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

Chapter Fifteen: Issues in International Economics 379 to England as in Step 3 of Figure 15.8 . So France will have to continue stimulating exports to build up gold, but then they must limit imports. France can limit imports in one of two ways: either by (1) sterilizing the gold when it comes in the French economy so it doesn’t increase prices, or (2) through trade policy (such as tariffs on imports). Let’s consider the effects of both of these options. In Figure 15.8 , Hume’s Price-Specie Flow mechanism would tend to reverse monetary flows if not actively countered by the government—but stop it they can! To illustrate how this monetary sterilization happens, we need to use a simplified T-account similar to those used in our money and banking chapter. In Figure 15.9 , we begin with a monetary imbalance like that in Step 2 of Figure 15.8 . Through a government export policy, France has amassed four units of gold in its banking system, while England now only has two units of gold. Absent further government action, deflation would occur in England and inflation would occur in France—the difference in prices would spur entrepreneurs to buy in the cheap country (England) and sell in the dear country (France) and the imbalance would be corrected. But if France wanted to preserve the monetary imbalance, they could issue a bond to their citizens for one unit of gold. This action would “sterilize” the gold since it would no longer be in circulation. That would stop the inflation in France, but what would it do about the deflation in England? Well, France could then loan the gold to England in exchange for its treasury bills. England could then spend the money STEP 1: Gold Imbalance ENGLAND $$ FRANCE $$$$ STEP 2: France Issues Sterilization Bond & Buys England T-bills STEP 3: England Buys More French Stuff! A Gov’t Public Gov’t Public L A L A L A L A L A L $$$$ $$ A L A L A L A L A L A L Gold from France T-Bills Gov’t Spending Gold $$ $$$ $ $ $ $ England T-Bills Sterilize Bond Sterile Bond $ Future Tax Revenue Future Tax Liability T-Bills Owned By France Gold $ $ $ $ $ $ $$$ $$$ England T-Bills Sterilize Bond Sterile Bond ENGLAND $$$ FRANCE $$$ Figure 15.9, France Sterilization of England $$. One way to counteract a currency imbalance is to “sterilize” the effects of money flowing into an economy by removing it from circulation. In step 1 above, we have a gold imbalance, as in Figure 15.8, Step 2. France can issue a “sterilization” bond to its citizens for one $ of gold, and then lend that gold to England by purchasing England’s T-bills. When England spends that money on its citizens, the public in both France and England will each have three $$$, so there will be no corrective measure to restore monetary balance.