At the other extreme is a system of fixed exchange rates, where governments specify the exact rate at which dollars will be converted into pesos, yen, and other currencies. Historically, the most important fixed-exchange-rate system was the gold standard, which was used off and on from 1717 until 1933. In this system, each country defined the value of its currency in terms of a fixed amount of gold, thereby establishing fixed exchange rates among the countries on the gold standard.'The functioning of the gold standard can be seen easily in a simplified example. Suppose people everywhere insisted on being paid in bits of pure gold metal. Then buying a bicycle in Britain would merely require payment in gold at a price expressed in ounces of gold. By definition there would be no foreign-exchange-rate problem. Gold would be the common world currency. GHD Hair Straightener
This example captures the essence of the gold standard. Once gold became the medium of exchange or money, foreign trade was no different from domestic trade; everything could be paid for in gold. The only difference between countries was that they could choose different units for their gold coins. Thus, Queen Victoria chose to make British coins about 1 /4 ounce of gold (the pound) and President McKinley chose to make the U. S. unit 1/20 ounce of gold (the dollar). In that case, the British pound, being 5 times as heavy as the dollar, had an exchange rate of $5/Â£l.
This was the essence of the gold standard. In practice, countries tended to use their own coins. But anyone was free to melt down coins and sell them at the going price of gold. So exchange rates were fixed for all countries on the gold standard. The exchange rates (also called par values or parities) for different currencies were determined by the gold content of their monetary units. The purpose of an exchange-rate system is to promote international trade while facilitating adjustment to shocks and disequilibria. Key to understanding international economics is to see how the international adjustment mechanism functions. What happens if a country's wages and prices rise so sharply that its goods are no longer competitive in the world market? Under flexible exchange rates, the country's exchange rate could depreciate to offset the domestic inflation. But under fixed exchange rates, equilibrium must be restored by deflation at home or inflation abroad. GHD Hair
Let's examine the international adjustment mechanism under a fixed-exchange-rate system with two countries, America and Britain. Suppose that American inflation has made American goods uncompetitive. Consequently, America's imports rise and its exports fall. It therefore runs a trade deficit with Britain. To pay for its deficit, America would have to ship gold to Britain. Eventually if there were no adjustments in either America or Britain â America would run out of gold.
In fact, an automatic adjustment mechanism does exist, as was demonstrated by the British philosopher David Hume in 1752. He showed that the outflow of gold was part of a mechanism that tended to keep international payments in balance. His argument, though nearly 250 years old, offers important insights for understanding how trade flows get balanced in today's economy.
Hume's explanation rested in part upon the quantity theory of prices, which is a theory of the overall price level that is analyzed in macroeconomics. This doctrine holds that the overall price level in an economy is proportional to the supply of money. Under the gold standard, gold was an important part of the money supply either directly, in the form of gold coins, or indirectly, when governments used gold as backing for paper money.
What would be the impact of a country's losing gold? First, the country's money supply would decline either because gold coins would be exported or because some of the gold backing for the currency would leave the country. Putting both these consequences together, a loss of gold leads to a reduction in the money supply. According to the quantity theory, the next step is that prices and costs would change proportionally to the change in the money supply. If the United States loses 10 percent of its gold to pay for a trade deficit, the quantity theory predicts that U. S. prices, costs, and incomes would fall 10 percent. In other words, the economy would experience a deflation. If gold discoveries in California increase America's gold supplies, we would expect to see a major increase in the price level in the United States.