| At the other extreme is a system of fixed exchange | | | | under fixed exchange rates, equilibrium must be |
| rates, where governments specify the exact rate at | | | | restored by deflation at home or inflation abroad. |
| which dollars will be converted into pesos, yen, and | | | | GHD Hair |
| other currencies. Historically, the most important | | | | Let's examine the international adjustment mechanism |
| fixed-exchange-rate system was the gold standard, | | | | under a fixed-exchange-rate system with two |
| which was used off and on from 1717 until 1933. In | | | | countries, America and Britain. Suppose that American |
| this system, each country defined the value of its | | | | inflation has made American goods uncompetitive. |
| currency in terms of a fixed amount of gold, thereby | | | | Consequently, America's imports rise and its exports |
| establishing fixed exchange rates among the | | | | fall. It therefore runs a trade deficit with Britain. To |
| countries on the gold standard.'The functioning of the | | | | pay for its deficit, America would have to ship gold |
| gold standard can be seen easily in a simplified | | | | to Britain. Eventually if there were no adjustments in |
| example. Suppose people everywhere insisted on | | | | either America or Britain — America would run out |
| being paid in bits of pure gold metal. Then buying a | | | | of gold. |
| bicycle in Britain would merely require payment in gold | | | | In fact, an automatic adjustment mechanism does |
| at a price expressed in ounces of gold. By definition | | | | exist, as was demonstrated by the British philosopher |
| there would be no foreign-exchange-rate problem. | | | | David Hume in 1752. He showed that the outflow of |
| Gold would be the common world currency. GHD Hair | | | | gold was part of a mechanism that tended to keep |
| Straightener | | | | international payments in balance. His argument, |
| This example captures the essence of the gold | | | | though nearly 250 years old, offers important insights |
| standard. Once gold became the medium of | | | | for understanding how trade flows get balanced in |
| exchange or money, foreign trade was no different | | | | today's economy. |
| from domestic trade; everything could be paid for in | | | | Hume's explanation rested in part upon the quantity |
| gold. The only difference between countries was that | | | | theory of prices, which is a theory of the overall |
| they could choose different units for their gold coins. | | | | price level that is analyzed in macroeconomics. This |
| Thus, Queen Victoria chose to make British coins | | | | doctrine holds that the overall price level in an |
| about 1 /4 ounce of gold (the pound) and President | | | | economy is proportional to the supply of money. |
| McKinley chose to make the U. S. unit 1/20 ounce of | | | | Under the gold standard, gold was an important part |
| gold (the dollar). In that case, the British pound, being | | | | of the money supply either directly, in the form of |
| 5 times as heavy as the dollar, had an exchange rate | | | | gold coins, or indirectly, when governments used gold |
| of $5/£l. | | | | as backing for paper money. |
| This was the essence of the gold standard. In | | | | What would be the impact of a country's losing gold? |
| practice, countries tended to use their own coins. But | | | | First, the country's money supply would decline either |
| anyone was free to melt down coins and sell them | | | | because gold coins would be exported or because |
| at the going price of gold. So exchange rates were | | | | some of the gold backing for the currency would |
| fixed for all countries on the gold standard. The | | | | leave the country. Putting both these consequences |
| exchange rates (also called par values or parities) for | | | | together, a loss of gold leads to a reduction in the |
| different currencies were determined by the gold | | | | money supply. According to the quantity theory, the |
| content of their monetary units. The purpose of an | | | | next step is that prices and costs would change |
| exchange-rate system is to promote international | | | | proportionally to the change in the money supply. If |
| trade while facilitating adjustment to shocks and | | | | the United States loses 10 percent of its gold to pay |
| disequilibria. Key to understanding international | | | | for a trade deficit, the quantity theory predicts that |
| economics is to see how the international adjustment | | | | U. S. prices, costs, and incomes would fall 10 percent. |
| mechanism functions. What happens if a country's | | | | In other words, the economy would experience a |
| wages and prices rise so sharply that its goods are | | | | deflation. If gold discoveries in California increase |
| no longer competitive in the world market? Under | | | | America's gold supplies, we would expect to see a |
| flexible exchange rates, the country's exchange rate | | | | major increase in the price level in the United States. |
| could depreciate to offset the domestic inflation. But | | | | |