ECON120: Monetary History

5a. Describe the Bretton Woods agreement of 1944, its ramifications, and its ultimate collapse

• How did the US dollar become the world's reserve currency by 1944?
• How did the Bretton Woods agreement affect the global hierarchy of money?
• After the Bretton Woods agreement, how was gold linked to the global monetary system?
• Why was a gold pool formed in the 1960s?
• Hpe did gold's role in the global monetary system formally end?
  

In 1944, world leaders met in Bretton Woods, New Hampshire, and formalized that all currencies besides the dollar were forms of third-layer money within the dollar pyramid. The Bretton Woods agreement was when the dollar became the world reserve currency. Federal Reserve notes still promised the bearer gold coins on demand at $35 per ounce, but currencies now had fixed exchange rates with the dollar and wouldn't be redeemable for gold. The dollar kept a link between itself and gold.
 
Foreign currencies were on the third layer of money because of their price relationship to dollars. Other currencies are below the dollar in the layers of money because their price is measured in dollars. While United States citizens were banned from owning gold, other nations were still allowed to convert their accumulated dollar reserves to metal. To prevent the dollar value of gold from changing, the United States, United Kingdom, and others formed the Gold Pool, whereby central banks sold precious metal into the market to keep a lid on its price at $35 per ounce. Nations accumulated dollars due to their world reserve currency status and began converting these dollars into gold. The Gold Pool collapsed when the price exceeded $35 in European markets.
 
Over the next few years, gold lost its official monetary status. In 1971, the United States suspended gold convertibility for the dollar. In 1973, the modern era of free-floating currencies began, which ended the Bretton Woods agreement.
 
To review, see Offshore Dollars.
 

5b. Explain the origins of the eurodollar (offshore dollar) system 

• How did demand for a dollar issued outside of the United States emerge?
• How are Eurodollars characterized?
• What were some of the primary sources of demand for Eurodollar deposits in the 1950s?
• How were Eurodollars related to the Federal Reserve system during this era?
  

During the Bretton Woods era, the dollar denominated most international commerce. Demand for dollars outside of the United States skyrocketed, and European banks offered more attractive deposit rates than their US counterparts because of regulatory differences. This steered people into European-domiciled dollar deposits. These offshore dollar deposits issued by banks of European origin came to be called Eurodollars.
 
Dollars were needed outside of the United States to participate in an increasingly dollarized global economy. European banks were responding to the emergent international demand for dollars by issuing Eurodollars. Due to the advent of the Eurodollar, the dollar money pyramid changed. The Eurodollar system has an unclear first layer of money because of the monetary ambiguity of international banks issuing USD.
 
To review, see Offshore Dollars.
 

5c. Illustrate how Money Market Funds (MMFs) work within the monetary hierarchy

• Why does demand exist for money market funds?
• What are the assets of MMFs?
• How did a US Treasury-collateralized lending market called "repo" evolve?
• Why is repo considered a core dollar-type within the layered-money system?
• How do MMF shares fit into the layered-money system?
• How are LIBOR and Eurodollars related?
• How are LIBOR and the Federal Reserve Funds rates related?
  

In a Treasury Repo transaction, a bank that owns a Treasury bond can pledge it as collateral and borrow money against it, just like in a pawn shop. Treasury Repo dollar creation occurred via bookkeepers. Banks could use the money they borrowed in the Treasury Repo market in interbank dollar settlement, and thus their Treasury holdings were a new source of money. By 1979, the Federal Reserve concluded that Treasury Repo transactions were causing an increase in the supply of dollars. By 1982, the Federal Reserve shifted to a monetary policy regime focused on managing short-term interest rates.
 
The Federal Reserve targets a short-term interest rate as a part of its monetary policy called the Federal Funds Rate (Fed Funds), an interbank lending rate for second-layer reserve deposits held at the Fed. Fed Funds is an essential reference rate because it is the Federal Reserve's desired price for short-term lending within the U.S. domestic banking system.
 
In 1986, interest rates on Eurodollar deposits in London were formalized in a rate called LIBOR, which would express the average rate at which banks in London lent Eurodollars to each other. These dollars didn't connect to the Federal Reserve's second-layer reserves or third-layer dollar deposits insured by the FDIC.
 
Money Market Fund (MMF shares) are a cash instrument that services demand for safe money. Money Market Funds became popular during the 1970s alongside the boom in Treasury Repo supply. MMF shares held a par value relative to other high-quality second- and third-layer money types. This means that a dollar invested in MMF shares could always be redeemed for a dollar. Depending on the exact composition of monetary instruments, Money Market Fund shares became second- and third-layer money types.
 
To review, see Money Market Funds.

5d. Describe the financial crisis in the money market in 2007-2009, and explain the Federal Reserve's FX swap lines 

• What happened on August 9, 2007, in the money markets?
• How did the Federal Reserve respond to the breakdown of the Eurodollar system, evidenced by the LIBOR market?
• How did the layered-money system evolve after the Federal Reserve's foreign exchange swap lines were extended to the ECB and SNB?
• How did the collapse of Lehman Brothers contribute to the financial crisis?
• Why did the Federal Reserve intervene in financial markets after the collapse of Lehman Brothers?
• What type of guarantees did financial markets and institutions receive during the financial crisis of late 2008?
  

On August 9, 2007, banks stopped lending money to each other because they weren't sure which banks might not open back up the next day. On December 12, 2007, the Federal Reserve addressed the European interbank trust and that the Eurodollar funding mechanisms had broken down. The Federal Reserve instituted foreign exchange swap lines to the European Central Bank and Swiss National Bank to provide liquidity to the offshore banking system. These foreign exchange swaps created another type of second-layer money made available by the Federal Reserve to other select central banks.
 
When Brothers failed on September 15, 2008, a money market fund called Reserve Primary Fund posted a share price of $0.97 because it owned a fair amount of newly defaulted Lehman Brothers commercial paper. This drop of three cents triggered financial panic from central banks and governments. This happened because of a fear that if Lehman Brothers' commercial paper could fail and Reserve Primary Fund's shares weren't worth a whole dollar, nothing could be trusted. Bank liabilities lost liquidity.
 
The insurance giant American International Group (AIG) received a Federal Reserve lifeline on September 16 because it had underwritten insurance on risky mortgage securities that were suddenly defaulting. The Money Market Fund complex received a guarantee from the Federal Reserve on September 19 that its share prices would be supported to prevent withdrawal panic. Goldman Sachs and Morgan Stanley received their lifeline on September 22 after being allowed to convert from investment banks into bank holding companies which gave them direct access to Fed lending. Concurrently, the Federal Reserve increased liquidity capacity for major central banks worldwide daily. This allowed the Federal Reserve to avoid systemic collapse.
 
To review, see Financial Crises.
 

5e. Define Quantitative Easing (QE) and other Federal Reserve asset purchase programs 

• How does Quantitative Easing provide liquidity to the financial markets?
• How does QE reinforce that US Treasuries exist on the first layer of money?
• How does QE give the Federal Reserve a monetary policy tool to use in a financial crisis?
  

On November 25th, the Federal Reserve purchased US Treasuries, many of which had been newly issued, to finance deficits resulting from economic recession, tax shortfalls, and corporate bailouts. This expansion of second-layer money responded to contraction elsewhere in the system; it met the collapse in interbank trust and liquidity with reliable liquidity. The Federal Reserve called it Quantitative Easing (QE).
 
To review, see Financial Crises.
 

5f. Describe the liquidity crises of 2019 and 2020 and the Federal Reserve's response 

• What happened to the Treasury repo market during September 2019?
• How has the Federal Reserve's treatment of the Treasury repo market evolved?
• How is the Treasury repo considered in the layered-money system after the Federal Reserve's guarantees?
• How did the pandemic reinforce the Federal Reserve's role as lender of only resort?
  

During the pandemic-induced global financial panic of March 2020, the Federal Reserve announced several additional lending facilities to backstop the Treasury Repo market, Money Market Funds, and fifteen additional central banks. To protect the system against foreign liquidation of US Treasuries, the Federal Reserve instituted a facility to lend money in the Treasury Repo market to approved foreign entities so that these governments and central banks didn't disrupt the Treasury market if they ever needed cash. They could post their Treasuries as collateral directly at the Federal Reserve's pawn shop. Treasury prices soared in the first few days of pandemic panic as demand emerged for safe assets while prices of stocks and corporate bonds fell. US Treasuries with longer maturities (ten to thirty years) lost a bid despite their typical safe-haven status because of all the chaos in the markets. US Treasury purchases and reserve creation were implemented to allow the Federal Reserve to prevent sustained disturbances to the security market.
 
To review, see Financial Crises.
 

Unit 5 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• Eurodollars
• Federal Funds Rate (Fed Funds)
• LIBOR
• Money Market Fund (MMF)
• Treasury Repo