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Polisci110G Week 7 notes

by: Erica Evans

Polisci110G Week 7 notes Polisci110G

Erica Evans
GPA 3.9

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Governing the Global Economy
Kenneth Scheve
Class Notes
25 ?




Popular in Governing the Global Economy

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This 3 page Class Notes was uploaded by Erica Evans on Monday February 22, 2016. The Class Notes belongs to Polisci110G at Stanford University taught by Kenneth Scheve in Fall 2016. Since its upload, it has received 11 views. For similar materials see Governing the Global Economy in Political Science at Stanford University.

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Date Created: 02/22/16
Polisci110G   2/18/2016       Exchange  Rates:   • Countries  decide  how  exchange  rate  will  be  set   • Doesn't  the  market  decide  though?  No!     • Fixed  exchange  rate:  Countries  will  choose  how  it’s  set  –  by  fixing  it  to   another  country.  So  it  fluctuates  not  at  all,  or  over  a  narrow  range  for  an   extended  time  period.     • Floating  exchange  rate:  the  government  doesn’t  try  to  set  it,  but  lets  the   supply  and  demand  or  assets  determine  what  the  exchange  rate  is     • Fixed-­‐but-­‐adjustable:  Bretton-­‐Woods  System  à  fixed  currencies  to  the  dollar   but  were  allowed  to  reset  them.   • Managed  flow:  governments  intervene  but  there  are  no  rules  and  rates  vary   significantly.       History:       • Before  WWI,  countries  had  lots  of  different  systems,  but  at  some  point   Britain  adopted  a  Gold  Standard  (the  currency  is  worth  x  amounts  of  gold.   Anyone  can  redeem  cash  for  gold,  or  gold  for  cash).    Britain  was  the  most   important  economy  in  the  world,  so  lots  of  countries  moved  to  a  gold   standard  (others  are  floating  or  on  a  silver  or  bimetallic  standard).     • In  WWI,  all  countries  suspended  the  gold  standard   • Would  the  Int.  financial  system  return  to  the  gold  standard?     • Late  1920’s  they  got  there  and  most  countries  were  back  to  the  Gold   Standard…  but  it  didn’t  last  (Great  Depression  hmmm)     • After  WWII,  a  bunch  of  countries  are  pegged  to  the  dollar,  the  pound  etc.  Lots   of  fixed  exchange  rates,  but  not  a  Gold  Standard.  Floating  becomes  more   popular.     th • In  the  later  half  of  the  20  century:  1974:  74%  countries  have  fixed.  Moves  to   58%  in  1990,  and  then  26%  in  2000  à  more  countries  adopting  floating   exchange  rates.       Albion  peg  to  the  Wotan  exercise:     • 1%  economic  downturn  in  home  country     • “Our  policies  will  not  change  unless  economic  conditions  deteriorate  further”   • Let’s  learn  more…  maybe  we  will  change  our  minds!       What  are  the  political  considerations  –  who  are  the  winners  and  losers?     • 2  main  ideas:     • Exchange  rate  volatility  discourages  trade  and  capital  flows.  You  will  have   more  certainty  about  prices  and  you  will  trade  more  with  that  country     • One  argument  à  the  greater  the  economic  integration  b/w  home  country   and  base  country,  the  more  the  home  country  will  benefit  from  a  fixed  rate.     • (even  more  pronounced  in  a  currency  union  like  the  EU)     • Costs  of  a  fixed  exchange  rate:  a  country  choosing  to  fix  its  exchange  rate  is   sacrificing  its  independent  monetary  policy.     • It  depends  on  how  symmetric  or  asymmetric  the  shocks  to  the  economy  are.   Suppose  the  countries  are  the  Netherlands  and  Germany  à  very  similar  and   close.  They  will  have  fewer  asymmetric  shocks,  so  low  cost  for  a  dependent   monetary  policy.  But  if  it  is  Germany  and  Greece  à  very  different.  There  will   be  very  asymmetric  shocks.  Germany  will  not  adjust  if  Greece  is  struggling   because  Germany  is  not  affected.     • Symmetry  of  shocks  vs.  Market  integration  à  allows  you  to  set  the  fix  line   (when  the  benefits  of  a  fixed  exchange  rate  out-­‐weigh  the  costs).       • What  determines  where  the  fix  line  is?       Why  does  Denmark  fix  its  exchange  rate  while  the  UK  floats  the  pound?     • How  much  does  Denmark  trade  with  Germany  vs.  the  U.K?  A  lot  more  with   Germany!  Denmark  would  be  more  symmetric  with  Germany  because  the   U.K.’s  economy  is  a  lot  more  global  (they  trade  with  the  U.S.  and  Asia  etc…  so   they  would  experience  shocks  that  have  nothing  to  do  with  the  Euro  area)       The  “Trilemma”  in  Theory:     • THIS  IS  REALLY  IMPORTANT!  A  lot  of  political  leaders  don’t  understand  this!     • It  is  reasonable  for  leaders  to  want  three  things  1)  fixed  exchange  rate  to   increase  trade  2)  (financial  integration)  capital  mobility  to  allow  capital  to   move  to  places  where  it  can  be  best  invested.  This  is  especially  important  if   you  are  a  capital-­‐poor  country  3)  monetary  policy  economy  à  having  an   independent  monetary  policy  that  allows  you  to  adjust.     • The  problem  is  you  cannot  have  all  three  of  these  things!     • Fiscal  policy  =  tax  and  spending,  raising  taxes  so  the  gov.  can  do  stuff.     • Monetary  policy  =  central  bank  setting  interest  rates.  When  interest  rates  go   down,  it’s  cheaper  to  borrow,  which  spurs  growth,  but  may  cause  inflation.   When  you  raise  the  interest  rate  it’s  more  expensive  to  borrow,  so  more   unemployment,  but  prices  will  come  down.     • Why  can’t  we  have  it  all?     • Investor’s  behavior  when  capital  markets  are  open:     • If  you  are  a  U.S.  investor,  you  want  the  expected  dollar  return  of  your   investment  to  be  the  same  all  over  the  world  –  otherwise  you  will  move  your   money  to  where  it  is  more  profitable.     • If  the  ER  is  fixed,  the  expected  exchange  rate  depreciation  is  0.  You  know  if   you  take  your  dollars  and  buy  some  Euros,  then  take  the  Euros  and  buy  the   dollars  back,  it  will  be  the  same.     • The  only  way  there  will  be  an  expected  return  that  is  the  same  is  if  the   interest  rate  is  exactly  the  same.  So  the  home  country  can’t  set  it’s  interest   rates  independently  of  the  base  country.     • Compare  fixed  exchange  rates  and  intermediate  exchange  rates  à  poor   country  that  fixes  their  exchange  rate  will  have  very  volatile  experience…  b/c   they  don't  have  an  independent  monetary  policy.     How  the  Trilemma  has  influenced  historical  relations:     • In  the  late  19  century,  many  countries  were  under  the  gold  standard.   • Countries  that  had  a  gold  standard  also  had  a  fixed  exchange  rate.     • The  ratio  of  gold  prices  in  each  country  –  arbitrage  kept  the  exchange  rate   stable     • The  gold  standard  is  an  example  of  a  fixed  exchange  rate  system  with  high   capital  mobility.     • With  the  exception  of  the  U.S.,  countries  wanted  to  trade  more.     • The  gold  standard  was  adopted  because  there  was  increasing  trade   integration.     • The  cost  of  lost  monetary  autonomy  was  bearable  because  the  symmetry  was   high,  or  governments  were  not  worried  about  the  cost.     • Benefits  of  the  gold  standard:  exchange  rate  and  price  stability.  Allowed  for   adjustment  in  trade  imbalances  à  a  natural  equilibrium  through  the  flow  of   gold.     • The  price  levels  were  arbitrarily  set  by  supply  and  demand  for  gold.  So  when   there  was  a  discovery  of  gold  in  California,  this  would  increase  the  monetary   supply.  If  they  didn’t  discover  anything,  then  there  was  no  money  supply.     • This  lack  of  independent  monetary  supply  generated  political  conflict.     • There  were  various  depressions  and  deflationary  periods.     • Like  recently  in  Japan  à  Japan  over  the  past  2  decades  has  had  a  problem   with  deflation.  There  is  not  enough  accommodation  in  the  monetary  supply  –   prices  are  falling,  people  are  waiting  to  buy  things.     • This  kind  of  deflation  happened  until  the  1890’s.  \   • Prior  to  1896  –  massive  political  conflict  over  the  gold  standard.     • William  Jennings  Bryan  “Crucify  us  on  a  Cross  of  Gold”     • WWI  disrupted  the  Gold  standard.  There  was  lower  trade,  so  fixed  exchange   rates  are  less  attractive.     • By  the  late  1920’s  most  countries  have  returned  to  the  Gold  Standard.     • The  depression  was  different  than  the  previous  deflations  though     • When  countries  leave  the  gold  standard,  they  can  choose  either  of  the  2  sides   of  the  triangle.    


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