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Monetary Recovery

After the end of World War II, the Fed struggled for several years to regain its independence from the Treasury and, then, under the leadership of William McChesney Martin, it began to experiment with open-market operations. It attempted to "lean against the wind," that is, it wanted to make monetary policy countercyclical, tightening when the economy boomed and easing when it slumped. During the 1950s, the Fed developed open-market operations as its primary tool and they have remained the dominant tool ever since.

Also, as the Second World War came to an end, delegates from 44 nations met in Bretton Woods, New Hampshire to redesign the international financial system. The Bretton Woods agreement of 1944 attempted to return to fixed-exchange rates and to reduce the barriers to trade. The agreement in effect put the world on a dollar standard: the United States linked its currency to gold, and the other nations then fixed their currencies to the dollar.

The dollar was the only currency linked directly to gold because the United States had accumulated almost all of the world's gold used for monetary purposes. But throughout the 1950s and 1960s the U.S. lost gold, and by the end of 1967 it had only one half of what it had had in mid-1949. The system was in trouble because everyone came to realize that the U.S. could continue linking the dollar to gold only if no nation tested the link. The system was patched up several times before collapsing completely in 1973 when the United States cut all links between the dollar and gold. Since that time the U.S. and most other industrialized nations have let their currencies float.

The breakdown of the Bretton Woods agreement was in large part caused by the refusal of the United States and other nations to sacrifice domestic macroeconomic policy for the goal of maintaining the international financial system. For example, when the U.S. used monetary policy to combat unemployment, it expanded its economy, increasing spending. Some of this spending was for products made in foreign countries. Dollars flowed out of the U.S. into foreign countries. The people in these countries were happy with the amounts they had been buying from the U.S., so they did not want to spend these extra dollars for U.S. goods. These excess dollars should have caused the value of the dollar to fall in the foreign exchange market, but they did not because foreign central banks had fixed the price of the dollar in terms of their currencies. The foreign banks would keep the price constant by buying the excess dollars in the market, and in the process they would create additional amounts of their own currency to pay for them. This transaction had the same effect as an open market purchase by a central bank—it tended to increase the amount of money.

The foreign central bank had three options after it bought the extra dollars. First, it could return the dollars to the United States and ask for payment in gold. By the rules of the game, the United States should have been forced to reduce its money stock when asked for payment of gold, but this often was not politically feasible in the U.S. By the 1960s other countries realized that if they demanded gold, they would force the U.S. off gold.

Second, a foreign central bank could sterilize the transactions by selling other assets, and thus keep its money stock steady, but this would not correct the problem and the inflow of dollars would continue. Third, a foreign central bank could let the transaction expand its money stock. As a result there would be increased spending in the nation, and some of the additional spending would increase imports, getting rid of the excess dollars. But if it chose this third option, it lost control of its domestic monetary policy.

The mechanics of a fixed-exchange-rate system, and the rationale for why it would limit monetary policy were understood by the mid 18th century when David Hume clearly explained them. The quantity theory of money was originally developed as a way of explaining how gold flowed from country to country. Thus, no one should have been surprised when the fixed-exchange-rate system broke down; the breakdown was inevitable once countries decided that they wanted to have domestic monetary policy. If a country wanted to use the world money, it was also required to have the world's price level. By going to floating rates, the world went to a system that partially closed each economy, at least for monetary policy.

Because Germany had a floating exchange rate in 1923, its monstrous inflation did not spill over its borders to France or Britain. Rather as the value of the mark dropped in terms of goods, it also dropped in terms of the French franc and the British pound. For a citizen of France buying things from Germany, the effect of the inflation was hardly noticeable because the fall in the franc price of marks almost exactly offset the rise in the mark price of goods. Thus, a floating exchange rate system accommodates countries that are pursuing policies leading to a variety of inflation rates.

Although a floating rate frees monetary policy, it reduces the effectiveness of fiscal policy. To see this, consider the case in which the government of country A runs a bigger deficit to spur spending, and it finances this deficit by borrowing. The increased borrowing raises the interest rates in the financial market of A. Unless country A has barriers on the flows of money, its financial markets are part of the larger world financial market. Hence, the higher interest rates will attract foreign funds eager to take advantage of the new higher interest rates. But if foreigners are using their foreign exchange to buy A's debt, they cannot use that exchange to buy its products. There will be a rationing problem—who will get the foreign exchange, the people lending in country A's financial markets or the people buying products from A? Under floating rates, the rationing is done by price. The price of country A's money will rise in terms of other currencies. As a result, people in A will buy more from abroad, thus providing more funds to the foreign exchange market, and they will be able to sell less abroad. The higher exchange rate will cut exports of A, and thus jobs will be lost. Since the original purpose of the government deficit was to create jobs, it is partially frustrated with a system of floating rates. Crowding out is more serious because now higher interest rates not only cut investment, but they cut exports as well.

Finally, a floating exchange rate system is not the only way a nation can maintain an independent monetary policy. Another way is to fix the exchange rate and then outlaw the market, which makes the local currency inconvertible. This system has especially popular in less-developed nations primarily for its political advantages, not its economic effects.

The table below summarizes the effect that the exchange rate system has on macroeconomic policy.

How the Exchange Rate System Influences Government Policy


Type of Exchange Rule

Fixed and Convertible

Monetary Actions

not offset
largely offset by money flows

Fiscal Actions

largely offset by changes in net exports
not offset

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Copyright Robert Schenk