Page 204 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes 17.4 Summary

• 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.
• 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.
• 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. 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.
• In a bimetallic system, a country’s mint will coin specified amounts of gold or silver into the
national currency unit (typically for a fee).
• The mint parity could differ from the market relative price of the two metals, however, and
when it did, one or the other might go out of circulation. For example, if the price of gold in
terms of silver were to rise to 20 : 1, a depreciation of silver relative to the mint parity of 16 : 1,
no one would want to turn gold into gold dollar coins at the mint. More dollars could be obtained
by instead using the gold to buy silver in the market, and then having the silver coined into
dollars.
• 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.
• 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.
• 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.
• In a system of fixed exchange rates, the exchange rate is fixed at an official predetermined rate.
The central bank acts as a market maker and steps in to fill any imbalance between demand and
supply. Such a system has two major advantages.
• The second is that fixed exchange rates act as to discipline monetary authorities, preventing
them from pursuing inflationary policies. This argument was emphasized when Brazil and
Argentina adopted fixed-exchange-rate-based arrangements in the 1990s. The logic is that
excessive money supply expansion generates inflation that, in turn, gives agents an incentive
to shift into currencies with purchasing power that is not being eroded. Such shifts force the
central bank to intervene and buy the currency to protect the exchange rate, thereby reducing
the money supply. In this fashion, fixed exchange rates establish an automatic mechanism that
prevents central banks from excessive money supply expansion, and central banks are forced
to tighten the money supply whenever inflation starts to increase to levels that will spur currency
flight.

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