Question

1. Type of exchange rate system was the gold standard? Explain how it is operated.
2. How does the gold standard eliminate the possibility of continuous balance of payments disequilibria?
3. “What is seigniorage Does the United State pom an unfair advantage in world commerce due to seigniorage?
4. Discuss the common economic reasons for why a country should adopt a fixed exchange rate arrangement.
5. Explain and graphically illustrate how speculators can attack a currency under the fixed exchange rate system.

Answer 1

Gold standard was a kind of system in which all countries had to fix the value of their respective currencies in terms of particular amount of gold or they can also do it in terms of other country who used gold standards. There were no restriction on the import or export of gold and domestic currencies were easily convertible. Gold coins were used as domestic currencies including other metals in order to do the transactions but the composition varied from country to country. Exchange rates were also decided in the fixed terms of gold. There were two important monetary policies under the gold standard. First relates to maintaining the convertibility factor of currency into gold amount and thus deciding the exchange rate. Second deals with the adjustment speed to balance the respective payments done. It mainly existed from 1870s till the First World War in 1914. Money supply of a country was linked to the gold in this particular system. There was a legal minimum ratios of gold to currency or notes issued.

Gold standard system eliminated the possibility of continuous balance of payments disequilibria. Because the international BOP differences were settled in gold were the country with surplus amount received the gold inflows and the countries with deficit in amount received the gold outflow. It was a kind of self-correcting methods for both the countries involved. The country having the balance of payments deficit would face reduced money supply, decrease in the price level with rise in competitiveness and further leading to the correction of BOP deficit. And for the countries having balance of payments surplus the reverse method followed the maintaining the equilibrium. This was also known price specie flow mechanism put forward in 18^th century.

Seigniorage is the difference between the face value of money, like a particular 10$ coin and its cost of production and distribution. It’s the economic cost of producing a given currency within a country which profits the government producing it since that cost is lower than the actual exchange value. It’s not necessary that it will always be a profit for the government, in some situations like creating a copper coins it can be a loss.

Seigniorage principle suggests that a country can generate revenue from the production of new bills but there are other factors also involved in the transaction like interest payments. For example, let’s suppose the Federal Reserve agrees to increase money supply in the US economy by increasing the number of dollars. It will make a purchase of Treasury Bill in exchange by allowing the production. The government can profit from this transaction if the face value is higher than the cpst of production but at the same time the treasury bills also requires the interest payments. The United State can have an unfair advantage in world commerce due to seigniorage because of the government monopoly in issuing the base money can generate huge profits. Governments can increase seigniorage at a cost inflation rates changing over the period of time which results showing when the inflation rates exceeded 7-8%, the US government fiscal seigniorage declined.

A country should adopt a fixed exchange rate arrangement because it can control the inflation rates since the supply of gold will be restricted to a particular amount. Most importantly the balance of payments can be maintained or corrected the cross border flows of gold. Fixed exchange rate system will help keeping a country’s currency within a particular band, increasing the certainty for both importers and exporters. Investors won’t have to worry about huge swings in the currency value and hedging the currency risk.

Speculators can attack a currency when they believe that currency is over-valued they sell that currency by anticipating that it will fall in future and buy another currency example selling the rupee and buy euros. In order to maximise profits the speculators also do short selling, which means they sell currency or assets which they don’t own and agrees to buy them again in future speculating the fall in its value. Thus it can happen easily carried out in a semi fixed exchange rate system where a government is committed to keep the currency value at particular level.

This shows the effect of the speculation through an event in 1990 when UK joined the ERM which had a fixed exchange rate system. But when UK entered huge recession, the speculators like George Soros thought it was overvalued and the government won’t be able to maintain the currency value and interest rates. Therefore the sold pounds and in exchange bought options. Later on when the currency actually devalued as shown in the graph, the pound fell by 20% and the speculators made huge profit out of it.