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A Short History Of The Worlds Exchange Rate Systems

2898 words - 12 pages

Abstract This paper shall discuss the Gold Standard, the Bretton Woods System and the European Exchange Rate Mechanism with a view to analysing their respective advantages and disadvantages; along with the circumstances surrounding their emergence and failure. Through this lens the author intends to draw comparisons between the current EMU and the Gold Standard and any implications these similarities have Introduction A prerequisite to any discussion on this topic is an understanding of certain classical and neo-classical analytical frameworks. Therefore section one will briefly present and explain the logic of Hume's Mechanism and the 'Impossible Trinity.' Section Two outlines a chronological history of various exchange rate mechanisms along with their corresponding successes and failures. Section three draws parallels between the Gold Standard and the European Monetary Union and discusses the consequences of these similarities. Section One: Analytical Frameworks Hume's Mechanism: This theory combines aspects of the purchasing power parity and interest rate parity conditions. It states that as the monetary base (M) increases domestic prices trend upwards. This induces a nation to import more goods than it exports, creating a current account deficit. This deficit gradually causes gold to leave the system, causing prices to revert back to their original levels- producing a balanced current account. This process in the goods markets is far slower than the complimentary process which occurs in the financial markets. When the money stock within the system exceeds its equilibrium level interest rates are forced downwards. This induces savers seeking higher yields to move their capital out of the domestic system and into foreign accounts offering higher interest rates. This reallocation of capital produces a financial account deficit. As this process continues interest rates gradually increase until they reach equilibrium levels once more. These processes in the goods and the financial markets reinforce one another to restore equilibrium in the nation's balance of payments. This system is particularly important given that central banks in a gold standard system cannot alter interest rates or 'print' gold, here Hume's Mechanism becomes the only means though which a nation can correct competitiveness imbalances. The Impossible Trinity (trilemma): states that nations may only achieve two of the following: Fixed Exchange Rates; Autonomous Monetary Policy; and Full Capital Mobility. Any attempt the obtain all three has historically proven to be disastrous. Currencies become vulnerable to speculative attacks when the Trinity is broken and more often than not collapse under the pressure of these attacks with destructive impacts on the real economy. Section Two: Historical Exchange Rate Regimes and their Fates Barter System: Before the metallic and bimetallic systems of the 1700 and 1800 hundreds there were no currencies, only an exchange of goods and...

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