Raymond Russell

ECON 425 Homework 3

29 April 2015

1. The financial burden of the First World War meant that many countries accrued
large fiscal deficits. Inflation followed, as governments financed their budgets by
printing money. Many major nations suspended convertibility during the war and
issued fiat currency. Inflation rates among countries varied, and so did exchange
rates (the rate of inflation in the US was generally lower than in Europe).
Throughout the war, the US had supported exchange rates that were advantageous
to its European partners, but this interventionism ceased at the end of the war, and
for several years the international system was one of freely-floating rates. Britain,
faced with a high price level relative to the United States, had to pursue a
monetary contraction to lower its prices. This policy move was detrimental to
British economic vitality and led to a sharp rise in unemployment, and the British
did not return to the gold standard until 1925. The Central Powers endured
hyperinflation after attempting to finance their deficits and war reparations by
printing money.
2. Consequences of the First World War hindered the redevelopment of the postwar
gold standard. The vast reparations demanded of the Central Powers and the debts
accrued by many participants made cooperation difficult. Many central banks
after the war pursued much more active policies than they had in the prewar era of
the gold standard a great deal of consideration was given to reducing
unemployment, for example. One side effect of this policy activism was a
reduction in the credibility of national commitments to convertibility. Markets,
unclear whether the central bank would intervene with a rate increase at the gold
export point or a rate decrease at the gold import point, would no longer derive
stability from the mere existence of a central bank. It has been shown that central
bankers continually failed to prove their commitment to defending convertibility
in the years following the First World War.
3. During the 1930s, money supplies declined despite growth in the global stock of
gold. This is in part due to central bank policy; in order to prevent markets from
appreciating too rapidly, the Federal Reserve intervened with contractionary
policy in 1928. Therefore the monetary base decreased and so did BASE/RES.
Other factors included banking panics that led to increases in the reserve ratio
(risk-averse banks will tend to hold more reserves), which led to a decrease in
M1/BASE, the multiplier. Further, RES/GOLD decreased as money left foreign
exchange reserves. When national governments sought to increase gold reserves,
prompting a scramble for gold, BASE/RES declined further. Since the money
supply is positively related to M1/Base, RES/GOLD, and BASE/RES, a decrease in
all three will mean a decrease in the money supply.
4. In 1931, the UK and other countries abandoned convertibility in favor of floating
exchange rates. Britains currency was overvalued, so this action meant
depreciation of the pound. Eichengreen examines the differences in recovery
between countries that left the gold standard and countries that maintained
convertibility. Those that suspended convertibility earliest were most able to use
 monetary policy to reflate their currency, while those that remained under a
convertibility regime continued to suffer falling price levels.
5. Aside aggregate demand forces as causes of the Great Depression, it is important
to look at the aggregate supply side as well. Despite the long-term neutrality of
money, it is thought that deflation in the 1920s led to financial upheaval. With a
falling price level, the debt burden of borrowers grows; this idea of debt-deflation
was put forward by Irving Fisher and examined again by Bernanke. When a
borrowers debt burden grows, his net worth decreases. The costs of borrowing
therefore increase as lenders see more risk in a borrower who cannot supply much
capital. After a certain level, the borrower can no longer obtain loans. Another
factor was nominal stickiness. Bernanke argues that this could be a
consequence of debt-deflation, as governments find it politically favorable to
provide support to an economy in crisis; this intervention can slow the economys
adjustment to dynamic circumstances. Citing Frances agricultural protectionism,
Bernanke posits that government involvement can often hinder downward
adjustment of wage and price levels.
6. There are three assumptions crucial to Eichengreens model of interwar monetary
policy interactions. Eichengreen assumes that a central bank has more targets than
instruments; it will face tradeoffs in deciding which targets to prioritize. Second,
he assumes interdependence domestic variables are affected by actions of the
foreign central bank, which may manipulate the foreign discount rate and affect
capital flows. Third is the assumption that a central bank has an optimal level of
gold reserves and a target price level and will act to maintain them. Fourth is that
the central bank able to affect the size of the money multiplier and alter the
composition of monetary base. Eichengreen states that the model is not an attempt
to depict the entirety of gold standard dynamics; rather it is a tool to demonstrate
simply the relationship between the actions of a foreign central bank and a home
countrys economy.
7. Please see attached.
8. Please see attached.
9. Please see attached.
10. A non-cooperative approach assumes that a central bank will pick an optimal
strategy given the discount rate of the foreign central bank. More fundamental is
the assumption that the central banks prioritize holding a large share of global
gold reserves over price stability and will act to further this goal, leading to a
scramble for gold of increasing interest rates. For a simplified example, a bank
A that starts at point K will prompt its counterpart, bank B, to set rate at point M,
prompting A to respond by shifting its rate to point N where the reaction functions
of banks A and B intersect, the point of Nash equilibrium. In a less simplified
version, there is a cycle several iterations of interest rate hikes between the initial
point K and the final point N.
11. There are three interpretations of central bank interaction: non-cooperative
behavior, a leader-follower solution, and cooperation. Non-cooperative behavior
iteratively yields a Nash equilibrium, the dominant strategy for both participants.
The leader-follower solution assumes that one bank sets its rate strategy
anticipating the foreign reaction (acting as the leader), while the foreign bank
 takes the leaders rate as given (acting as the follower). The third, the cooperative
solution, assumes that the central banks coordinate policy toward a Pareto-optimal
solution, where neither party can be made better off without making the other
party worse off. Assuming that the central banks have similar goals, collaboration
can reduce discount rates and raise prices. In most cases, however, there is a
deflationary bias due to competitive interest rate hikes. An example of this is
competition in the 1920s between the Bank of England and the Bank of France
over augmentation of national gold reserves. Interest rate hikes in the United
States meant to moderate stock market exuberance worsened Britains position.
Britain attempted to collaborate with foreign nations by expressing its reluctance
to further increase rates. Because of this, equilibrium was reached at Figure 2s
point M, not N (an increase in the foreign rate, but not matched by an increase in
the domestic rate). This monetary contraction, though not the worst-case scenario,
still lead to an overall contraction in output. Consistently high rates led to
deflation and ultimately the Great Depression.
12. There were various differences in the plans of Harry Dexter White and John
Maynard Keynes around exchange rate flexibility and capital mobility. Keynes
favored a regime that would allow for exchange rate manipulation and trade
controls. White preferred a system without trade controls and with pegged
currencies controlled by an international body. Keynes advocated for the creation
of international liquidity by a supranational central bank (the International
Clearing Union), while White prioritized exchange rate stability under a United
Nations Stabilization Fund. A compromise was reached in which the liquidity
desired by the British was reduced, but member nations retained a say in the
exchange rate, and the agreement included provisions for capital controls. The
ICU did not survive negotiations, but the agreement did provide for the
establishment of the IMF and concurrently the World Bank. The aims of Articles
of Agreement of the Bretton Woods Conference included the maintenance of full
employment and robust growth, stable exchange rates, and a multilateral system
of payments with liquidity to correct periodic fluctuations in the balance of
payments.