Exchange Rates of a Country: Gold and Paper Standard

One important respect in which international trade differs from domestic trade is the fact that different currencies are used in international trade.

International and domestic economic stability presupposes stability in the value of money along with other requirements.

The external value of money or the domestic price of foreign currencies on the foreign exchange market is determined diversely under different monetary standards and the way in which it is determined affects domestic and international economic welfare differently.

It is therefore necessary to examine both the theoretical basis and the practical implications of various international currency systems.

The Gold Standard: Stable Exchange Rate:

A country is said to be on the gold standard:

(i) When its monetary authority is committed to a policy of buying and selling gold at a fixed price in unlimited amounts;

(ii) When the purchasing power of a unit of its currency is kept equal to the purchasing power of a given weight of gold and

(iii) When the external value of its currency is fixed through the medium of gold. Practically all major trading nations were on gold standard in the above sense before 1931 and gold served as a principal international means of payment and as an important reserve of international liquidity.

Under an international gold standard exchange rates are fixed, since each national currency is convertible into gold at a fixed rate and therefore into another currency at a fixed rate. If, for example, $4 and £1 can both be exchanged for the same amount of gold, it follows that the exchange value of £1 cannot be above or below $4. In reality, exchange rates under the gold standard do fluctuate but only within the narrow limits set by the gold export and import points that is by the cost of sending gold from one point of the system to another.

The gold export point is the upper limit beyond which the domestic price of a foreign currency may not rise, while the gold import point is the lower limit beyond which the domestic price of a foreign currency may not fall. It goes without saying that one country’s export point is another’s import point.

Thus under the international gold standard the external value of a national currency is determined by:

(i) The mint part of the standard monetary unit relative to that of foreign currencies, and

(ii) The limits set by the gold export and import points.

Thus, there is stability of exchange rates under the gold standard and it promotes International trade and finance by eliminating risks involved in otherwise unstable exchange rates. Yet it was partly rigid adherence to fixed exchange rates that eventually made the gold standard countries go off gold in protest during the 1930s’.

The main fault of the gold standard was that the external value of a national currency was kept stable at the expense of the stability of its internal value. That is precisely why the entire world today is disposed to share Keynes’ conviction that the external value of a national currency should be adjusted to conform to Its Internal value instead of the other way around.

The Paper Standard:

The Gold standard imposes on the gold standard countries the alternatives of Inflation and deflation. The internal price level and the internal value of national currency, under that standard, are left to the vagaries of the yellow metal. In other words, the; external value of a national currency is kept stable at the expense of Internal economic stability.

Irving Fisher in the United States and John Maynard Keynes in England did most to convince the world that the traditional policy of maintaining exchange stability should be abandoned in favour of internal economic stability. Fisher emphasized price stability and Keynes income stability.

The nations of the world realized the wisdom of exchange flexibility only under the pressure of the worldwide depression of the 1930’s. Flexible exchange rates are generally associated with autonomous, local monetary systems. A local monetary system is usually a paper standard. In the absence of an international gold standard the external value of national currencies may be made flexible:

(i) By leaving automatic market forces free to influence it, or

(ii) By letting the monetary authority deliberately adjust it.