GEI Projects

16. UNEXPLAINED RELATIONSHIPS IN THREE REGIMES OF THE INTERNATIONAL MONETARY SYSTEM

Principal Researchers

Professor RONALD MACDONALD
University of Strathclyde

Professor MICHAEL D BORDO
Rutgers University

AIMS AND OBJECTIVES

The purpose of this project is to examine some unexplained relationships in three regimes of the International Monetary System, namely the Classical and Inter-War Gold Exchange Standards and the Bretton-Woods regime. It is our intention to examine an apparent paradox in the operation of the Classical Gold Standard. There is a body of work which suggests that central banks did not play by the ‘rules of the game’ during the period and, indeed, they had some scope to alter domestic interest rates. However, this apparently conflicts with the interpretation of the Classical gold standard as a system of rigidly fixed exchange rates and with the view that the system was highly credible. We intend using a simple interest rate reaction function model combined with recently developed econometric methods, to investigate this issue. We will also examine a similar theme for the inter-war gold standard experience – seen as a badly flawed system having two reserve currencies, the absence of a hegemonic leader and the failure of key members to cooperate. Yet there is compelling evidence to suggest it operated efficiently and with a degree of credibility. To shed some light on these issues we intend modelling the connection between underlying policy processes and domestic and international financial markets.

For the Bretton-Woods episode of the International Monetary regime, we intend examining three separate themes. First, the traditional view of the operation of the Bretton-Woods system is that it behaved as an assymmetric gold dollar system with the US pegging the dollar to gold and the rest of the world pegging to the dollar. But how important was Sterling in this period? Although there was a very noticeable decline in the economic importance of the UK during this period, sterling’s role as a reserve currency was still quite substantial and an unexplored issue is the role, if any, sterling played as a secondary reserve currency. A second question we would hope to address for the Bretton-Woods system is the role of France in undermining the system. In particular, a standard analysis of the breakdown of the Bretton-Woods system suggests that France deliberately tried to undermine the operation of the system by purposefully converting dollars into gold after 1965. A third theme relating to the Bretton-Woods system is the issue of the nominal stability which participating countries achieved during the period and whether or not adherance to a fixed nominal anchor contributed to this and also to the growth rate of real output.

STUDY DESIGN

The study will use state-of-the-art econometric methods to analyse the issues discussed above. For example, vector autoregressive models, which include both long-run economic restrictions and short-run dynamics, will be used, as will more specific forms of modelling, such as the construction of reduced form reaction functions. Before the econometric work can be undertaken, however, a substantial amount of data collection will be required, particularly for the Classical Gold Standard period. The main output from the study will consist of a series of papers closely tied to the topics noted in the previous section.

POLICY IMPLICATIONS

Although our project is concerned with quantitative economic history issues, it should, nevertheless, have implications for policy particularly those relating to the design of an optimal international monetary regime. Thus, and for example, it has recently become fashionable to advocate the return to an international monetary regime based on fixed exchange rates. The starting point of such a discussion is the extreme volatility of both real and nominal exchange rates that has been observed during the recent floating exchange rate period. Such volatility seems unrelated to observable fundamentals and is therefore usually interpreted as a function of the regime rather than the policies pursued in the regime. Fixing exchange rates should therefore have an immediate and dramatic effect on the volatility of real exchange rates. Some proponents of fixity advocate a move to a system of rigidly fixed rates based on gold standard whilst others advocate a return to reformed version of the Bretton-Woods system. A thorough and systematic historical analysis of how these regimes actually operated should hopefully assist in the debate about the construction of new versions of these systerns.