Quiz 19: International Monetary Systems: an Historical Overview

Business

Refer to the following information to answer the following as follows: The external balance refers to the current account balance that is the inflow of the money from the exports and the amount of expenses that are incurred on the imports. The policy makers always aim at achieving the external balance while formulating broad economic policies. There are some factors that leads to the disruption of the balance of the current account which leads to the surplus or deficit in account. a)the first case is of the large deposits found in the interior of the country. When large deposits are discovered in the interiors of the country, the country needs huge capital requirements which leads to huge borrowings. Hence, it leads to capital movements from the foreign country to home country. Since, the capital movements are from the foreign country to home country therefore the current account gets imbalanced and the deficit occurs. b)if the prices of the copper increases, the returns from it exceeds and leads to the surpluses in the current account. However, one must consider the cost of the copper mining for which huge capital investments are required.If the returns exceed the cost of investment, it will add to the current account surplus. c)when the prices of the copper increase temporarily, the amount of the surplus increases as the number of exports are increased.d)a temporary shoot up in the oil prices leads to a current account deficit for the country which imports oil but leads to a surplus which exports oil. But the exporting oil country the cost of the investment must be considered.If the costs exceed the returns, it will lead to the current account deficit and if the returns exceed the costs, then it will lead to surplus.

According to Hume, under gold standard a balance of payment disequilibrium between two countries A and B can be restored by an adjustment mechanism called Price-Specie-Flow Mechanism. It is an automatic mechanism which adjusts the external balance deficits that arises due to international trade. Under the gold standard, gold is the only means of international payments. When income is transferred from B to A, country B will experience a current account deficit while country A will have a current account surplus. Consequently, a corresponding gold flow from B to A restores balance of payment equilibrium between two countries A and B. When gold is transferred from B to A, B will experience a decrease in money supply and that A will experience an increase in money supply. As a result, price level will tend to fall in B and rise in A; B's products become more competitive in the export market while that of A will be less competitive. This change will improve B's balance of payments and deteriorates that of A; thus eliminating the initial disequilibrium in the balance of payment.

Under the Classical Gold Standard (1870s - 1914), exchange rate stability was unprecedented for many countries including the United States and the European countries. Under this system, the external value of all currencies is denominated in terms of gold.Thus, central banks must maintain gold reserves to facilitate purchase and sale of unlimited quantities of gold at the designated exchange rate. By maintaining gold reserves, the central bank, upon demand, can give out gold in exchange for coin and currency. Thus, this system ensures that the exchange rate between currencies remains fixed. Moreover, in the gold standard system, there is free capital mobility or export of gold by private individuals across countries. However, during the interwar period: • High exchange rate volatility became frequent among the core countries. • There was instability in the exchange rate • The classical gold standard ceased to function. The war has reduced the GDP drastically among different countries. Thus, countries deviated as per their economic requirements and developed in different directions. Thus, they were concentrating more on their macroeconomic policies to get the home economy on right track. The excess pressure due to fiscal deficit has made them to print more money to finance war and other needs. This resulted in high inflation and lead to devaluation of the currency. Indeed, lead to a greater monetary instability, which resulted in ignoring the objective of exchange rate stability.

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