Chapter38S - mcc75691_ch38s_001-004.indd Page 1 9/17/08...

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Chapter 38 discusses the current system of managed floating exchange rates in some detail. But before this system began in 1971, the world had previously used two other exchange rate systems: the gold standard, which implicitly created fixed exchange rates, and the Bretton Woods system, which was an explicit fixed-rate system indirectly tied to gold. Because the features and problems of these two sytems help explain why we have the current system, they are well worth knowing more about.± ±Previous±International± Exchange-Rate Systems 38S-1 Supplemental Web Content SUP 38 SUPPLEMENTAL WEB CONTENT FOR CHAPTER 38: THE BALANCE OF PAYMENTS, EXCHANGE RATES, AND TRADE DEFICITS
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CHAPTER 38S Previous International Exchange-Rate Systems 38S-2 The Gold Standard: Fixed Exchange Rates Between 1879 and 1934 the major nations of the world adhered to a fixed-rate system called the gold standard . Under this system, each nation must: Define its currency in terms of a quantity of gold. Maintain a fixed relationship between its stock of gold and its money supply. Allow gold to be freely exported and imported. If each nation defines its currency in terms of gold, the various national currencies will have fixed relationships to one another. For example, if the United States defines $1 as worth 25 grains of gold, and Britain defines £1 as worth 50 grains of gold, then a British pound is worth 2 ± 25 grains, or $2. This exchange rate was fixed under the gold standard. The exchange rate did not change in response to changes in currency demand and supply. ±Gold±Flows± If we ignore the costs of packing, insuring, and shipping gold between countries, under the gold standard the rate of exchange would not vary from this $2 ² £1 rate. No one in the United States would pay more than $2 ² £1 because 50 grains of gold could always be bought for $2 in the United States and sold for £1 in Britain. Nor would the British pay more than £1 for $2. Why should they when they could buy 50 grains of gold in Britain for £1 and sell it in the United States for $2? Under the gold standard, the potential free flow of gold between nations resulted in fixed exchange rates. ±Domestic±Macroeconomic± Adjustments When currency demand or supply changes, the gold stan- dard requires domestic macroeconomic adjustments to maintain the fixed exchange rate. To see why, suppose that U.S. tastes change such that U.S. consumers want to buy more British goods. The resulting increase in the demand for pounds creates a shortage of pounds in the United States (recall Figure 38.2 ), implying a U.S. balance-of- payments deficit. What will happen? Remember that the rules of the gold standard prohibit the exchange rate from moving from the fixed $2 ² £1 rate. The rate cannot move to, say, a new equilibrium at $3 ² £1 to correct the imbalance. Instead, gold will flow from the United States to Britain to
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This note was uploaded on 10/06/2010 for the course ECO 2013 taught by Professor Haroldj.vanboven during the Fall '09 term at Edison State College.

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Chapter38S - mcc75691_ch38s_001-004.indd Page 1 9/17/08...

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