Econ 191 - University of California, Berkeley

Econ 191: Background material for Prof. Eichengreen’s 

Lecture on International Currencies 

Owen Zidar 

University of California, Berkeley 

owenzidargsi@gmail.com 

September 11, 2012 

Owen Zidar (Econ 191) Background for Eichengreen September 11, 2012 1 / 33

Announcements 

Twitter: Follow @economics191 

Sample Question: Turn in sample research question now please 

Attendance: Please sign attendance sheet that is going around 

Office Hours: Sign up online - need to see GSI once by Oct 2. 

Next Week: Professor Eichengreen lecturing on international 

currencies 


Overview of Today’s Lecture 

1 Historical Context: Brief History of the Evolution of the 

International Monetary System 

2 Tools: Referesher on Multivariate Regression 


1. Big Picture - History of International Monetary System 1 

Gold Standard 1821-1914 

Interwar period 

Bretton Woods Fixed Exchange Rates: 1946-1973 

After Bretton Woods 

1 Sources: ritholtz.com/blog/ for exchange rate images and International 

Economics by Krugman and Obstfeld 


I. Gold Standard: 1821-1914 


I. Gold Standard 

You can “cash in” your paper notes for predetermined amount of gold 

Some Issues: 

Limits monetary growth to gold stock, which can’t be adjusted in 

response to economic conditions 

Global shortage of gold put downward pressure on prices 

E.g. In 1896, the U.S. price level was roughly 40% below its 1869 level 

Farmers were squeezed between declining prices for crops and the 

fixed dollar payments for their mortgages and other debts. 

William Jennings Bryan, Cross of Gold, and Wizard of Oz 


II. WWI ‘Dirty Float’ 1915-1925 


II. Interwar Period 

War is Expensive: Many countries suspended gold standard, US did 

a few year later when it entered WWI 

Inflation Taxes 

Strength in US: US returned to Gold in 1919 

Genoa: 1922 conference establishing gold exchange standard 2 

Restricted Monetary Flexibility: 1925 Britain returned to the gold 

standard. Contractionary policy to get back to prewar price level. 

2 Countries could hold securities convertible into gold issued by other 

countries as reserves 


II. Interwar Gold-Exchange Standard: 1926-1931 


II. Pre-Bretton Woods Floats: 1932-1944 


III. Bretton Woods: 1945-1971 

Fixed exchange rates against the dollar 

Unvarying dollar price of gold: $35 an ounce 

Member countries held international reserves in dollars 

They had the right to sell dollars for gold at the official price 3 

They also had the right to adjust their peg to the dollar (pending IMF 

agreement) 

3 Bretton Woods differed from interwar gold exchange standard in that the 

right to sell dollars to the Treasury for gold was limited to official foreign 

creditors (governments and central banks 


III. Bretton Woods: 1945-1971 


IV. Smithsonian Agreement: 1972-1973 


III. Floats and Pegs: 1974-1979 

US macro policies in the late 1960s helped cause the breakdown of 

Bretton Woods by early 1973 

Most advanced countries abandoned stated pegs, while many 

developing countries stayed pegged 

1974-1975: Stagflation 4 led most gov’ts to use monetary and fiscal 

policy 

Many attempts to coordinate pseudo-fixed exchange rates within 

Europe 

4 Stagnant growth, high inflation. Higher commodity prices increased 

inflation & depressed output. Expectations of future inflation fed into wages & 

prices 


IV. Floats and Pegs: 1974-1979 


IV. ERM, Euro, ... : 1980- 

Dollar Fluctuates: 1976-1979 Weak Dollar, Paul Volker & Deficits, 

Joint Intervention to depreciate in 1985 

ERM semi-pegged system: member banks would intervene to 

maintain 2.25% band. UK joined in 1990 and exited 2 years after. 

German Reunification: 1990 reunification set off inflationary 

pressures, divergent needs in Europe and speculative attacks (leading 

to 15% bands in 1993). 

Inflation Convergence: European countries peg to deutche mark 

within Europe’s fixed exchange rate mechanism EMS 5 

Euro: Maastrict Treaty and a common currency in 1999 

Asian Crisis of 1997: Many stopped adhering to dollar pegs after 

5 European Monetary System 


IV. ERM, Euro, ... : 1980- 


Part 2: Multivariate Regression Refresher 6 

Contents 

1 Preliminaries 

2 Big picture idea: summarize data 

3 Linear model 

4 Multivariate 

Frisch Waugh interpretation 

Omitted Variable Bias 

Reading reg output 

5 Methods: D-D and IV 

6 Probit 

6 Some of these notes are based on Mostly Harmless Econometrics and 

Charlie Gibbon’s 140 notes 


1. Preliminaries 

1 Expectations 

2 Variance 

3 Covariance 

E(Y ) = Y1 × Prob1 + Y2 × Prob2 + ... + Yj × Probj 

Var(Y ) = E[Y − µy ] 2 

(1) 

(2) 

Cov(X , Y ) = E[X − µx][Y − µy ] (3) 


2. Big picture 


3. Linear model 

Decomposition 

Example: Height by gender 

yi = E[yi|xi] + (yi − E[yi|xi]) 

� �� 

≡ɛi 

= β0 + β1xi + ɛi 

Owen Zidar (Econ 191) Background for Eichengreen September 11, 2012 21 / 33 

(4) 

(5)

3. Linear model Continued 

What is β1? β1 = Cov(x,y) 

Var(x) 


4. Multivariate model 

(6) 

yi = β0 + β1x1i + β2x2i + ... + +βkxki + ɛi 

βk = 

Cov(y, ˜xk) 

Var( ˜xk) 

where ˜xk is the residual regression of xk on all the other covariates. 

Takeaway: βk is the relationship between y and the part of xk that 

isn’t related to other x’s 

Owen Zidar (Econ 191) Background for Eichengreen September 11, 2012 23 / 33 

(7)

4. Multivariate model: Omitted Variable Bias 

Suppose that the true model is 

yi = γ0 + γ1Schoolingi + γ2Abilityi + ˜ɛi 

Also suppose that Abilityi can be written: 

Abilityi = α0 + α1Schoolingi + ηi 

What happens if we omit ability and run a “short” regression? 

yi = β0 + β1Schoolingi + ɛi 

(8) 

(9) 

(10) 


4. Multivariate model: Omitted Variable Bias cont. 

What happens if we omit ability and run a “short” regression? 

Plug in ability expression from (10) into true model to see 

Takeaways 

yi = γ0 + γ1Schoolingi + γ2(α0 + α1Schoolingi + ηi) + ˜ɛi 

yi = (γ0 + γ2) + (γ1 + γ2α1) Schoolingi + (ηi + ˜ɛi) 

� �� 

� �� 

ɛi 

β1 

β2 

β2 = γ1 + γ2α1 

Short equals long plus the effect of omitted times the regression of 

omitted on included. 

Does γ2α1 = 0? 


4. Reading regression output 


5. Methods: Difference in Difference 

Effect = [After-Before]Treatment − [After − Before]Control 


5. Methods: Instrumental Variables 

Setup 

yi = γ0 + γ1Schoolingi + γ2Abilityi + ˜ɛi 

� �� 

≡vi 

Exclusion Restriction: 7 An instrument, zi, is correlated with Schoolingi 

but uncorrelated with other determinants of dependent variables 

Cov(vi, zi) = 0 

Cov(yi − γ0 − γ1Schooling,zi) = 0 

Cov(yi, zi) − γ1Cov(Schooling,zi) = 0 

Cov(yi, zi) 

= γ1 

Cov(Schooling,zi) 

7 because zi can be “excluded” from the causal model 

(11) 


5. Methods: Instrumental Variables continued 

Implementing this: First stage and reduced form 

γ1 = 

γ1 = 

Schoolingi = θ0 + θ1zi + ηi 

γ1 = π1 

θ1 

yi = π0 + π1zi + ui 

Cov(yi, zi) 

Cov(Schooling,zi) 

Cov(yi, zi)/Var(zi) 

Cov(Schooling,zi)/Var(zi) 

Caution: Important that first stage is strong (rule of thumb is F > 10) 

(12) 

(13) 


6. Probit 8 

What if limited dependent variable? Yi = 0 or Yi = 1 

8 Graph from Ashenfelter et al’s Statistics and Econometrics Book 


6. Probit (continued) 

Setup: 

Marginal Effects: 

E(Yi) = Pr(Yi = 0)0 +Pr(Yi = 1)1 

� �� 

=0 

= Pr(Yi = 1) 

≡ Φ(xiβ) 

� �� 

probit 

∂Pi 

∂xi 

= ∂Φ(xiβ) 

∂xi 

= βφ(xiβ) 

where Φ is the c.d.f. and φ is the p.d.f. of the normal distribution 9 

9 Φ is prob(z < xiβ), z ∼ N(0, 1), so need to standardize if actually using this 


6. Probit continued 

What does this look like in a graph? 


Next Time 

Professor Eichengreen on International Currencies

Econ 191 - University of California, Berkeley

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