Under the gold standard, each country fixed the par value of its currency against gold,
maintained the convertibility of its currency into gold at this price, and linked the domestic
money supply to gold stocks at the central bank. It was a fixed exchange rate regime.
Without capital flows, countries with a trade deficit faced a payments deficit, lower gold
stocks and a lower money supply. Domestic recession then bid down wages and prices,
raising competitiveness, an automatic adjustment mechanism. Trade surplus countries
faced a monetary inflow, higher prices and lower competitiveness. In practice, this
adjustment mechanism was hampered by capital flows.
The postwar Bretton Woods system was an adjustable peg in which fixed exchange rates
were sometimes adjusted. It was a dollar standard. But domestic money supplies were no
longer linked to forex reserves, so the adjustment mechanism of the gold standard was
weakened.
The purchasing power parity path of the nominal exchange rate is the path that maintains
constant competitiveness by offsetting differential inflation across countries. In the long run,
floating exchange rates return to the PPP path if no real shocks occur.
In the short run, the level of floating exchange rates is determined largely by speculation.
Exchange rates adjust to ensure interest differentials are offset by expected exchange rate changes. This chokes choke off large speculative flows. In the short run, exchange rates
can depart significantly from their long run level.
Unlike fixed exchange rates, floating exchange rates can cope with permanent differences in
national inflation rates. High-inflation countries have a depreciating exchange rate in the long
run. In practice, floating exchange rates also coped with the severe real shocks of the
1970s. Floating exchange rate regimes are more robust than fixed exchange rate regimes.
Critics of floating exchange rates claim they are volatile in the short run, which discourages
international trade and investment. However, they are volatile because the world is
uncertain. Under fixed exchange rates the uncertainty would show up somewhere else,
possibly in volatile domestic interest rates to maintain the fixed exchange rate.
Fixed exchange rates impose financial discipline by preventing a country having
permanently higher inflation than the rest of the world. However, there are other ways to
commit to low inflation. And fixed exchange rates do not always survive!
International policy co-ordination is hard to implement but allows policy-makers to take
account of the externalities they impose on each other. It may allow individual governments
to commit themselves to policies that would otherwise not be credible.
The UK was always a member of the European Monetary System but belonged to its key
feature, the Exchange Rate Mechanism, only during 1990–92. The early survival of the ERM
arose only partly from greater co-ordination of monetary policy by ERM participants. Foreign
exchange controls and exchange rate bands were also important. After 1983 devaluations
became harder to obtain and monetary policies had to converge on the low inflation rate in
Germany.
