International Exchange Rate Systems by cmz65105


									                    International Exchange Rate Systems
                  The Gold Standard: Fixed Exchange Rates
Handout                                                                    A.Hammi

Between 1879 and 1934 the major nations of the world adhered to a fixed exchange rate
system called the gold standard. In this system, each nation:

   1. Defined its currency in terms of a quantity of gold
   2. Maintained a fixed relationship between its stock of gold and its money supply
   3. Allowed gold to be freely exported and imported

E.g. If Canada defined $1 as worth 25 grains of gold, and Britain defined its pound as
worth 50 grains of gold, then a British pound is worth 2 x 25 grains, or $2. Under the
gold standard, the potential free flow of gold between nations would result in exchange
rates that are fixed (i.e. it would change in responses to changes in demand and supply for
currency). When the demand for, or supply of, currencies changes, the gold standard
requires domestic macroeconomic adjustments for the fixed exchange rate to be


Suppose tastes and preferences change in the domestic country such that now they would
like to buy more foreign goods. Under a system of flexible exchange rates, the domestic
currency depreciates causing the domestic price of foreign currency to rise until the
(increased) demand for foreign currency equals the supply of foreign exchange (i.e. the
domestic price of foreign currency to rises to eventually eliminate the deficit in the
balance of payments).

Under a fixed exchange rate system, exchange rates do not move to correct the
imbalance in the balance of payments. Instead, in this example, gold will flow from the
domestic country to the foreign country to remove the balance of payments imbalance.
The flow of gold from the domestic country to the foreign country will require a
reduction of the money supply in the domestic country. Ceteris paribus, the decrease in
the money supply reduces total spending and thereby lowers real domestic output (Real
GDP), employment (as a result of falling national output), income (total output equals
total income in the Circular Flow of Income model), and perhaps prices. Also, the decline
in the money supply will raise domestic interest rates as the supply of money is now
smaller relative to its demand (i.e. a situation of excess demand for money).

The opposite occurs in the foreign country. The flow of gold from the domestic country
into the foreign country increases their money supply (remember, the relationship
between the quantity of money and a nation’s gold supply is fixed). The increase in the
money supply increases total spending. As a result, total output rises (to be able to meet
the increase in total spending), employment rises (since more labour is required to
produce more goods), income rises (total output equals total income in the Circular Flow
of Income model), and perhaps prices will rise as well. Also, the increase in the money
supply lowers interest rates (a situation where the supply of money is bigger than the
demand for it, the “price” of money-interest rates-falls).

The fall in the incomes and prices in the domestic country will reduce the domestic
demand for foreign goods, thereby reducing the domestic demand for foreign currency.
Also, the lower interest rates abroad will make it less attractive to “invest” in the foreign
country, further decreasing the demand for foreign currency. By contrast, the rising
incomes and prices in the foreign country, along with higher interest rates in the domestic
country, will make it attractive for foreigners to buy the exports of the domestic country
(i.e. foreign country’s imports) and make financial investments in the domestic country.
Foreigners will supply more foreign exchange in the foreign exchange market.

The result is that, from the perspective of the domestic country, new demand and supply
conditions in the foreign exchange market will result in an exchange rate that remains
fixed (i.e. the increase in the demand for foreign currency due to the increase in tastes and
preferences by domestic residents for foreign goods shifts the demand for foreign
currency to the right. At the same time, foreigners will supply more foreign exchange to
the foreign exchange market, thereby shifting the supply of foreign exchange curve
outward to the right, until the intersection of the new demand and supply curves for
foreign exchange result in a price that is the same as before).

The gold standard has the advantage of stable exchange rates and automatic corrections
to balance of payments deficits and surpluses. The major drawbacks are twofold. First
and most obvious, a nation loses control over its money supply (i.e. a country cannot
conduct its own monetary policy to smooth out economic fluctuation and promote
sustainable economic growth). Second, sometimes nations must accept domestic
adjustments which end up hurting the domestic economy even more. In the example
above, if the domestic country was already experiencing a decline in incomes and output,
the example above would exacerbate their problem (i.e. the higher interest rates brought
about by the outflow of gold-decrease in the money supply-leads to lower borrowing,
domestic investment in physical capital, and lower spending), causing a further decline in
output and income.

Demise of the Gold Standard
The Great Depression of the 1930s led to the collapse of the gold standard. Because many
nations were already experiencing falling output (GDP) and incomes, nations around the
world began enacting protectionist measures to reduce imports. The idea was to expand
consumption of domestically produced goods and get their economies moving again. In
terms of international trade, the idea was to restrict imports and still try and maintain a
healthy level of exports. The later was mainly achieved by way of a devaluation of the
domestic currency, thereby making that country’s exports more attractive abroad. The
problem was that many countries around the world had the same exact idea. It was these
forces that brought and end to the gold standard.

Recession: One way to help mitigate the effects of a recession (period of negative
economic growth, unemployment) is to devalue one’s currency. Doing so will make a
countries exports look more attractive (imports look more expensive). Therefore a
country in a recession could export more and import less. The problem is that the foreign
country (the one buying the country’s exports) will find that their exports to the domestic
country will fall, and their unemployment will rise as a result (i.e. imports may hurt
domestic industries since the price of imports may be lower than that of domestic
industries). Policies that attempt to solve one country’s problem by inflicting them on
others are called beggar-thy-neighbour policies (export unemployment to other
countries). In a situation of inadequate world demand, as was the case during the
Depression, a beggar-thy-neighbour policy on the part of one country can only work in
the unlikely event that other countries do not react by changing their policies to protect
themselves (i.e. they too would devalue their currency to make their exports look
attractive as well). A situation in which all countries devalue their currencies in an
attempt to gain a competitive advantage over one another is called a situation of
competitive devaluations. This is one of the reasons why the IMF was created (to reduce
the chances of competitive devaluations)

                            The Bretton Woods System
At the end of WWII, an international conference was held in Bretton Woods, New
Hampshire with the goal of laying the groundwork for a new international monetary
system. With the Great Depression and WWII over, many economies around the world
were in shambles. The conference produced a commitment to a modified fixed exchange
rate system called the adjustable peg system, or simply the Bretton Woods system. The
new system sought to capture the advantages of the fixed exchange rate system (fixed
exchange rates), but avoid the disadvantages (painful macroeconomic adjustments). To
participate in this new exchange rate system, the International Monetary Fund (IMF) was
set up to make the new exchange rate system feasible and workable.

How did the Bretton Woods system work? As with the gold standard, nations had to
define their currency in terms of gold (or dollars), thus establishing fixed exchange rates
with other countries. In addition, nations were obligated to keep its exchange rate stable
with respect to every other currency. To do so, nations would have to use their official
currency reserves to intervene in foreign exchange markets (see notes on fixed exchange

Under the Bretton Woods system, nations may obtain the necessary foreign exchange
from one of three sources:

   1. Official International Reserves (central bank)
   2. Gold Sales: a nation may sell some of its gold for foreign exchange so as to be
      able to increase the supply of that foreign exchange on the foreign exchange
   3. IMF borrowing: The needed foreign exchange may be borrowed from the IMF on
      a short-term basis by supplying its currency as collateral.
The Bretton Woods system recognized that from time to time a nation may be confronted
with persistent and sizeable deficits in its balance of payments. The remedy of such a
situation was devaluation of that country’s currency, that is, an orderly reduction of that
nation’s pegged exchange rate (i.e. in this sense the fixed exchange rate becomes
“adjustable”-hence its name). Such a devaluation makes that country’s exports more
attractive (imports less attractive), thereby improving the country’s balance of payments

                      Demise of the Bretton Woods System
Under the adjustable-peg system, gold and the American dollar came to be accepted as
international reserves. Gold was an international medium of exchange, with its origins
well established. However, the US dollar became accepted because the US had
accumulated large quantities of gold. Between 1934 and 1971, the US maintained a
policy of buying gold from, and selling gold to, foreign countries at US$35 per ounce.
The US dollar was convertible into gold on demand; thus the dollar became regarded as
“as good as gold”.

During the 1950s and 1960s, the US began experiencing persistent balance of payments
deficits. These deficits were financed partly by selling gold for foreign currency, but they
also resorted to payments made with US dollars. As the amounts of US dollars held by
foreigners increased, and the amount of gold held by the US dwindled, people questioned
whether the US dollar was really “as good as gold” (i.e. they questioned whether the US
could continue to buy/sell gold at US$35 per ounce. The problem was simple:

To maintain the US dollar as an international reserve medium, the US balance of
payments deficit had to be eliminated. However, eliminating the balance of payments
deficit would remove the source of additional US dollar reserves (i.e. they would start to
behave in a somewhat “protectionist” way), and thus limit the growth of international
trade and finance.

In 1971, the problem came to a head, and the US abandoned its 37 year old policy of
exchanging gold for dollars at US$35 per ounce. It severed the link between gold and the
international value of the dollar, thereby “floating” the dollar and letting its value be
determined by market forces.

                   The Current System: The Managed Float
The current exchange rate system is an “almost” flexible exchange rate system called the
managed floating exchange rate system. Exchange rates among major currencies are free
to “float” to their equilibrium market levels, but nations occasionally intervene in the
foreign exchange market to stabilize or alter market exchange rates.

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