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AS Economics Unit 4 – Fixed exchange rates and the end of the Gold Standard

September 26, 2016 Leave a comment

Currently doing some revision on fixed exchange rates which is now part of Unit 4 in the new CIE AS syllabus. The following post is an explanation of how fixed exchange rates worked. For many years after the Second World War most countries operated a system of fixed exchange rates. The external value of a currency was fixed in terms of the US$ and the value of the US$ itself was fixed in terms of gold. In effect, therefore, the values of the currencies were fixed in terms of gold. The ‘fixed’ rate was not absolutely rigid. The value of a currency was allowed to vary within a narrow band of 1 or 2% on each side of the ‘fixed’ rate or parity. For example, if the value of the NZ$ were fixed at NZ$1 = US$0.50, a permitted deviation of 2% would allow it to vary between NZ$1 = US$0.51 and NZ$1 = US$0.49. These limits are often described as ‘the ceiling’ and ‘the floor’. Central banks were responsible for maintaining the values of their currencies within the prescribed bands. They are able to do this by acting as buyers or sellers of the currency in the foreign exchange market. For this purpose each central bank must have a fund containing supplies of the home currency and foreign currencies.

The way in which the Reserve Bank of NZ can use its funds of currencies to influence the exchange rate can be explained by making use of the diagram below. Let us assume that the value of the NZ$ has been fixed at A and, initially, the market is in equilibrium at this exchange rate. The permitted band of fluctuation is PP1 and the value of the pound must be held within these limits. A large increase in imports now causes an increase in the supply of NZ$’s in the foreign exchange market. The supply curve moves from SS to S1S1 causing a surplus of NZ$’s at the ‘fixed’ rate (A). If no intervention takes place, the external value of the
NZ$ will fall to B which is below the permitted ‘floor’.

The Reserve Bank will be obliged to enter the market and buy NZ$. In doing so that will shift the demand curve to the right and raise the value of the NZ$ until it is once again within agreed limits. In the diagram below intervention by the Reserve Bank of NZ has raised the exchange rate to C.

When the Reserve Bank of New Zealand is buying NZ$’s, it will be using up its reserves of foreign currencies; when buying NZ$’s it exchanges foreign currencies for NZ$’s. ‘Supporting the NZdollar’, that is, increasing the demand for NZ$’s, therefore leads to a fall in the nation’s foreign currency reserves. In the opposite situation where an increased demand for NZ$’s tends to lift the value of the NZ$ above the permitted ‘ceiling’, the central bank will hold down its value by selling NZ$’s. This will increase the supply of NZ$’s and lower the exchange rate. When the Reserve Bank is selling NZ$’s it will be increasing its holdings of foreign currencies.

The main argument for a fixed exchange rate is the same as that against a floating rate. A fixed rate removes a major cause for uncertainty in international transactions. Traders can quote prices which will be accepted with some degree of confidence; buyers know that they will not be affected by movements in the exchange rate. The risks associated with international trade are lessened and this should encourage more trade between nations and more international borrowing and lending.

The arrival of the floating exchange rate system – 15th August 1971

Under the Bretton Woods regime, world currencies were pegged to the dollar, which in turn was tied to a set price of gold. Central banks had the right to convert their dollar holdings into bullion. But on August 15th 1971 Nixon, in the face of economic difficulties, closed the gold window, devalued the dollar against bullion and imposed a 10% surcharge on imports. The era of paper money and floating exchange rates had arrived. Below is a news clip of President Nixon announcing the end of trading gold at the fixed price of $35/ounce. At that point for the first time in history, formal links between the major world currencies and real commodities were severed.

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A2 Revision – Keynesian and Post-Keynesian Period

May 6, 2015 Leave a comment

I have discussed with my A2 class the end of the Gold Standard and the new era of self-regulating markets that started in the 1980’s under Reagan (US) and Thatcher (UK). This relates to Unit 5 in the A2 syllabusMain schools of thought on how the macroeconomy functions – Keynesian and monetarist.

Robert Skidelsky, in his book “Keynes – The Return of the Master”, outlined the Keynesian and Post-Keynesian periods. The Keynesian period was the Bretton Woods system whilst the “New Classical” Washington consensus system succeeded it. Both are outlined below:

The Bretton Woods system was designed to improve the rules and practices of the liberal world economy which had grown up sporadically in the 19th century. However in 1971 the fixed exchange rate system collapsed (see post Fixed exchange rates and the end of the Gold Standard) and the full employment objective was cast aside. Futhermore controls on capital were removed in the 1990’s. The new system introduced was more free market based and took the name of the Washingotn Consensus System.

According to Skidelsky the two regimes were shaped by two different philosophies. The Bretton Woods system broadly reflected the Keynesian view that an international economy needed strong political and institutional supports if it was to be acceptably stable. The Washington consensus was driven by free market principles of self-regulation and limited government intervention.

Gold Prices, Google Searches and S&P Volatility Index

January 15, 2012 1 comment

Well, I didn’t get sunburnt after 3 weeks at the beach, however it was good to get away.

Below is a chart from a series that The Economist produced entitled Charting 2011. It shows the correlation between google searches in the US for the “Gold Price” and the “S&P 500 Volatility Index”.

Often referred to as the fear index or the fear gauge, the S&P 500 Volatility Index (VIX) represents one measure of the market’s expectation of stock market volatility over the next 30 day period. It is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. Wikipedia

However it is interesting to relate the above chart to that of the actual gold price for 2011 – see below. Here we can see that there is a reasonable correlation between the actual gold price and the google searches and the VIX. Gold prices rose once again from the turbulence on world markets and recorded its 11th straight gain. Will gold prices continue to rise? The fundamentals that have pushed up the price of gold are still evident, namely:

– the problems of debt within the eurozone
– the concern of a double dip recession in a lot of the larger economies
– the increasing demand for gold jewelry amongst the developing economies such as India and China.

Switzerland – lowest inflation since 1900

December 21, 2011 Leave a comment

A recent article in the New Zealand Herald by Mark Lister (Craigs Investment Partners) suggested that the best way for an investor to beat inflation is to have an allocation of precious metals in a portfolio. Inflation affects the holders of monetary assets, e.g. bank deposits, savings, loans,government securities – as money loses value, so do these assets. Therefore, savings in real assets such as property are also advisable to beat the inflation monster. However what was interesting about the article was the history of global inflation and money over the last 100 years. Over that time period inflation has averaged 4.5% but it has been the last 10 years that has seen it accelerate significantly.

The table shows inflation rates of industrialised countries since 1900. Switzerland is the only country to have maintained an average inflation rate below 3% over the time period. One has to ask why other countries have found it so hard to keep inflation under the 3% level. Up until the mid 1970’s most major currencies were backed by precious metals. What it bascially meant was that a country could only print more money if it increased its stock of gold or other precious metals – the currency was backed by these precious metals. The rationale here was that the notes and coins could be exchanged for precious metals which meant that you couldn’t just print more money (quantitative easing) like they have been doing over the last couple of years. It was in 1971 when President Nixon suspended the convertibiity of US dollars into gold and by 1975 most other developed countries had followed suit. This led to a new era of just prinitng more money and currencies become known as fiat currencies – no inherent value. The term derives from the Latin fiat, meaning “let it be done” or “it shall be (money)”, as such money is established by government law. The key aspect about fiat money is the fact that its value relies entirely on the confidence the public have in it.

Up to 2000 Switzerland still kept linking its currency to gold and it was only after a referendum that authoriites loosened the requirement to hold a certain amount of gold as a back-up to paper money. Today, it’s as easy as a few extra numbers entered on a computer keypad. Printing money doesn’t achieve much other than inflation. There is still the same amount of goods and services to go around, but now there is more money chasing the same amount of goods, so the price simply goes up in reaction, which in turn makes your money worth less in terms of its purchasing power.

Gold – safe as houses?

October 7, 2011 Leave a comment

For a number of years Gold has been championed as having store value (one of the functions of money) and a safe haven for investors. On Friday 16th September Gold prices hit a high of US$1,920 per ounce but by Monday 26th Spetember it had dropped to US$1.534 – a fall of 20%. So why has this commodity become a risky asset to hold. It seems that when economic conditions become really serious that gold gets ‘hit’ – according to one hedge fund manager “It is hard to say that something that can fall 15% in 3 days is a store value.”

However, the same happened in 2008 when Lehman Brothers went under. Gold appreciated in value quite rapidly as people sought a medium with good store value. But the contagion on financial markets that follwed saw Gold lose a lot of its value. To many this was a sign of the interconnectedness of world markets as asset values seem to move together in a crisis. Obviously these wide variations in price could be demotivating for the risk-averse investor. According to the Financial Times in London there are two significant questions that must be asked of Gold:

1. Does the recent fall mark the loss of haven status and the beginning of the end for gold’s decade-long bull market?
2. If the answer to one above is no, how long will it take for Gold to recover?

Warren Buffett quite rightly points out that there is some madness in digging up, refining and shipping the metal across the world, and burying it again in expensive vaults. Some have argued that its value is founded on ‘human stupidity’ as it is something that is built on what you can dream up. So if everyone believes it has value then it will continue to be a store of value. However, with the quantitative easing and the recent loans to banks in the euro zone there is a greater chance that investors will be seeking an alternative to money as they try to maintain the purchasing power of their assets. There is a lot of instability in the market place which will no doubt keep Gold prices pushing towards that US$2,000 target once again.

Japan Earthquake and Gold Prices

March 14, 2011 Leave a comment

With the huge earthquake and tsunami in Japan one wasn’t surprised that there was an increase in demand for gold. Investors generally buy gold as a hedge or safe haven against any economic or political event. In this case a natural disaster. Below is the price of gold – notice the increase in price to US$1431.60 per ounce.

This event reminded me of a scene from The Corporation DVD with Carlton Brown, a commodities trader at the NYSE. He describes the tragedy of 9/11 as a blessing in disguise because for some people, it translated into great riches. Brokers celebrated the death and destruction of the Iraq war because “in devastation, there is opportunity”. An unfortunate way to look at how the market sometimes works when you consider the death and devastation in Japan.

Return of the Gold Standard – Part 2

November 25, 2010 Leave a comment

Back in September this year I blogged on the return of the Return of the Gold Standard as with many countries now holding significant amounts of US dollars as reserves there is the probability that preference will be given to hold something else that maintains its value – gold is likely to be part of the mix. In recent months, worries about inflation and deflation and anxiety over the security of all sorts of financial instruments have seen the gold price surge. It has doubled from $700 to $1,400 an ounce in two years.

Robert Zoellick, president of the World Bank, recently argued that leading economies should consider adopting a modified Gold Standard. Does some modified version of the Gold Standard offer a way out of our current travails? The subsequent 40 years have seen wild swings in currency values, prolonged periods of high inflation and several acute financial crises. So you can readily see why some people support resurrecting gold’s monetary role. However according to Roger Bootle of Capital Economics in London there are 4 strong arguments against:

1. The Gold Standard helped to sustain long-term price stability, it did not achieve anything like price stability in the short run eg. the UK experienced deflation of 14pc. Yet by 1825 this had given way to inflation of 17pc.

2. The idea that gold offers a guarantee of stable money values in the long run, and therefore supports confidence and long-term decision-making, is a delusion.

3. It is a fallacy to think that a return to a system based on gold would end financial instability. The 1920s asset boom, and the crash of 1929 which followed, occurred while the US was on the Gold Standard.

4. The world’s supply of gold tends to rise at a much slower rate than the trend growth of real and financial activity which would govern the demand for it. This means that the system would display a marked deflationary bias.

Economists have been partial to the thought of a global monetary standard based on a basket of commodities. This would take money creation out of the hands of governments and lay down a more stable system than one based purely on gold alone. China has floated a variant of this idea, suggesting a currency based on 30 commodities along the lines of the Bancor proposed by John Maynard Keynes.

The Bancor was a World Currency Unit of clearing that was fixed in terms of commodities of which
one would be gold. It would stabilize the average prices of commodities, and with them the
international medium of exchange and store of value. Central to Keynes’ proposal was to tax
countries’ current account surpluses, encouraging domestic demand and promoting global trade
balance.

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