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

uncertainty rather than production efficiency concerns. Moreover, firms may end up with overall Notes
excess capacity that they are willing to carry as a hedge against exchange-rate exposure. This raises
costs. Additionally, to the extent that internationally diversified production increases firms’ bargaining
power with labor, the distribution of income may be tilted away from wages to profits. Volatile
flexible exchange rates may, thereby, have contributed to the adverse income distribution outcomes
associated with globalization.
A second problem with flexible exchange rates relates to the issue of capital mobility. In the absence
of capital mobility, demand and supply in exchange markets will reflect the balance of trade. Countries
running surpluses will experience excess demand for their currency, as their trading partners seek to
obtain currency to pay for imports, and this will cause the surplus country currency to appreciate.
Conversely, currencies of deficit countries will tend to depreciate, as they sell their currency to get
surplus country currency. This is the double-entry logic of market exchange. Every purchase is matched
by an offer of exchange. In currency markets, the match is one currency for another. If the Marshall-
Lerner elasticity conditions are met, the depreciation of the deficit country’s exchange rate will tend,
over time (after J-curve effects have worked through), to restore trade balance, which will then cause
its currency to stop depreciating. Under such conditions, the foreign exchange market is stable.
However, given capital mobility, demand and supply in exchange markets will reflect more than just
trade balance considerations. They will also reflect asset portfolio considerations and decisions to
hold wealth across different national financial markets. This brings an asset market dimension to
foreign exchange markets that can be highly problematic. In particular, currency markets will take
on the character of asset markets. As such, they may be volatile and subject to speculative manias and
herd behaviors. This opens the way for asset market volatility to impact exchange rates and, thereby,
impact output and employment. Thus, as financial investors move money into a country, they will
appreciate the exchange rate. This can make industries uncompetitive, resulting in plant closures
and job losses despite the absence of any change in factory floor productivity. Capital inflows will
also drive up asset prices and lower interest rates, thereby promoting asset-centered booms and
distorting the allocation of resources.
In the event that the inflows reverse, the result can be a collapse in asset prices and a rise in interest
rates, as happened in East Asia in 1997. Flexible exchange rates plus unrestricted capital mobility
can, therefore, make a volatile cocktail.

Self-Assessment
1. Choose the correct options:
(i) The British economist John Maynard Keynes characterized gold as a barbarous relif in
............... .
(a) 1901 (b) 1923
(c) 1920 (d) None of these
(ii) The United States was bimetallic from 1837 until the Civil War, although the major bimetallic
power of the day was ..............., which abandoned bimetallisus for gold in 1873.
(a) Germany (b) France
(c) Itly (d) None of these
(iii) President Nixon unilaterally severed the dollar’s link to gold in August, ............... .
(a) 1971 (b) 1965
(c) 1980 (d) 1951
(iv) Brazil and Argentina adopted fixed-rate-based arrangements in ............... .
(a) 1970s (b) 1990s
(c) 1920s (d) None of these.

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