THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 556

524 PA R T V I GLOBAL International Finance and Monetary Policy Why the Large U.S Current Account Deficit Worries Economists The massive U.S current account deficit in recent years, which now exceeds 6% of GDP, the highest level reached over the past century, worries economists for several reasons First, it says that at current values of the exchange rate, foreigners demand for U.S exports is far less than Americans demand for imports As we saw in the previous chapter, low demand for U.S exports and high U.S demand for imports may lead to a future decline in the value of the U.S dollar Some economists estimate that the decline could be very large, with the U.S dollar depreciating by as much as 50% Second, the current account deficit means that foreigners claims on U.S assets are rising, and these claims will have to be paid back Americans are thus mortgaging their future to foreigners, and when the bill comes due, Americans will be poorer Furthermore, if Americans have a greater preference for U.S dollar assets than foreigners, the movement of American wealth to foreigners can decrease the demand for U.S dollar assets over time and provide another reason why the U.S dollar might depreciate The hope is that the eventual decline of the U.S dollar resulting from the large U.S current account deficit will be a gradual one, occurring over a period of several years If however, the decline is precipitous, it could potentially disrupt financial markets and hurt the U.S economy EXCH ANG E RAT E RE GI M ES I N T HE I NT E RNAT IO N AL FI NA NCI AL SYSTE M Exchange rate regimes in the international financial system are of two basic types: fixed and floating In a fixed exchange rate regime, the value of a currency is pegged relative to the value of one other currency (called the anchor currency), so that the exchange rate is fixed in terms of the anchor country In a floating exchange rate regime, the value of a currency is allowed to fluctuate against all other currencies When countries intervene in foreign exchange markets in an attempt to influence their exchange rates by buying and selling foreign assets, the regime is referred to as a managed float regime (or a dirty float) In examining past exchange rate regimes, we start with the gold standard of the late nineteenth and early twentieth centuries Gold Standard Before World War I, the world economy operated under the gold standard, a fixed exchange rate regime in which most currencies were convertible directly into gold at fixed rates, so exchange rates between countries were also fixed Canadian dollar bills, for example, could be exchanged for approximately 1/20 ounce of gold Likewise, the British Treasury would exchange 1/4 ounce of gold for Because a Canadian could convert $20 into ounce of gold, which could be used to buy 4, the exchange rate between the pound and the Canadian dollar was effectively fixed at approximately $5 to the pound The fixed exchange rates under the gold standard had the important advantage of encouraging world trade by eliminating the uncertainty that occurs when exchange rates fluctuate