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Week 10


Internal Balance: The Gold Standard did not prevent short term price instability. ... It pegged the Pound to gold, however, at the pre-war price. ... – PowerPoint PPT presentation

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Title: Week 10

Week 10 From the Gold Standard to Fluctuating
Exchange rates.
  • In this chapter we begin by looking at
  • From the Gold Standard to Fluctuating Exchange
  • Implications of Fluctuating Exchange Rates on
  • 3. Fluctuating Exchange Rates and Currency

Origins of the Gold Standard. Gold was used as
1) a medium of exchange 2) a unit of account
and 3) a store of value in England and Europe, by
the late 1700s. The existing Gold standard was
suspended during the Napoleonic wars. The gold
standard was re-institution in England by 1819,
when the British Parliament passed the Resumption
Act. 1) The Bank of England resumed the practice
of exchanging bank notes for gold on demand, at a
fixed rate. 2) The act repealed restrictions on
the export of gold coins and bullion from
Briton. Later in the 19th century, Germany and
Japan also adopted the Gold Standard.
The US effectively joined the Gold Standard in
1879, when it pegged the greenbacks which were
issued during the Civil War, to gold. The US Gold
Standard Act of 1900, institutionalized the
dollar-gold link. External Balance Under the Gold
Standard. Assume 1) 2 countries, Home and
Foreign 2) The Gold Standard, 3) fixed exchange
rates in terms of gold, 4) a fixed relationship
between vol. of gold and local bank notes in
circulation, 5) current account imbalances must
be financed with gold shipments.
Assume further that PLH lt PLF This will result
in Exports Imports gt 0 in Home Exports
Imports lt 0 in Foreign Under the Gold Standard,
gold have to be shipped from Foreign to Home
Central Bank in Home
i Rate
i Rate
Central Bank in Foreign
i Rate
i Rate
The Gold Standard could be trusted to restore
external balance. Internal Balance The Gold
Standard did not prevent short term price
instability. Neither did the Gold Standard do
much for full employment. The Gold Standard
subordinated internal economic policy to external
objectives. The Interwar Years 1918 1939
Governments effectively suspended the Gold
Standard during World War 1, and financed part of
their massive military expenditure by printing
To finance reconstruction after WW 1, government
expenditure was increased. (G?) while Tax
revenue did not increase. The resulting budget
deficits were financed by selling bonds.
When a Central bank buys bonds on a Primary Bond
market, it is the equivalent of the government
printing money.

In Germany this resulted in hyperinflation.
The extend of German hyperinflation can be seen
in the following table
Date Price Index
Jan. 1919 262
Dec. 1923 126,160,000,000,000 Thi
s situation was ended in Germany at the end of
1923, with currency reform.
The Fleeting Return to Gold. The US returned to
the Gold Standard in 1919. In 1922, at a
conference held in Geneva, Italy, Britain, France
and Japan agreed on a program calling for a
general return to the Gold Standard and
cooperation among central banks to attain
external and internal objectives. In 1925,
Britain returned to the Gold Standard. It pegged
the Pound to gold, however, at the pre-war price.
Price levels in Britain dropped after the war,
but in 1925, was still higher than in the days of
the pre-war Gold Standard.
Low gold price leading to gold supply shortage
Money Market
The too low price of gold, meant that the the
supply of money linked to the gold reserves (Ms),
was also too low, this meant that England ended
up with a very contractionary monetary policy.
The inadequate supplies of gold, created by the
low pound price of gold, turned out to be a
major problem. The partial gold exchange system
which had to be adopted, required that smaller
countries hold as reserves, gold and the
currencies of several large countries. The large
countries reserves had to be held entirely in
gold. Severe unemployment resulted as predicted
by J M Keynes and others. This was a repeat of
developments 100 years earlier, when Britain
returned to the Pound gold price that prevailed
before the Napoleonic wars. The practice amounted
to a revaluation of the pound against foreign
Many countries held international reserves in the
form of Pound deposits in London. Britains gold
reserves were limited, so that other countries
lost their confidence in it to meet its foreign
obligations. The smaller foreign countries
started to convert their pound holdings into
Gold. (M1 ? in England)
International Economic Disintegration The US left
the Gold Standard in 1934, after raising the
Dollar price of gold from 20.67 to 35 per
ounce. Countries that clung to the gold standard
without devaluing their currencies, suffered most
during the Great Depression. This was a period
of protectionism. In the US the Smoot-Hawley
tariffs were imposed in 1930. The foreign
response involved trade restrictions and
preferential agreements among groups of
countries. A measure that raises domestic
welfare at the cost of a trade partner is called
a beggar-thy-neighbor policy.
During the Great Depression, tariffs and other
beggar-thy-neighbor policies inevitably provoked
foreign retaliation and often left all countries
worse off in the end. Some governments used
multiple exchange rates to allocate scarce
foreign exchange reserves among competing uses.
The world economy disintegrated into
increasingly autarkic national units in the early
1930s. The elimination in the 1930s, of gains
from trade, imposed high costs on the world
economy. All countries could be better off in a
world with freer international trade. This
realization inspired the blueprint for the
post-war Bretton Woods Agreement.
  • The Post-war Years Under the Bretton Woods
  • In July 1944, during the war, representatives of
    44 countries met in Bretton Woods, New Hampshire.
    They drafted and signed the articles of
    agreement of the International Monetary Fund
    (IMF), and also that of the World Bank.
  • The IMF charter was inspired by the disastrous
    economic events of the inter-war years.
  • Objectives
  • The delegates wanted an international monetary
    system that would promote

  • Full employment and 2) Price stability.
  • While allowing individual countries to attain
    external balance without imposing restrictions on
    international trade.
  • The system called for
  • Fixed exchange rates against the US ,
  • An un-varying -price of gold (35 / oz)
  • Member countries holding their reserves largely
    in US and in gold, with the right to sell to
    the Fed. for gold at the official price.

What was created was a Gold Standard, with the
US as the principle reserve currency. The
inter-war years had convinced the Funds
architects that floating exchange rates were the
cause of speculative instability and were harmful
to international trade. After the publication of
Keynes General Theory …, governments were widely
viewed as responsible for maintaining full
employment. The IMF agreement tried to
incorporate sufficient flexibility to allow
countries to attain external balance, without
sacrificing internal objectives or fixed exchange
Two major features of the IMF articles of
agreement 1) IMF lending facilities A pool of
gold and currencies from which loans could be
made to a country with a current account deficit.
(Countries in trouble will be those with a
current acc. deficit, but unable to follow a
tight money policy because it would cause
unemployment domestically (called a fundamental
Lending fund details Each country was assigned a
quota which it had to contribute to the reserve
pool (1/4 gold, 3/4 own currency). A member was
entitled to use its own currency to purchase
temporarily from the Fund, gold or foreign
currencies up to an amount equal to the value of
its gold subscription. If it needed more, it
could borrow it under increasingly stringent Fund
supervision. 2) Adjustable parities If
necessary, and with the approval of the IMF,
countries with fundamental disequilibria, could
adjust their exchange rates, I.e. devalue or
The IMF urged member countries to make their
currencies convertible, i.e. a currency that can
be freely exchanged for foreign currencies. With
the exception of Germany and Japan, every other
country devalued their currencies several times.
The long-term effect for the US. Was, that its
exports became more expensive, which caused trade
deficits. Initially countries held either gold or
US as foreign reserve assets. As -holdings
increased, more countries wanted to exchange US
for gold at the official price of 35 /
oz. Robert Triffen (Yale), pointed out in 1960,
that a stage will be reached, at which the US
gold holdings will be insufficient, and the US
will no longer be as good as gold. (Like the case
with Britain in 1931.). The resulting
confidence problem lead central banks to
exchange increasingly their US holdings for
Expansionary monetary policies in the US after
1958, and the build-up for the Vietnam war caused
a large built up of US internationally. 1960,
marked the end of the dollar shortage and the
beginning of a period dominated by fears that the
US might devalue the dollar relative to gold. In
1967, the British pound devaluated and private
speculators started to buy gold in anticipation
of a rise in its dollar price. After massive gold
sales by the Federal Reserve and European central
banks, the Bank of England closed the gold market
on 15 March, 1968.
Two days later, the Central banks announced a
two-tier gold market. (Private gold traders will
continue to trade gold on the London gold market
at fluctuating prices, but central banks will
transact with each other at the official 35 per
oz. By severing the link between the supply of
dollars and a fixed market price of gold, the
central banks jettison the systems built-in
safeguard against inflation. On May 4, 1971, the
German Bundesbank decided to let the DM float
against the US.
Nixon declared on August 15, 1971 1) The US will
no longer sell gold to foreign Central banks for
dollars. 2) A 10 tax on all imports to the US.
To remain effective until Americas trading
partners agree to revalue their currencies
against the dollar. An international agreement
was reached on December 1971 at the Smithsonian
Institution in Washington D.C.. (Dollar devalued
by about 8, and surcharge on imports removed,
official gold price increased to 38.) On
February 12, 1973, the dollar had to be devalued
further by 10.
When the markets opened on March 19 1973, the
currencies of Japan, and most European countries
were floating against the Dollar. When the
governments of the industrialized countries
adopted floating exchange rates in 1973, they
viewed it as a the temporary emergency step. The
dollar exchange rates of the industrialized
countries have continued to float since
1973. Many observers now think that the current
exchange rate system is badly in need of reform.
  • Floating Exchange rates
  • At the time of the final break-down of Breton
    Woods in 1971, the demand for foreign exchange
    was driven by the need to finance the following
    interactions between national economies
  • trade in goods and services
  • direct investments and
  • tourism.

Exchange Rate Determination Market for

Market for

Demand by Japanese importers, tourists, and
direct investors. Supply by US importers,
tourists, and direct investors.
Demand by US importers, tourists, and direct
investors. Supply by Japanese importers,
tourists, and direct investors.
Now Demand for goes up, in die diagram on the
The demanded yen must be paid for with . That
implies, in the diagram on the left, that the
supply of US dollars increases. This will result
in the price of the yen increases (the yen
appreciates), and the yen price of the
decreases (the depreciates). At the time of
Breton Woods, a countrys currency could come
under pressure to devalue as a result of a
prolonged trade deficit (i.e when a countrys
imports exceeds its exports). With its December
1999 monthly trade deficit of 27 Billion, the US
is celebrating its 20th year of running
consecutive monthly trade deficits that while
the US is appreciating against most other
  • What happened since Breton Woods?
  • To understand this phenomenon, it must be realize
    that since the days of Breton Woods, two
    additional reasons developed for wanting to hold
    control over foreign currency balances, viz.
  • .Investment in financial assets and derivatives,
  • .Speculation (arbitrage)
  • According to Bryan and Farrel, in their book
    Market Unbound, the original 3 reasons currently,
    accounts for only a fraction of 1 of the reasons
    to hold foreign currency. The foreign exchange
    market is in fact the first truly one-price
    global market.

  • The prices on this market, i.e. exchange rates,
    can in the short-run not be controlled, not even
    by the US Federal Reserve in coalition with its
    European and Japanese counter parts!
  • This uncomfortable situation was experienced a
    few times over the last 10 years.
  • Two Arguments Against Fluctuating exchange
  • 1) Fluctuating Exchange Rates can cause injury to
    global trade
  • Solve the following problem to see potential of
    fluctuating exchange rates to effect trade

Microeconomics review Price elasticity of demand

D in quantity demanded
D in price
Remember that the price elasticity of demand is
always a negative number.
Dell sells computers only on the Internet. A
popularly configured Dell computer sells in the
US for 1,500. When the exchange rate was DM
2.026 per US, German sales of this model Dell
computer took place at a rate of 20,000 per year.
The price elasticity of the demand for computers
in Germany is e 1.4. While the US price
for similarly configured Dell computers remained
at 1,500, the DM appreciated. The exchange rate
became DM 1.772 per US. At what rate will
these Dell computers now sell in Germany?
2) Fluctuating Exchange Rates can Impoverished
small nations. In today's global economy
exporters accept US, Yen, or Euro, in payment
for exports. They do this rather than loosing an
export sale. The importers prepared to pay in
these currencies, therefore, need no longer buy
the currency of the exporting country to conclude
the transaction (as was the case in the Breton
Woods era). In the process, the foreign demand
for smaller countries' currencies are,
drastically reduced in the foreign exchange
markets. In this post Breton Woods international
trade environment, small currencies can,
therefore only depreciate.
Fluctuating Exchange Rates and Currency
Boards Currently, the exchange rates of most
countries are market determined floating exchange
rates. There are, however, a few countries whos
exchange rates are determined by Currency
Boards. Currency Boards A currency board is a
monetary authority that issues notes and coins
convertible into a foreign anchor currency or
commodity (also called the reserve currency) at a
truly fixed rate and on demand.
A currency board can operate in place of a
central bank or as a parallel issuer alongside an
existing central bank cases of parallel issue
have been quite rare, though. As reserves, a
currency board holds low-risk, interest-bearing
bonds and other assets denominated in the anchor
currency. A currency board's reserves are equal
to 100 percent or slightly more of its notes and
coins in circulation, as set by law. The main
characteristics of a currency board are as
follows. Anchor currency The anchor currency is
a currency chosen for its expected stability and
international acceptability. For most currency
boards the British pound or the U.S. dollar has
been the anchor currency.
Convertibility A currency board maintains full,
unlimited convertibility between its notes and
coins and the anchor currency at a fixed rate of
exchange. Monetary policy By design, a currency
board has no discretionary powers. Its operations
are completely passive and automatic. The sole
function of a currency board is to exchange its
notes and coins for the anchor currency at a
fixed rate. Recent currency board-like
systems Since 1991, a few countries have
established currency board-like systems.
Argentina did so on 1 April 1991, establishing an
exchange rate of 10,000 australes (now 1 peso)
US1. Estonia followed on 20 June 1992,
establishing an exchange rate of 8 kroons 1
German mark (DM). Lithuania, influenced by
Estonia's success, did likewise on 1 April 1994,
establishing an exchange rate of 4 litas (the
Lithuanian plural is litai) US1.
END Next Open Market Economics
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