fin 440 exam 1 - The international monetary system can be...

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The international monetary system can be defined as the institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. Prior to the 1870s, many countries had bimetallism, that is, a double standard in that free coinage was maintained for both gold and silver. Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce) money out of circulation. This kind of phenomenon was often observed under the bimetallic standard under which both gold and silver were used as means of payments, with the exchange rate between the two metals fixed. An international gold standard can be said to exist when : 1) gold alone is assured of unrestricted coinage, 2) there is two-way convertibility between gold and national currencies at a stable ratio, and 3) gold may be freely exported and imported. Under the gold standard, the exchange rate between any two currencies will be determined by their gold content. Thus, the exchange rate between the two currencies will remain stable. Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. The adjustment mechanism under the gold standard is referred to as the price-specie-flow mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it exports to the latter. Under the classical gold standard, gold, which is the only means of international payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease (increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the U.K. Consequently, the U.S. products become more competitive in the export market, while U.K. products become less competitive. This change will improve U.S. balance of payments and at the same time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium. The advantages of the gold standard : (1)Under the gold standard, misalignment of the exchange rate will be automatically corrected by cross-border flows of gold;(3)since the supply of gold is restricted, countries cannot have high inflation;(2)any BOP disequilibrium can be corrected automatically due to price-specie- flow mechanism. The disadvantages of the gold standard : (1)The supply of gold is so restricted that the growth of world trade and investment can be seriously hampered for the lack of sufficient monetary reserves. The world economy can face deflationary pressures.(2) The international gold standard per se has no mechanism to compel each country to abide by the rules of the game. Thus, countries may pursue national policies that are inconsistent with maintaining the gold standard.
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This note was uploaded on 02/19/2011 for the course FIN 360 taught by Professor Kesler during the Spring '11 term at Northern Oklahoma College.

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fin 440 exam 1 - The international monetary system can be...

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