Page 205 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

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

• Third, the nature of the adjustment process under fixed exchange rates may have a significant Notes
deflationary bias. Abstracting from capital flows, countries with trade surpluses will experience
an excess demand for their currencies, while countries with trade deficits will experience an
excess supply of their currencies. If a deficit country is forced to keep buying its currency to
defend the exchange rate, this leads to domestic monetary contraction in the deficit country,
while the money supply of the surplus country increases due to the selling of foreign reserves
by the deficit country.
• A final problem with fixed exchange rates concerns their impact on private-sector borrowing
decisions, particularly in developing countries. Fixed exchange rates create a moral hazard,
whereby agents think there is no currency risk associated with foreign currency borrowing.
Agents, therefore, over-borrow foreign currency, and sudden collapses of the exchange rate
can leave them saddled with huge debt burdens measured in domestic currency terms.

17.5 Key-Words

1. Equilibrium : A state in which oppositing forces or influences are balanced.
2. International reserves : Foreign exchange reserves in a strict sense are only the foreign currency
deposits and bonds.
17.6 Review Questions

1. What is the mechanics of a gold standard? Explain.
2. What are the benefits and drawbacks of the gold standard? Explain.
3. What are the demand for International Reserves? Discuss.
Answers: Self-Assessment

1. (i)(b) (ii)(b) (iii)(a) (iv)(b)
17.7 Further Readings

1. Dornbusch, Rudiger and Stanley Fischer (1980). \Exchange Rates and the Current
Account." American Economic Review 70, 960 {71.
2. Frenkel, Jacob A. and Michael L. Mussa (1985). \Asset Markets, Exchange Rates,
and the Balance of Payments: The Reformulation of Doctrine." See Jones and
Kenen (1985), pp. 679{747.
3. Isaac, Alan G. (1989). \Wealth E_ects and the Current Account with Endogenous
Terms of Trade." Journal of Macroeconomics 11(4), xxx.
4. Jones, Ronald W. and Peter B. Kenen, eds. (1985). Handbook of International
Economics, Volume 2. Amsterdam: North Holland Publishing Co.
5. Kenen, Peter (1985). \Macroeconomic Theory and Policy: How the Closed
Economy was Opened." See Jones and Kenen (1985), Chapter 13, pp. 625{677.
6. Kouri, Pentti J.K. (1976, May). \The Exchange Rate and the Balance of Payments
in the Short Run and the Long Run: A Monetary Approach." Scandinavian Journal
of Economics 78(2), 280{304.

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