Page 197 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

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

17.1 The Gold Standard Notes

An international gold standard avoids the asymmetry inherent in a reserve currency standard by
avoiding the “Nth currency” problem. Under a gold standard, each country fixes the price of its
currency in terms of gold by standing ready to trade domestic currency for gold whenever necessary
to defend the official price. Because there are N currencies and N prices of gold in terms of those
currencies, no single country occupies a privileged position within the system : Each is responsible
for pegging its currency’s price in terms of the official international reserve asset, gold.
The Mechanics of a Gold Standard
Because countries tie their currencies to gold under a gold standard, official international reserves
take the form of gold. Gold standard rules also require each country to allow unhindered imports
and exports of gold across its borders. Under these arrangements, a gold standard, like a reserve
currency system, results in fixed exchange rates between all currencies. For example, if the dollar
price of gold is pegged at $35 per ounce by the Federal Reserve while the pound price of gold is
pegged at £14.58 per ounce by Britain’s central bank, the Bank of England, the dollar/pound exchange
rate must be constant at ($35 per ounce) ÷ (£14.58 per ounce) = $2.40 per pound. The same arbitrage
process that holds cross exchange rates fixed under a reserve currency system keeps exchange rates
fixed under a gold standard as well.
Symmetric Monetary Adjustment Under a Gold Standard
Because of the inherent symmetry of a gold standard, no country in the system occupies a privileged
position by being relieved of the commitment to intervene. By considering the international effects of
a purchase of domestic assets by one central bank, we can see in more detail how monetary policy
works under a gold standard.
Suppose the Bank of England decides to increase its money supply through a purchase of domestic
assets. The initial increase in Britain’s money supply will put downward pressure on British interest
rates and make foreign currency assets more attractive than British assets. Holders of pound deposits
will attempt to sell them for foreign deposits, but no private buyers will come forward. Under floating
exchange rates, the pound would depreciate against foreign currencies until interest parity had been
reestablished. This depreciation cannot occur when all currencies are tied to gold, however. What
happens ? Because central banks are obliged to trade their currencies for gold at fixed rates, unhappy
holders of pounds can sell these to the Bank of England for gold, sell the gold to other central banks
for their currencies, and use these currencies to purchase deposits that offer interest rates higher than
the interest rate on pounds. Britain therefore experiences a private financial outflow and foreign
countries experience an inflow.

A gold standard therefore places automatic limits on the extent to which central banks
can cause increases in national price levels through expansionary monetary policies.

Benefits and Drawbacks of the Gold Standard
Advocates of the gold standard argue that it has another desirable property besides symmetry. Because
central banks throughout the world are obliged to fix the money price of gold, they cannot allow
their money supplies to grow more rapidly than real money demand, since such rapid monetary
growth eventually raises the money prices of all goods and services, including gold. These limits can
make the real values of national monies more stable and predictable, thereby enhancing the transaction
economies arising from the use of money. No such limits to money creation exist under a reserve
currency system; the reserve currency country faces no automatic barrier to unlimited money creation.

LOVELY PROFESSIONAL UNIVERSITY 191