[MUSIC] In the examples we have used thus far, the value of the various currencies that we discussed were allowed to freely move in response to market conditions. This type of monetary system is called a floating exchange rate system. However, not all countries of the world allow their currencies to float. Instead, some use what is called a fixed exchange rate system. In a fixed exchange rate system, a country will peg the value of its currency tightly to the value of another. Most often, the US dollar, or a basket of currencies. The country will then make the necessary adjustments to maintain the value of that pay. To better understand these two starkly different systems, floating versus fixed exchange rates, let's take a trip through time. Between 1867 and 1933, except for the period around World War I Most of the nations in the world were on the gold standard. Under this fixed exchange rate system, the currency issued by each country had to either be gold or redeemable in gold. And once a country agreed to be on the gold standard, its currency was convertible into a fixed amount of gold. With these fixed exchange rates, if the nation ran a trade deficit, it would be required to use its gold reserves to buy currency to prevent the value of the currency from falling. In contrast, if a nation ran a trade surplus, it would accumulate gold. Now you might wonder why the gold standard was so popular? The answer lies in something called perhaps rather strangely the gold specie flow mechanism. This monetary adjustment mechanism was first described by Scottish philosopher and economist, David Hume in 1752. And it is illustrated in this figure. Suppose, then, that both Britain and the US start with an equal amount of gold reserves, and begin trade. The US initially runs a trade deficit, so that it has to ship some of its gold to Britain. If the U.S. continues to run such a deficit it will eventually run out of gold. However, before that can happen Humes multi-pronged adjustment mechanism takes hold. First, the U.S. money supply is reduced by its loss of gold. Second, the U.S. price level falls. The same time, the British money supply increases and British prices rise. This all happens because by the quantity theory of money, if the velocity of money v and real output q stay the same, this reduction in money m must then reduce the price level p. As a result of these changes in relative prices in the U.S. and Britain, four things happen. First, America decreases its imports of British and other foreign goods, which had become relatively expensive. Second, America's exports increase because America's domestically produced goods have become relatively inexpensive on world markets. Third British consumers import more of America's now more relatively inexpensive goods. And fourth British exports decline because British exports have become more expensive. The matter of fact is that a balance of payments equilibrium is restored in both Britain and the US by the gold specie flow mechanism. Now, it is a matter of some debate whether Hume's Mechanism actually works. But what is true, is that the gold standard worked reasonably well at stabilizing the currency markets right up until World War I, however, with the advent of the war, many nations had to temporarily abandon the gold standard to finance their war efforts. This led to inflation and, in particular, to differing rates of inflation to differing countries. As we explained above. Differing rates of inflation distort the relative value of currencies. Thus when peace returned and nations return to the gold standard, the old exchange rate no longer reflected the true value of the different currencies. For example, the French Franc was significantly undervalued, as a result, upon its return to the gold standard, the French economy enjoyed an export led boom and France began to accumulate large surpluses of foreign currencies. In contrast, Britain had sustained lower inflation rates than many of its trading partners so its currency was overvalued. As a result, Britain found it difficult to sell its exports and found itself overwhelmed by cheap imports. By 1930, Britain was so drained of its gold reserves that it had to abandon the gold standard. At that point the U.S. dollar came under similar attack. France in particular began to unload large amounts of its surplus dollars for U.S. gold. While the Hoover administration first stemmed this gold flow by raising domestic interest rates, this act of contractionary monetary policy also helped push, indeed some would say helped shove, the US further ended the Great Depression. Eventually in 1933, President Roosevelt followed the British in abandoning the gold standard. With the collapse of the gold standard in the 1930s, countries desperate to create jobs in a depressionary global economy, engaged in so-called competitive devaluations. In particular, they began to devalue their currencies in order to boost exports and reduce imports. However, these competitive devaluations acted in a fact like a beggar thy neighbor trade policy. Jobs created in one country lead to job losses in other countries. These economic pressures in turn contributed to growing political pressures It eventually led to World War II. It was the harsh lessons of the 1930s that brought the Allied powers to Bretton Woods, New Hampshire in 1944, as representatives from 44 countries met for 22 days to design a new international monetary system.
