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 maintained. Example: 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. (Aside) 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 rates). 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 market. 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 imbalance. 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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