Question

The pre-1914 value of the British pound to the U.S. dollar was $4.87. (To purchase one pound, one had to pay $4.87.) Following World War I, if the dollar had traded for the pound on an open currency market, the value would have been about $3.50. However, the British government insisted that the pound trade at its pre-war value to the U.S. dollar. Under such an arrangement:

1. Would Great Britain run annual trade surpluses or trade deficits with the USA? Why?

2. Would British goods have been more attractive or less attractive to U.S. consumers? Why?

3. Would there have been an influx of British tourists to the USA, or would there have been an increase in American tourists to Britain? Why?

Answer 1

1 pound was equal to $4.87 pre 1914, in open currency 1 pound would have equalled $3.50. However it was traded at the previous rate of $4.87 to one pound.

Now in dollar terms $ = 0.2pound (1/4.87) . Whereas in open market, $=0.29pound (1/3.50). Pound depreciates in open currency.

1. Great Britain will run trade deficit with the US as it will import more because for one pound, it is getting $4.87.worth of goods, whereas it won't export much to US as US will import less because it is just getting 0.2pounds worth of goods. Thus imports will exceed exports to US.

2. British goods would have been more attractive to US consumers in open currency market as they would have paid just $3.50 for 1 pound of a good, but they are instead paying $4.87 for one pound of good. Thus in this arrangement they are less attractive.

3. There would be more influx of British tourists to USA as they would have only gotten $3.50 previously, instead they are getting $4.87 per pound.