Download Gold Standard

Gold Standard

The gold standard was a commitment between
participating countries to fix prices of their domestic
currencies in terms of a specified amount of gold.

Money can be freely converted into gold at the fixed
price.

Gold standard can be internal – anyone can demand
conversion of currency into gold, or external – only
central bank.

Central banks were required to hold reserves in gold.
Gold Standard
Monetary authorities must obey the following 3 rules:



Fix once for all conversion rate of money into gold.
There must be free flows of gold between countries
on gold standard.
Money supply must be tied to amount of gold
monetary authorities have in reserve.

Central Banks were supposed to play by the rules of the
game.

They were supposed to increase interest rates to speed
a gold inflow (surplus) and reduce rates to ease an
outflow (deficit).

But it hits domestic goals – for ex. Reduce
unemployment.
Gold Standard

In 1834, US fixed price of gold at $20.67 per ounce, where
it remained until 1933.

The gold standard regulated the quantity and growth rate
of a country’s money supply.

New production added only a little to accumulated stock.
So the GS ensured that money supply and hence price level
would not vary much.

However, periodic surges in world gold stock, ex. Gold
discoveries in Australia and California in 1850, would make
price levels very unstable in the short run.

As exchange rates were fixed, price levels around the
world moved together – because of the automatic balance
of payments adjustment process, called the price-specieflow mechanism.
Gold Standard

Ex: Innovation brings about faster real economic growth
in the US. With supply of money (gold) essentially fixed in
the short-run, U.S. prices fell. So prices of US exports fell
relative to prices of US imports.
So British demand more exports and Americans demand
less imports. So, US BOP surplus is created. So gold
(specie) flows from UK to US.
Gold inflow increases US money supply, reversing initial
fall in prices. In UK, money supply reduced, thus reducing
prices. Net result is balanced prices amongst countries.

However, this also led to a shock in one country being
transmitted to another country.

This happened in California at the time of gold discovery
in 1848.
Gold Standard

Central Banks were supposed to play by the rules of
the game.

They were supposed to increase interest rates to
speed a gold inflow and reduce rates to ease an
outflow.
Effects:

Central banks cannot significantly alter money
supply. So inflation remains under check.

If all countries use gold standard, there is
effectively only one currency in the world, i.e. gold.
So, it provides stability to world markets.
Gold Standard
Drawbacks:

However, stability is also a major drawback. Exchange
rates are not allowed to respond to changing
circumstances in the country.

It severely limits the stabilization measures of the
central bank.
During the Great Depression, the gold standard was
finally abandoned.

Bretton Woods System
Came into force post World War II. IMF and
World Bank formed.
Features:

The US govt. undertook to convert the US dollar freely
into gold at a fixed parity of $ 35 per ounce.

Other member countries of the IMF agreed to fix the
parities of their currencies vis-a-vis the dollar, with a
variation of 1% on either side being permissible.
If exchange rate hit either of the limits, the monetary
authorities were obliged to correct the situation by
buying/selling dollars, as necessary.
Bretton Woods System

Thus, this was an adjustable peg system. The novel feature
was that the parity of a currency against the dollar could
be changed in case there was a fundamental
disequilibrium. + - 10% was allowed even without the
consent of the fund.

However, US had no flexibility.

Suppose Rs. 100 = 1USD. So allowable limit is 99 and 101.
Say demand for dollars increases due to Indians preferring
American goods. So exchange rate will become 102. This is
outside limits. So RBI will have to sell dollars.

Under this system, in effect the USD became international
currency. Other countries accumulated and held USD by
which they could settle international obligations. This
could work so long as the world had confidence in the
stability of USD and the ability of US treasury to convert
dollars into gold on demand at the specified rate.
Bretton Woods System

However, problems started surfacing in the 70s, when US
BOP deficits started increasing. This reduced US gold
reserves, reducing confidence in its ability to redeem
dollars in gold.
On 15th Aug. 1971, the US Govt. finally abandoned its
commitment to convert dollars in gold and the system
came to an end.
What do we use today?

We use the fiat system which says “money is intrinsically
useless. It is used only as a medium of exchange”. Prices
of gold are allowed to fluctuate as per demand and supply.
Fixed and Flexible
Exchange Rate System
Merits of fixed exchange rates:
 Transparent and simple: A fixed exchange regime is considered
to be more transparent and simple anchor for monetary policy.
 Suitable for countries with less developed financial sector: In
a country with less developed financial sector and weak
institutions, monetary stability can be achieved by anchoring to a
currency with a credible central bank. The economic agents in
such an economy may not have the financial tools to hedge long
term currency risks.
 Provides necessary stability for developing economies:
Suitable for developing economies as it provides the necessary
stability to implement the plans for economic development.
 Helps smooth international borrowing and lending: As it
provides certainty in the minds of foreign investors.
Fixed and Flexible
Exchange Rate System
 Promotes foreign trade: Removes uncertainty in foreign
exchange transactions and helps importers and exporters to
chalk out their policies in a better way.
 Check on speculative tendencies: As the exchange rate is
fixed, unnecessary speculation in the forex markets, which can
be quite harmful to international trade, is avoided.
 Reduction in transaction costs: As exchange risk is avoided,
transaction costs involved in hedging are also avoided.
Fixed and Flexible
Exchange Rate System
Demerits of fixed exchange rate:
Volatility in money supply: To maintain exchange stability, it is
necessary to persue a policy of monetary expansion and contraction,
wherever necessary. This can create serious volatility on domestic
incomes and price levels. Also, adjustments under fixed exchange
rates can be very gradual and require significant flexibility in domestic
prices, especially in the face of changing capital flows.
Constraints on monetary policy: In the process of taking monetary
measures to maintain exchange stability, domestic goals which could
otherwise be effectively pursued with the help of the monetary policy
may have to be sacrificed. This may also involve a political cost.
Independent economic policies not possible
Fixed and Flexible
Exchange Rate System
 Interest rate differences could influence capital flows: If
interest rates in the domestic economy are higher that that of the
economy of the anchor currency, it could lead to huge capital flows
from the foreign economy to the domestic economy, creating
excessive money supply and resulting in inflation. Also, any
adjustment in exchange rates could seriously influence capital
flows, resulting in jolts in domestic money supply.
 Capital Controls: To withstand currency pressures, authorities
may have to put in place rigorous capital controls, which may
prove to be harmful to the domestic economy.
 Difficult to correct disequilibrium in the BOP position:
Disequilibrium in the BOP position of a country can get corrected
by suitable changes in the exchange rate. However, this is
hampered in the fixed exchange rate system.
 A country cannot maintain fixed exchange rate, open capital
market and monetary policy independence at the same time.
Fixed and Flexible
Exchange Rate System
Merits of the flexible exchange rate system:
 Independence in monetary policy: A floating exchange rate
system allows a country to pursue independence in monetary
policy, rather than have its own monetary policy set up by an
anchor currency country. This can help in maintaining internal
stability.
 Reduction in shocks in money supply: Under a flexible
exchange rate system, exchange rates are market determined.
Any arbitrage opportunity that exists due to diverse variables in
two countries (for example interest rates) tends to get absorbed
by the market immediately. This reduces sudden shocks in
money supply.
 Automatic equilibrium in BOP:
 Shock absorbing mechanism: Flexible exchange rate systems
are more resilient in the face of shocks and are better able to
distribute the burden of adjustment between the external sector
and the domestic economy.
Fixed and Flexible
Exchange Rate System
Demerits of the floating rate system:
 Economy exposed to external events: Under this system,
the economy is exposed to external events as such events
could have an impact on exchange rates and consequently
international trade, BOP, etc. This hinders economic stability.
 Uncertainties for importers and exporters: If suitable
hedging tools are not available, it could seriously hamper
business.
 Speculation: Floating exchange rate encourages speculation.
This may lead to hoarding of currencies, leading to many
undesirable effects such as reducing money supply, inflation,
etc.
 Uncertainty in international lending: Problem for countries
which need capital very badly.
Fixed and Flexible
Exchange Rate System
To conclude, one can say that there is probably no
universally optimal regime.
Regime choices should reflect the individual properties
and characteristics of an economy.
In a pure fixed exchange rate regime, economic activity
adjusts to exchange rate. In a purely floating regime,
the exchange rate is a reflection of economic activity.
In either case, the economy’s fundamentals are the
chief determinants of whether economic stability and
prosperity are achieved.