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 1. Because a Canadian could convert $20 into 1 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.