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Subject ECONOMICS

Paper No and Title 6: Advanced Macroeconomics

Module No and Title 2: Exchange Rate Regimes: Gold Standard, Fixed and
Flexible Exchange Rate

Module Tag ECO_P6_M2

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
____________________________________________________________________________________________________

TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Basic Definitions
3.1 Exchange Rate
3.2 Gold Standard
3.3 Fixed Exchange Rate
3.4 Flexible Exchange Rate
3.5 Appreciation
3.6 Depreciation
4. Gold Standard
4.1 Benefits of Gold Standard
4.2 Drawbacks of Gold Standard
5. Fixed Exchange Rate
5.1 Merits of Fixed Exchange Rate Regime
6. Floating/Flexible Exchange Rate System
6.1 Merits of Flexible Exchange Rate Regime
7. Summary

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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1. Learning outcomes
After studying this you shall be able to:
 Know the different regimes of exchange rate
 Understand about the determination of exchange rates under the different regimes
 Evaluate the merits and demerits of these regimes

2. Introduction
The exchange rate shows the price of domestic currency in terms of foreign currency.
When any two countries open up for trade, then the goods, services and capital move in
and out of one country to the other. In the process, the price or exchange rate is
important, as it is the rate at which trade takes place. The demand for foreign exchange
occurs. There are three systems/regimes of exchange rate- the gold standard, fixed
exchange rate and flexible exchange rate.

3. Basic definitions
3.1 Exchange Rate – It is defined as the price of one currency in terms of the other
currency.
3.2 Gold Standard – In this case, each country fixes the price of its currency in the terms
of gold.
3.3 Fixed Exchange rate - In this case the central bank fixes the exchange rate at a given
level.
3.4 Flexible Exchange Rate – In this case the rate of exchange is determined by the
interplay of the supply and the demand for the foreign exchange.
3.5 Appreciation – It refers to a decline in the domestic price of foreign currency.
3.6 Depreciation – It refers to an increase in the domestic price of foreign currency.

4. Gold Standard
Here each country is ready to trade domestic currency for gold. Thus in this case no
single country occupies a privileged position as the number of currencies and number of
prices of gold in terms of those currencies are equal. Thus, in this case every country is
free to fix its own price in terms of gold.
Since the ancient times gold coins were used as medium of exchange unit of account and
the store of value. The gold standard as a legal institution dates from 1819. And in the
ECONOMICS Paper 6: Advanced Macroeconomics
Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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19th century, Germany, Japan, and other countries also adopted the gold standard as the
world’s leading economic power was Britain, the other nation’s imitated British
institution and, the United States effectively joined the gold standard in 1879. During
1918 to 1939 government effectively suspended the gold standard and financed part of
their massive military expenditures by printing money. This resulted in higher money
supplies and consequently higher consequences. In 1919 U.S. returned to gold and in
1922 a group of countries including Britain, France, Italy and Japan agreed to return to
gold standard in meeting the external and internal balances. And in 1925 Britain took
back to the gold standard by pegging the pound to gold at the pre-war price. However,
Britain’s price level fell but it was still higher than that during the days of prewar gold
standard. Thus to reduce the price level the bank of England followed contractionary
monetary policy. As a result of this, there was serious unemployment in this period. This
resulted in the onset of great depression in 1929 and, as the depression continues many
countries renounced the gold standard and allowed their currencies to float in the foreign
exchange market. However, the U.S. left gold standard in 1933 but it returned to gold in
1934 with increasing the dollar price of gold from $ 20.67 to $ 35 per ounce. The
countries in order to correct external balance and internal balance reduced the
international trade. However, it was realized that they would have been better off by
having free international trade. And in 1944 Bretton Woods’s agreement was made. It
called for fixed exchange rate against the U.S. dollar, the dollar price of gold was $35 per
ounce. As the country express their price of currency in the form of gold, gold becomes
the official international reserve. And thus the gold standard results in a fixed exchange
rate between all currencies.

4.1 Benefits of Gold Standard

 Symmetry
Under the gold standard the nature of international monetary adjustment is
symmetrical that is whenever a country is losing reserves i.e. money supply. This
results in a gain of reserves with the foreign countries and resulting in expansion
of their money supplies.

 Automatic limits
Another benefit of gold standard is that it places automatic limits on the increase
in the price level (including gold). This is due to the fact that the central banks
cannot increase money supply to grow more than real money demand.

4.2 Drawbacks of Gold Standard

 The gold standards constraints or restricts the use of monetary policy to fight
unemployment.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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 Attaching currency value to gold ensures a stable overall price level only if the
relative price of gold and other goods are stable.
 The use of gold as an international payment system is easy only if the supply of
gold is ever increasing.
 Moreover the gold standard gives more power to those countries which have large
gold production such as Russia and South Africa.

5. Fixed Exchange Rate Regimes

In this case the central bank of a country fixes the exchange rate at a given level. There is
no market for foreign exchange and the exchange rate is policy determined.

5.1 Merits of Fixed Exchange Rate Regime

In this section we present the case for fixed exchange regime. There are three main points
in favour of this regime:

 Uncertainty
It avoids the wild day to day fluctuations that are likely to occur under flexible
exchange rates. These fluctuations discourage specialization in the production, the
flow of international trade and investment. The fluctuations in the exchange rate
depends on the elasticity on demand and supply curve on foreign exchange. For
example- consider diagram (1) drawn below:

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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Figure 1

In the above diagram we measure R, that is the exchange rate on the y axis and we
measure U.S. demand for pounds on the x axis. The D£ curve shows the average U.S.
demand for pounds and S£ shows the U.S, supply curve for pounds (which is elastic).
Consider an increase in the U.S. demand for pounds which results in a shift of the
demand curve from D£ to D’£. This causes exchange rate to rise from R to R’. Now,
suppose the demand curve shifts down to D£* then the equilibrium exchange rate rise
to R*. This was the case with elastic supply curve. Suppose the supply curve is
inelastic that is S£’ the same shift would result in exchange rate to the R’’ and R*. The
above reasoning clearly shows that there are fluctuations in the exchange rate when
exchange rate is flexible. These fluctuations disappear in the fixed exchange rate.

 Stabilizing Speculation
It is generally argued that the speculation is more likely to be destabilizing under a
flexible than under a fixed exchange rate systems. Suppose there is destabilizing
speculation, speculators generally by foreign currency when the exchange rates are
rising. They expect that exchange rate will rise further. And vice-versa and in the
process the fluctuation in the exchange rates resulting from business cycle are
amplified. And the opposite occurs under stabilizing speculations.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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 Price Discipline
Theoretically, the flexible exchange rates are more inflationary than the fixed
exchange rates. This is so because there is a price discipline in the flexible exchange
rate systems. In other words, it happens so because the balance of payments
disequilibrium is automatically and immediately corrected by the change in the
exchange rate and thus it results in importing foreign inflation. Such a case does not
occur in fixed exchange rate system. As fixed exchange rate impose a price discipline
that is a nation with a higher rate of inflation than the rest of the world likely to face
persistent deficits in its balance of payments.

6. The Floating/Flexible Exchange Rate System

In this case, there is a foreign exchange market and the exchange rate is determined in
this market. We first explain the foreign exchange market. It is the market in which
international currency trade takes place. The exchange rate is like any other price in the
economy. The foreign exchange trading takes place in many financial centers, with the
largest volume of trade occurring in such major cities as London, New York, Tokyo,
Frankfurt and Singapore. The direct telephone, fax and internet links are the modes of the
foreign exchange market. Thus the foreign exchange market is composed of commercial
banks, corporations, non-banking financial institutions and the central banks. The
commercial bank plays a central role in the foreign exchange market almost all the
international transactions involve the exchange of bank deposits denominated in different
currencies.
The corporations operate in several countries and thus receive payments in different
currencies. For example – to pay workers at a plant in India, the companies need Indian
rupees. If IBM has only dollars then it needs to buy the Indian rupees thus, the demand
for rupees or for foreign currency is generated.
The non-banking financial institutions are important institutions of foreign exchange
market their need arised after the de-regulation of financial markets in various countries.
For example the mutual funds offer their customers a broader range of services involving
foreign exchange transactions.
The final constituent of foreign exchange market is central bank of a country. It is the
most regular official participant.

We shall now discuss how the exchange rate is determined.

The exchange rate is determined by the intersection of demand and supply curve for
foreign exchange. Suppose there are two nations and therefore two currencies - one is
domestic currency for example dollar and the second currency called foreign currency is
pound. The exchange rate between them is defined as the rate at which two countries
trade. In other words, how many dollars are required to obtain one pound. Thus, the

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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exchange rate is equal to dollars by pound i.e. R=$/£. If R=3 , this means that 3 dollars
are required to purchase a pound. Consider the following diagram drawn below:

Figure 2

Here we show how the dollar price R is determined. It is determined by the intersection
of market demand and supply curve for pound. In the diagram, on the vertical axis we
measure the dollar price of pound i.e. R, the exchange rate between the two currencies
viz: dollars and pounds and on the horizontal axis we measure the quantity of pounds.
The two curves can be seen – demand curve and supply curve of pounds. The demand for
pounds comes from U.S, it is negatively sloping indicating that lower is the exchange rate
(R), the greater is the quantity demand of pounds by the U.S. This is due to facts that
lower is the exchange rate the cheaper it is to buy pounds and use in its own country to
invest.
The two curves intersect at point E. it is point of equilibrium. Suppose, there is excess
demand for foreign exchange, then, the dollar price of pounds i.e. R will rise to E 1. This
is shown by points cd in the diagram (appreciation of the currency). Suppose the U.S.
demand for pounds shifted as a result of increase demand for British goods i.e. there is a
shortage of demand for pounds and excess supply of pounds then the price of dollars in
pound that is R will fall (depreciation of the currency).

6.1 Merits of Floating Exchange Rate Regime

The case for floating exchange rate depends on three major claims:
 Monetary Policy Autonomy
Under the fixed exchange rate the Federal Reserve- The Central Bank of U.S. had
the power to change the rate of exchange. The other central bank abroad had little

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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scope to use the monetary policy to attain internal and external balance. However
in the case of flexible exchange rate the central bank of all countries have the
power to control to change or monitor the money supply. For example- consider a
country which is in unemployment state the central bank can use monetary
expansion to cure the unemployment. This is possible because there are o
restrictions on the value of currency in the flexible exchange rate. Then under
flexible exchange rte the foreign exchange market automatically brings the
exchange rate changes that protect these countries from U.S. inflation. So, there is
no force to import inflation from abroad.
Under the fixed exchange rate regimes the countries could hold their dollar
exchange rate fixed by keeping the domestic rate of interest in line with that of the
world interest rate. To do that the central banks used to impose strongest
restrictions on international payments. These restriction were only partially
successful in strengthening the monetary policy also they had the damaging side
effect of distorting international trade. For example: if the central banks faced
unemployment and to counter that expand their money supply. So this results in
an enhanced control over monetary policy which would allow the countries to
dismantle their distorting barriers to international payments. Then floating rates
would also allow each country to choose its own desired long run inflation than
passively importing the inflation rate established abroad. Thus, the country can
insulate itself from the inflationary increase in foreign prices by revaluing its
currency and so remain in internal and external balance.

 Symmetry
It is argued that under the floating exchange rate, the two types of asymmetry that
occur in fixed exchange rate would not occur. The two symmetries are – 1, the
central banks fixed their currencies to the dollar and thus accumulated dollars as
international reserves. Here, the U.S. Federal Reserve played the leading role in
determining the money supply. 2, any foreign country could devalue its currency
against the dollar but U.S. did not have the option of devaluing against the foreign
currency. These two asymmetries would disappear in floating exchange rate as the
countries would no longer fix dollar exchange rate. And secondly, each country
would be able to regulate monetary conditions at home thus all the countries
exchange rate would be determined symmetrically by the foreign exchange
market.

 The exchange rate as automatic stabilizers

The exchange rate automatically changes in the flexible exchange rate system. It
changes due to any change in the demand or in the supply of imports and exports.

Let us consider a change in the demand for the home country’s exports. Let there
be a fall in demand for exports to foreign country. This reduces the aggregate

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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demand for every level of the exchange rate. Thus, there is a shift in the demand
curve. Consider the figure 3.1, here, the initial point of equilibrium is 1 where the
AA schedule and DD schedule intersect. Due to a decrease in demand of exports
of home country, the demand curve moves leftwards from DD1 to DD2. The
demand schedule shows exchange rate and output pairs for which aggregate
demand equals output and the AA schedule shows exchange rate and output pairs
at which the foreign exchange market and domestic money market are in
equilibrium. As demand falls the transactions demand for money falls which
result in a fall in the domestic interest rate. This fall in domestic interest rate
causes the domestic currency to depreciate in the foreign exchange market. And
so as a consequence the exchange rate rises from E1 to E2.

Figure 3.1
Let us now consider an increase in demand of foreign country’s exports i.e. there
is an increase in demand for imported goods.

This increases the aggregate demand for every level of the exchange rate. Thus,
there is a shift in the demand curve. Consider the figure 3.2, here, the initial point
of equilibrium is 1 where the AA schedule and DD schedule intersect. Due to a
decrease in demand of foreign country’s export (i.e. imports rise) the demand
curve moves rightward from DD1 to DD2. As demand rises the transactions
demand for money rises which result in a rise in the domestic interest rate. This
rise in domestic interest rate causes the domestic currency to appreciate in the
foreign exchange market. And so as a consequence the exchange rate falls from
E1 to E2.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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Figure 3.2

Now, suppose there is an increase in domestic interest rate due to an increase in

transaction demand for money. This rise in domestic interest rate causes
disequilibrium in the foreign and domestic exchange market and as a result AA
schedule shifts to the left from AA1 to AA2. This causes the domestic currency to
appreciate in the foreign exchange market. And so as a consequence the exchange
rate falls from E1 to E2.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate
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Figure 3.3

7. Summary
In this module, we have discussed the three systems of exchange rate- the gold standards,
fixed exchange rate and flexible exchange rate. All the systems determined the rate of
exchange between any two currencies in foreign exchange market. This determination
holds true for n number of countries using n number of currencies.
The foreign exchange market for any currency is comprised of all the locations such as
U.S , Paris, India, Hong Kong ,etc. where the currencies are bought and sold. These
different monitories sector are connected by a telephone network, video screens and are
in constant contract with each other. The main function of foreign exchange market is the
movement of purchasing power from one country to another. The demand for foreign
exchange comes from the desire to buy i.e. import goods and services from other nations
and to make investments abroad. The supply of foreign exchange comes from export of
goods and services and the inflow for foreign capital.
Under the fixed exchange rate, the central bank holds constant the price of foreign
currency in terms of the domestic currency. It does this by buying and selling the foreign
currency at a fixed rate. For this it has to keep reserves of foreign currency.
Under the flexible exchange rate system, the exchange rate may Change from movement
to movement. In a system of clean floating, the exchange rate is determined by supply
and demand without the central bank intervention. Under dirty floating the central bank
intervenes by buying and selling foreign exchange in an attempt to influence.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 2: Exchange Rate Regimes: Gold Standard, Fixed and Flexible
Exchange Rate