixed exchange rate: Under a fixed exchange rate currency regime, a country stands ready to redeem its currency at a fixed rate in some other currency (such as gold, dollars, or Euros). Flexible exchange rates: Under a flexible exchange rate regime, currencies are trades on open market exchanges, and the value is set by markets. Financial derivatives: Investment instruments whose value is derived from some underlying financial instrument. For example, an option to purchase a stock is a derivative since its value is derived from the price of the underlying stock dollarization: This occurs when a country abandons an independent monetary policy and follows US monetary policy by either directly using dollars or indirectly by issuing additional domestic currency units backed by dollars.