Homework answers / question archive /   governments based their exchange rates on this prior to WWI- governments exchanged national currency notes for gold at a permanently fixed rate of exchange because all national currencies were fixed to gold, all national currencies were permanently fixed against each other as well this emerged at center of international monetary system during 1870s GB adopted this in early 18th century but other currencies remained based on silver/ combo of silver and gold network externalities- benefit of adopting gold grew in line with number of countries that already adopted gold this exchange- rate stability facilitated rapid growth of international trade and financial flows in late 19th century with exchange rates permanently fixed, prices in each country moved in response to cross- border gold flows: prices rose as gold flowed into country and fell when gold flowed out cross- border gold flows were driven by "price specie- flow mechanism" which generates a balance- of- payments surplus and this payments surplus would pull gold into US from rest of world an accounting device that records all international transactions between a particular country and the rest of the world for a given period, provides an aggregate picture of the international transactions the US conducts in a given year transactions are divided up into 2 broad categories 1) current account: records all current (nonfinancial) transactions between American residents and the rest of world and divided into 4 subcategories a) trade account: imports and exports of goods, including manufactured items and agricultural products b) service account: registers imports and exports of service- sector activities, banking services, insurance, consulting, transportation, tourism, construction c) income account: registers all payments into and out of US in connection with royalties, licensing fees, interest payments, and profits d) unilateral transfer account: registers all unilateral transfer from the US to other countries and vice versa, among such transfers are wages that immigrants working in US send back to their home countries, gifts, and foreign aid expenditures by the US gov payments US => other countries: debits other countries => US: credits debits are balanced against credits to produce overall current- account balance 2) capital account: registers financial flows between the US and rest of world capital outflow: when US resident purchases a financial asset, a foreign stock, a bond, or a factory in another country (-) capital inflow: every time a foreigner purchases an American financial asset (+) if country has current- account deficit- must have capital- account surplus and if country has current- account surplus, must have capital account deficit US able to spend more than it earned in come because the rest of world was willing to lend to Am residents and US capital account surplus reflects willingness of other residents of other countries to finance Am

  governments based their exchange rates on this prior to WWI- governments exchanged national currency notes for gold at a permanently fixed rate of exchange because all national currencies were fixed to gold, all national currencies were permanently fixed against each other as well this emerged at center of international monetary system during 1870s GB adopted this in early 18th century but other currencies remained based on silver/ combo of silver and gold network externalities- benefit of adopting gold grew in line with number of countries that already adopted gold this exchange- rate stability facilitated rapid growth of international trade and financial flows in late 19th century with exchange rates permanently fixed, prices in each country moved in response to cross- border gold flows: prices rose as gold flowed into country and fell when gold flowed out cross- border gold flows were driven by "price specie- flow mechanism" which generates a balance- of- payments surplus and this payments surplus would pull gold into US from rest of world an accounting device that records all international transactions between a particular country and the rest of the world for a given period, provides an aggregate picture of the international transactions the US conducts in a given year transactions are divided up into 2 broad categories 1) current account: records all current (nonfinancial) transactions between American residents and the rest of world and divided into 4 subcategories a) trade account: imports and exports of goods, including manufactured items and agricultural products b) service account: registers imports and exports of service- sector activities, banking services, insurance, consulting, transportation, tourism, construction c) income account: registers all payments into and out of US in connection with royalties, licensing fees, interest payments, and profits d) unilateral transfer account: registers all unilateral transfer from the US to other countries and vice versa, among such transfers are wages that immigrants working in US send back to their home countries, gifts, and foreign aid expenditures by the US gov payments US => other countries: debits other countries => US: credits debits are balanced against credits to produce overall current- account balance 2) capital account: registers financial flows between the US and rest of world capital outflow: when US resident purchases a financial asset, a foreign stock, a bond, or a factory in another country (-) capital inflow: every time a foreigner purchases an American financial asset (+) if country has current- account deficit- must have capital- account surplus and if country has current- account surplus, must have capital account deficit US able to spend more than it earned in come because the rest of world was willing to lend to Am residents and US capital account surplus reflects willingness of other residents of other countries to finance Am

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1. governments based their exchange rates on this prior to WWI- governments exchanged national currency notes for gold at a permanently fixed rate of exchange
   because all national currencies were fixed to gold, all national currencies were permanently fixed against each other as well
   this emerged at center of international monetary system during 1870s
   GB adopted this in early 18th century but other currencies remained based on silver/ combo of silver and gold
   network externalities- benefit of adopting gold grew in line with number of countries that already adopted gold
   this exchange- rate stability facilitated rapid growth of international trade and financial flows in late 19th century
   
   with exchange rates permanently fixed, prices in each country moved in response to cross- border gold flows: prices rose as gold flowed into country and fell when gold flowed out
   
   cross- border gold flows were driven by "price specie- flow mechanism" which generates a balance- of- payments surplus and this payments surplus would pull gold into US from rest of world
2. an accounting device that records all international transactions between a particular country and the rest of the world for a given period, provides an aggregate picture of the international transactions the US conducts in a given year
   transactions are divided up into 2 broad categories
   1) current account: records all current (nonfinancial) transactions between American residents and the rest of world and divided into 4 subcategories
   a) trade account: imports and exports of goods, including manufactured items and agricultural products
   b) service account: registers imports and exports of service- sector activities, banking services, insurance, consulting, transportation, tourism, construction
   c) income account: registers all payments into and out of US in connection with royalties, licensing fees, interest payments, and profits
   d) unilateral transfer account: registers all unilateral transfer from the US to other countries and vice versa, among such transfers are wages that immigrants working in US send back to their home countries, gifts, and foreign aid expenditures by the US gov
   
   payments
   US => other countries: debits
   other countries => US: credits
   debits are balanced against credits to produce overall current- account balance
   2) capital account: registers financial flows between the US and rest of world
   capital outflow: when US resident purchases a financial asset, a foreign stock, a bond, or a factory in another country (-)
   capital inflow: every time a foreigner purchases an American financial asset (+)
   
   if country has current- account deficit- must have capital- account surplus and if country has current- account surplus, must have capital account deficit
   
   US able to spend more than it earned in come because the rest of world was willing to lend to Am residents and US capital account surplus reflects willingness of other residents of other countries to finance Am. expenditures in excess to American income
   a country can only have current- account deficit only if it has a capital account surplus
   
   balance of payment adjustments:
   imbalance: when current and capital accounts does not balance each other out, country might have current- account deficit that it cannot fully finance through capital imports or might have current account surplus that cannot be offset by capital outflows and when imbalance arises- country must bring its payment back into balance and the process to do so is balance of payment adjustments
   
   - fixed exchange rate system: adjustment occurs through changes in domestic prices
   e.g Japan and US
3. links exchange- rate policy choices to competition between sector- based interest groups
   
   does not assume that all governments value monetary autonomy more than exchange- rate stability, interest groups hold different preferences over the trade- off between domestic economic autonomy and exchange- rate stability, some interest groups prefer floating and other prefers fixed exchange rates and some prefer strong currencies while others weak currencies and each group lobbies the government on behalf of its preferred exchange- rate policy and exchange- rate policy is determined by the group that has the greatest influence
   
   - splits domestic actors into 4 domestic interest groups/ sectors:
   1. import- competing producers: prefers a floating exchange rate, generate revenues from sales in domestic market, not greatly affected by exchange rate movements and attach little value to exchange rate stability- interest in retaining the government's ability to use monetary policy to manage the domestic economy; monetary policy autonomy > fixed exchange rate
   prefers weak/ undervalued currency
   2. export- oriented producers: prefers a fixed exchange rate, heavily engaged in international trade, and exchange- rate movements damage their economic interests so exchange- rate stability is extremely valuable, attach little value to monetary policy autonomy because they deal with foreign trade so they lose very little if the governmeny cannot use monetary policy to manage the domestic economy; fixed exchange rate > monetary- policy autonomy
   prefers weak/ undervalued currency
   3. nontraded- goods producers: prefers a floating exchange rate, generate revenues from sales in domestic market, not greatly affected by exchange rate movements and attach little value to exchange rate stability- interest in retaining the government's ability to use monetary policy to manage the domestic economy; monetary policy autonomy > fixed exchange rate
   prefers strong/ overvalued currency <- raises income in this sector
   4. financial services industry: highly internationalized, exchange- rate movements can damage their interests - international exposure creates some interest in exchange rate stability but financial institution profit from exchange- rate volatility - currency trading become an important source of profits for financial services industry and banks offer services that help businesses engaged in international trade manage their exchange- rate risk
   - value monetary- policy autonomy because they depend on central banks to maintain the stability of domestic banking system and to keep domestic inflation in check but then it's damaged by excessive fluctuations in domestic interest rates and using monetary policy to maintain a fixed exchange rate can produce more volatile domestic- interest rates
   - the financial sector prefers monetary- policy autonomy and is will to accept exchange- rate flexibility
   > like strong currency because allows them to purchase foreign assets at lower price but strong currency can weaken the financial institutions that have loaned heavily to firms in traded- goods sector
   so agnostic with respect to level of exchange rate
   
   - each group has preferences over 2 dimensions of exchange rate policy
   1) has preference regarding the degree of exchange- rate stability
   2) has preference regarding the level of exchange rate
   
   preferences over exchange rate stability reflect the value that each attaches to exchange- rate stability and monetary- policy autonomy
   
   Weaknesses:
   1) overestimate the importance the export- oriented firms attach to exchange- rate stability; although exporters may be harmed by exchange- rate volatility- true that businesses can reduce their exposure to volatility by using forward markets to cover the risk they face so exchange- rate volatility may be less damaging in practice
   2) overestimate the importance that traded- good sector attaches to weak currency- in open economy- many firms import intermediate inputs and because a weak currency raises domestic currency price of imports- raises production costs and as a consequence- a portion of gains that these firms realize from a weak currency is eliminated
   3) does not provide much help understanding which competing demands will be represented in exchange- rate policy
4. - revolutionary ideas in economic theory that emerged during the 1930s
   - offered rationale for governments to use monetary policy to manage domestic economy
   - focused on unemployment- high rates of unemployment defied the expectations of the standard economic theory, neoclassic economics which argued that persistent high unemployment was impossible because markets have equilibrating mechanisms that keep the economy at full employment and because labor markets are no different than any other markets, an imbalance between supply and demand should give rise to adjustment processes that eliminates the imbalance and in this case- excess supply of labor represented by high unemployment should cause the price of labor- wages- to fall and as price of labor falls, the demand for labor will increase and these adjustments will guide the economy back to full employment and therefore in neoclassical theory- unemployment was expected to give rise to an automatic adjustment process that would lead the economy back to full employment
   
   - high unemployment in interwar Britain caused Keynes to reevaluate neoclassical explanation of unemployment - The General Theory of Employment, Interest, and Money- challenged neoclassical economics in 2 ways
   1) neoclassical economists were wrong to think that economy would always return to full employment automatically - economy could get stuck at an equilibrium
   
   2) governments need not accept persistent high unemployment- governments could use macroeconomic policy- monetary policy and fiscal policy to restore economy to full employment
   
   economies stuck at high levels of unemployment because of fragility of investment decisions -investments expenditures account for 20% of total national expenditures- variation in investment expenditures can have important influence on overall level of economic activity: when investment rises, economy grows, and when investment falls, economy stagnates and investment decisions are strongly influenced by firms' expectations about the future demand for their products
   
   cause of persistent high unemployment lay in inadequate demand for goods, proposed that governments use fiscal and monetary policy to manage aggregate demand (sum of all consumption and investment expenditures made by the government, by domestic and foreign consumers, and by producers)
   when government cuts taxes without reducing expenditures, aggregate demand increases because private individuals' consumption expenditures increase by some proportion of tax reduction and when government increases expenditures without raising taxes, total government expenditure rise
   additional demand for goods and services that results from these increased expenditures causes firms to hire more workers to produce the additional goods being demanded
   
   > argued that be spending when others would not or by increasing the money supply to induce others to spend- the government could increase demand in economy and by increasing total demand in economy- investment would rise and unemployment would fall and thus by using macroeconomic policy to manage aggregate demand, government could keep economy running at full employment
   
   saw market economy as potentially unstable and susceptible to large and sustained departures from full employment
   
   - by end of WWII, many governments had reevaluated role they could and should play in domestic economy
   Employment Act of 1946: the government accepts as one of their primary aims and responsibilities the maintenance of a high and stable level of employment after the war
   
   - made governments more aware of the policy measures that could be used to promote employment and broke the neoclassical strictures on their use and as a consequence- governments have responded by becoming more willing to use monetary policy to meet these expectations
5. named after British economist A.W Phillips, trade- off between unemployment and inflation, partisan model is based on this
   
   - suggests that government can reduce unemployment only by causing more rapid inflation and can reduce inflation only be causing higher unemployment