Page 196 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance Dilfraz Singh, Lovely Professional University

Notes Unit 17 : Process of Adjustments : Gold Standard, Fixed
Exchange Rates and Flexible Exchange Rate

CONTENTS
Objectives
Introduction
17.1 The Gold Standard
17.2 Fixed Exchange Rates
17.3 Flexible Exchange Rates
17.4 Summary
17.5 Key-Words
17.6 Review Questions
17.7 Further Readings

Objectives

After reading this Unit students will be able to:
• Know the Gold Standard.
• Discuss the Fixed Exchange Rate and Flexible Exchange Rate.
Introduction

This process reestablishes equilibrium in the foreign exchange market. The Bank of England loses
foreign reserves since it is forced to buy pounds and sell gold to keep the pound price of gold fixed.
Foreign central banks gain reserves as they buy gold with their currencies. Countries share equally in
the burden of balance of payments adjustment. Because official foreign reserves are declining in
Britain and increasing abroad, the British money supply is falling, pushing the British interest rate
back up, and foreign money supplies are rising, pushing foreign interest rates down. Once interest
rates have again become equal across countries, asset markets are in equilibrium and there is no
further tendency for the Bank of England to lose gold or for foreign central banks to gain it. The total
world money supply (not the British money supply) ends up being higher by the amount of the Bank
of England’s domestic asset purchase. Interest rates are lower throughout the world.
Our example illustrates the symmetric nature of international monetary adjustment under a gold
standard. Whenever a country is losing reserves and seeing its money supply shrink as a consequence,
foreign countries are gaining reserves and seeing their money supplies expand. In contrast, monetary
adjustment under a reserve currency standard is highly asymmetric. Countries can gain or lose reserves
without inducing any change in the money supply of the reserve currency country, and only the
latter country has the ability to influence domestic and world monetary conditions. 1

1. Originally, gold coins were a substantial part of the currency supply in gold standard countries. A country’s
gold losses to foreigners therefore did not have to take the form of a fall in central bank gold holdings :
Private citizens could melt gold coins into ingots and ship them abroad, where they were either reminted
as foreign gold coins or sold to the foreign central bank for paper currency. In terms of our earlier analysis
of the central bank balance sheet, circulating gold coins are considered to make up a component of the
monetary base that is not a central bank liability. Either form of gold export would thus result in a fall in
the domestic money supply and an increase in foreign money supplies.

190 LOVELY PROFESSIONAL UNIVERSITY