What were the two major types of fixed exchange rate regimes
and how did they differ?
Under the gold standard, nations defined their respective
domestic units of account in terms of so much gold (by weight and
fineness or purity) and allowed gold and international checks
(known as bills of exchange) to flow between nations unfettered.
Thanks to arbitrageurs, the spot exchange rate, the market price of
bills of exchange, could not stray very far from the exchange rate
implied by the definition of each nation’s unit of account. For
example, the United States and Great Britain defined their units of
account roughly as follows: 1 oz. gold = $20.00; 1 oz. gold = £4.
Thus, the implied exchange rate was roughly $5 = £1 (or £.20 = $1).
It was not costless to send gold across the Atlantic, so Americans
who had payments to make in Britain were willing to buy
sterling-denominated bills of exchange for something more than $5
per pound and Americans who owned sterling bills would accept
something less than $5 per pound, as the supply and demand
conditions in the sterling bills market dictated. If the dollar
depreciated too far, however, people would stop buying bills of
exchange and would ship gold to Britain instead. That would
decrease the U.S. money supply and appreciate the dollar. If the
dollar appreciated too much, people would stop selling bills of
exchange and would order gold shipped from Britain instead. That
increased the U.S. money supply and depreciated the dollar. The
GS system was self-equilibrating, functioning without government
intervention (after their initial definition of the domestic unit
of account).
As noted in Figure 19.2 and shown in Figure 19.3 , the great
strength of the GS was exchange rate stability. One weakness
of the system was that the United States had so little control
of its domestic monetary policy that it did not need, or
indeed have, a central bank. Other GS countries, too, suffered from
their inability to adjust to domestic shocks. Another weakness of
the GS was the annoying fact that gold supplies were rarely in
synch with the world economy, sometimes lagging it, thereby
causing deflation, and sometimes exceeding it, hence
inducing inflation.
Stop and Think Box
Why did the United States find it
prudent to have a central bank (the B.U.S. [1791–1811] and the
S.B.U.S. [1816–1836]) during the late eighteenth and early
nineteenth centuries, when it was on a specie standard, but not
later in the nineteenth century? (Hint: Transatlantic
transportation technology improved dramatically beginning in the
1810s.)
As discussed in earlier chapters, the
B.U.S. and S.B.U.S. had some control over the domestic money supply
by regulating commercial bank reserves via the alacrity of its note
and deposit redemption policy. Although the United States was on a
de facto specie standard (legally bimetallic but de facto silver,
then gold) at the time, the exchange rate bands were quite wide
because transportation costs (insurance, freight, interest lost in
transit) were so large compared to later in the century that the
U.S. monetary regime was more akin to a modern managed float. In
other words, the central bank had discretion to change the money
supply and exchange rates within the wide band that the costly
state of technology created.
The Bretton Woods System adopted by the first world
countries in the final stages of World War II was designed to
overcome the flaws of the GS while maintaining the stability of
fixed exchange rates. By making the dollar the free
world’s reserve currency (basically substituting USD for gold), it
ensured a more elastic supply of international reserves and also
allowed the United States to earn seigniorage to help offset the
costs it incurred fighting World War II, the Korean War, and the
Cold War. The U.S. government promised to convert USD into
gold at a fixed rate ($35 per oz.), essentially rendering the
United States the banker to more than half of the world’s economy.
The other countries in the system maintained fixed exchange rates
with the dollar and allowed for domestic monetary policy
discretion, so the BWS had to restrict international capital flows,
which it did via taxes and restrictions on international financial
instrument transactions.For additional details, see Christopher
Neely, “An Introduction to Capital Controls,” Federal Reserve
Bank of St. Louis Review (Nov./Dec. 1999): 13–30.
research.stlouisfed.org/publications/review/99/11/9911cn.pdf
Little wonder that the period after World War II witnessed a
massive shrinkage of the international financial system.
Under the BWS, if a country could no longer defend its fixed
rate with the dollar, it was allowed to devalue its currency, or in
other words, to set a newer, weaker exchange rate. As Figure 19.4
reveals, Great Britain devalued several times, as did other members
of the BWS. But what ultimately destroyed the system was the fact
that the banker, the United States, kept issuing more USD without
increasing its reserve of gold. The international equivalent of a
bank run ensued because major countries, led by France, exchanged
their USD for gold. Attempts to maintain the BWS in the early 1970s
failed. Thereafter, Europe created its own fixed exchange rate
system called the exchange rate mechanism (ERM), with the German
mark as the reserve currency. That system morphed into the European
currency union and adopted a common currency called the euro.
Most countries today allow their currencies to float freely or
employ a managed float strategy. With international capital
mobility restored in many places after the demise of the BWS, the
international financial system has waxed ever stronger since the
early 1970s.
key takeaways
The two major types of fixed exchange rate regimes were the
gold standard and Bretton Woods.
The gold standard relied on retail convertibility of gold,
while the BWS relied on central bank management where the USD stood
as a sort of substitute for gold.