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

The Gold Exchange Standard Notes
Halfway between the gold standard and a pure reserve currency standard is the gold exchange
standard. Under a gold exchange standard central banks’ reserves consist of gold and currencies
whose prices in terms of gold are fixed, and each central bank fixes its exchange rate to a currency
with a fixed gold price. A gold exchange standard can operate like a gold standard in restraining
excessive monetary growth throughout the world, but it allows more flexibility in the growth of
international reserves, which can consist of assets besides gold. A gold exchange standard is, however,
subject to the other limitations of a gold standard listed above.
The post-World War II reserve currency system centered on the dollar was, in fact, originally set up
as a gold exchange standard. While foreign central banks did the job of pegging exchange rates, the
U.S. Federal Reserve was responsible for holding the dollar price of gold at $35 an ounce. By the mid-
1960s, the system operated in practice more like a pure reserve currency system than a gold standard.
For reasons explained in the next chapter, President Nixon unilaterally severed the dollar’s link to
gold in August 1971, shortly before the system of fixed dollar exchange rates was abandoned.
The Demand for International Reserves

The unit explained that a central bank’s assets are divided between domestic-currency assets, such as
domestic government bonds, and foreign-currency assets, the bank’s international reserves.
Historically and up to the present day, international reserves have been prized by central banks
because they can be traded to foreigners for goods and services even in circumstances, such as financial
crises and wars, when the value of domestic assets may come into doubt. Gold played the role of
international reserve asset par excellence under the gold standard—and economists debate whether
the United States dollar plays that role today and, if so, for how long that unique American privilege
can last. Because central banks and governments may alter their policies to affect national holdings
of international reserves, it is important to understand the factors that influence countries’ demands
for international reserves.
A good starting point for thinking about international reserves is the model in the chapter in which
domestic and foreign bonds are perfect substitutes, the exchange rate is fixed, and confidence in the
fixed exchange rate is absolute. In that model, our result that monetary policy is ineffective also
implies that individual central banks can painlessly acquire all the international reserves they need!
They do so simply by an open-market sale of domestic assets, which immediately causes an equal
inflow of foreign assets but no change in the home interest rate or in other domestic economic
conditions. In real life matters may not be so easy, because the circumstances in which countries need
reserves are precisely those in which the above conditions of perfect confidence in creditworthiness
and in the exchange-rate parity are likely to be violated. As a result, central banks manage their
reserves in a precautionary manner, holding a stock they believe will be sufficient in future times of
crisis.
As usual there are costs as well as benefits of acquiring and holding reserves, and the level of reserves
that a central bank wishes to hold will reflect a balance between the two. Some monetary authorities
(such as that of Hong Kong) value reserves so highly that the entire money supply is backed by
foreign assets—there are no domestic monetary assets at all. In most cases, however, central banks
hold both domestic and foreign assets, with the optimal level of reserves determined by the tradeoff
between costs and benefits.
Starting in the mid-1960s, economists developed and sought empirical verification of formal theories
of the demand for international reserves. In that setting, with international capital markets much
more limited than they are today, a major threat to reserves was a sudden drop in export earnings,
and central banks measured reserve levels in terms of the number of months of import needs those
reserves could cover. Accordingly, the variability levels of exports, imports, and international financial
flows, all of which could cause reserves to fluctuate too close to zero, were viewed as prime
determinants of the demand for international reserves. In this theory, higher variability would raise
the demand for reserves. An additional variable raising the average demand for reserves might be
the adjustment cost countries would suffer if they suddenly had to reduce exports or raise imports to

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