C
3
X B
2
A D1
1 S1
D0
Q
Pounds
Flexible exchange rates
Disadvantages of floating exchange rates
• Uncertainty and diminished trade
– Uncertainty on prices due to movements in the
exchange rate and discourage the flow of trade
• Terms of trade
– A decline in the international value of a country’s
currency will result in worsening terms of trade
• Destablising nature of capital flows
Flexible exchange rates (cont.)
Disadvantages of floating exchange rates
• Instability in the macroeconomic environment
– Destablising effects on the domestic economy
arising from shifts in net exports brought about
by changes in the exchange rate
– Complicates the use of domestic monetary and
fiscal policies
Fixed exchange rates
• Exchange rate for which the values are
determined by government decision
• Nations have often fixed or pegged the
exchange rate to overcome the
disadvantages of floating exchange rates
• Fixed exchange rates require adequate
reserves to accommodate periodic
balance of payment deficits
Fixed exchange rates (cont.)
• Trade policies
– To maintain a fixed exchange rate, a country
may enact protectionist trade policies to increase
net exports
• Exchange controls: rationing
– Restricting imports to the amount of foreign
exchange earned by exports
• Domestic macroeconomic adjustments
– Use fiscal and monetary policies to adjust GDP
to a level consistent with the fixed exchange rate
International monetary system:
the gold standard
• A system under which the value of a nation’s
monetary unit was backed by gold rather than
fiat
• Gold standard conditions
– Define the monetary unit in terms of a certain
quantity of gold
– Fixed relationship between stock of gold and the
domestic currency
– Allow gold to be freely exported and imported
The gold standard (cont.)
• Gold flows
– This would result in exchange rates that are fixed
• Domestic macro adjustments
– The gold standard implies changes in the domestic
money supply of nations, which affects prices,
real output and employment
• Advantages of gold standard
– Stable exchange rates resulting from the gold
standard reduces uncertainty and risk
– The flow of gold between countries caused shifts
in the supply and demand curves and automatically
corrects balance of payments deficits or surpluses
The gold standard (cont.)
• Disadvantages of gold standard
– Nations must accept domestic adjustments in
the form of higher unemployment or inflation
– Countries must have sufficient reserves of
gold
• Demise of the gold standard
– During the Depression years of the 1930s
Bretton Woods monetary system
• Bretton Woods conference 1944
• Adjustable peg system of exchange rate
emerged
– A system by which members of the IMF were
obligated to define their monetary units in terms
of gold (or US dollars), establishing par rates of
exchange between the currencies of all other
members, and to keep their exchange rates within 1
per cent of these par values
– US Dollar the main international currency
– Capital flows were believed to be destabilizing,
prewar controls were left in place.
IMF and pegged exchange rates
• The main aim of the agreement to encourage
world trade in goods and services
• Stabilisation funds
– Suppliers of both foreign and domestic moneys
and gold held with the central bank or treasury for
the purpose of intervention in the foreign exchange
market to maintain the par value of the exchange
rate
• IMF credit
– Provided short-term loans to nations with temporary
or short-term balance of payments deficits out of
currencies and gold contributed by member nations
Bretton Woods monetary system