Floating Exchange Rate and Gold Standard


Floating exchange rate (FER) is a state whereby a country’s money value is determined by the value of money in the international market depending on demand and supply of other currencies. The concept is contrary to the fixed exchange rates, where the government determines the rate in a predominant way (Mele, 2019, p. 1). The FER systems imply that a long-term currency price reflects the changes subject to the economic strength and differentials of interest rates between countries. The moves in short-term in a floating exchange rate currency indicate speculation, daily demand, and supply of the currency (Krause, 2019, p. 6). In a case where supply outshines demand, the value of the currency would fall, but if the demand outstrips supply that currency worth might go up.

In situations of extreme short-term public debt, the central banks can intervene even in an environment of floating rate. Although major global currencies may consider floating governments and central banks may intervene in case the country’s currency goes too high or too low. Therefore, the state government might intervene to implement measures which balance their currency to a favourable price. The floating exchange rate operates in an open market with assumptions where the price is driven by demand and supply forces (Ilzetzki, Reinhart and Rogoff, 2019, p. 599). The FER structured shows that the changes occurring in the long-term currency prices represent the comparative economic strength and the modifications in interest rates in different countries.

The market sentiment for a country’s economy influences the perception of whether strong or weak the floating currency is, for example, a nation’s currency may depreciate if the market sees the government as unstable (CFI, 2020, para. 3). The government does not entirely determine the FER, but it can intervene if the value of the currency very low or too high to balance the price. The graph shows that an increase in the supply of currency S1 to S2 for the same demand D1 indicates that the price of the currency might depreciate (CFI, 2020, para. 3). On the contrary, an increase in demand D1 to D2 supplied at the same rate leads to an appreciation of the currency.

Floating Exchange Rate 
Figure 1. Floating Exchange Rate 

A shift in the exchange rates for a country helps to achieve the primary goal of a stable exchange rate. The rate is under the control of the international monetary system (IMS) which provides a set of policies and regulations for determining the rate for exchanging one currency for another (Saantana-Gallego and Pérez-Rodríguez, 2019, p. 88). The exchange rate regime involves the management of exchange rates of a monetary system while comparing with another country and the international market, which is depended on another monetary policy of different a country. Choosing a foreign exchange rate (FER) regime influences or determines the movement of FER between currencies and the fluctuation in the market.

In a situation where an arrangement to fix the currency’s exchange rate against the US dollar, it indicates that studying the market forces does not make sense in determining the rate of the currency. Currency regime links to a valuable product using gold or silver for establishing the currency value where the international exchange value of the currencies depends on the bullion value (Krause, 2019, p. 6). The problem of determining the exchange rate is to remove the restrictions placed on the financial capital movement, which happened during the 1970s. The strategy of the FER and IMS began in 1870 and marked the beginning of the gold standard.

Gold refers to the hardy perennial which provides a psychological and safe material haven for many individuals across the world, although its entreaty produces deep-seated visceral reactions to the larger group. In a situation where economic conditions are not favourable, individuals propose to strengthen gold roles in the monetary system to find an audience that is broader than the gold thugs (Chen and Ward, 2019, p. 165). The situation led to the view of the demise of the gold standard as the negative turning point for western civilization (Chen and Ward, 2019, p. 167). The exchange rate that was stable got into a time when there was an extremely unstable rate. The period continued until stability was achieved through the use of gold and silver coins marking a start of the international rate of the valuing currency.

The commodities, such as gold and silver, were used to determine the growth rate and establishment of the currency value. As the 19th century approached, European countries, the US, Japan and India used the same silver coins which were reflecting both the metallic and bimetallic standards (Gourinchas, Rey, and Sauzet, 2019, p. 875). However, the bullion content of its relative market price begun to vary with the exchange rate that showed the nominal rates. The exchange rates might be flexible to float on the foreign exchange market freely while fixed to a basket of currencies where the two situations exchange rate arrangements and combinations can exist.

The gold standard refers to the system with regular modification between the surplus and deficit countries where the central banks permitted the gold flow to control the money supply while playing by the rules of the game. The gold standard did not involve the entire world but only the major countries which were led by Britain among other countries (Alper, 2016, p. 146). As time passed by, financial started rising until he first world war where a flexible exchange rate system was adopted although some traders wished to go return to the gold standards, the available gold was not enough to meet the market demand of the prewar the fixed exchange rate.

The trade agreement continued until France decided to reject the pounds and to convert the foreign exchange holdings into gold during the great depression rose to a serious balance of payment difficulties in Britain. It is this time when policymakers decided to confront the situation of the stable economy through main objectives of stabilizing the exchange rate, enjoying the free international capital mobility, and engaging in monetary policy for orienting towards the domestic goals (Alper, 2016, p. 143). The Bretton system was thus formed and endorsed that caused the creation of national institutions such as the world bank and IMF. The IMF was given the role of supervising the new international monetary system and ensure the stability of the exchange rate while promoting international monetary cooperation through consulting and collaborating with international monetary problems (Alper, 2016).

The Gold Standard and the Effect of Changes in Domestic and Foreign Interest/Exchange Rates, How Does That Affect Monetary Policy?

Gold was a means of payment and was used to restore value during ancient times. It was used as a means of commitment through the participation of countries to stabilize the prices of domestic currencies for a certain amount of gold. Money and different forms of currency were converted to gold using a fixed price. During the time, the US was using the bimetallic standard and decided to switch to the gold standard after congress passed the Gold Standard Act (Officer, 2020, p. 614). Other countries also followed the gold business resulting in unparalleled economic growth with free trade. The gold standard started to break down during the first world war when the key belligerents resorted to inflationary funding and were later reinstated as Gold Exchange Standard (GES).

In this approach, nations held gold and dollars as assets except for the US and UK who used only gold. After Britain decided to leave gold at the time of massive gold but President Franklin D. nationalized privately owned gold by citizens and revoked the contracts which used gold as the means of payment. The Bretton system was thus adopted where countries paid their international balances using the dollars instead of gold using a fixed rate of 35 dollars in one ounce, but US deficits decreased the gold reserves (Accominotti, 2020, p. 633). Nevertheless, the ability of the US of redeeming the currency in gold reduced the confidence of the trade. In 1971, Richard M. Nixon, the president made an announcement that the US would no longer use gold as the exchange currency, and it marked the final step in deserting the gold standard.

The gold standard was formed to regulate domestic quantities and the country’s growth rate of the money supply. As the evolving gold production would increase by a small fraction of the accrued stock and due to guarantee given by the authorities on gold convertibility into non-gold money, the standard made sure that the money supply which was the price level had low variations. However, there were periodic surges of the globe’s stock of gold like the gold discovered in California and Australia that led to increased levels of prices to vary during the short-run (Seddon, 2020, p. 14). The gold standard became the international way to determine the value of a country’s currency compared to the currency of other countries. For countries which adhered to the set, regulations maintained a fixed gold price, and exchange rates between currencies related to golds were fixed.

Due to the fixed rates, the gold standard made the price levels to move together across the world using an automatic Balance of Payment (BOP) modification process known as price price-specie-flow. The central banks which existed at the time were supposed to play the game by raising the discount rates. Again, the interest rates were used by banks to lend money and had to speed up the gold inflow and lower the rates for facilitating a gold outflow (Dorn, 2020, para. 4). Therefore, as Dorn (2020) state, a country which had a BOP deficit had to allow a gold outflow according to the rules of the game until the price level and principal trade partners were reinstated based on the exchange rate. When Britain faced a BOP deficit, its bank of England indicated declined gold reserves, thus, raising the bank rate and made other interest rates increase in the UK. This caused inventories of other inventories and investments to go down, resulting in decreased overall domestic spending and the level of prices.

The golden value should not be seen as a panacea but one of the monetary arrangements in which many thrive to check arbitrary government. Many financial plans may exist, but most of them are imperfect which makes it necessary to choose an attainable alternative because tradeoffs always exist (Officer, 2020, p. 610). It is important to deliberate in a principled way of thinking about the monetary reforms and not agree to the status quo. Appealing the gold standards means arresting the control of issuing money out of imperfect human beings. The value of monetary policy prevents both inflation and deflation to support in promoting a financial environment which can achieve full employment (Murau, Rini, and Haas, 2020, p. 12). The gold standard shows that the supply of money would be determined by the amount of gold delivered, and, therefore, monetary policy would not be used for stabilizing the economy (Murau, Rini, and Haas, 2020, p. 14).

Even though the standard offers a long-run price has an association with the high short-run price instability. Schwarz argued that short-term price instability leads to fiscal variability because lenders and borrowers are not sure of the debt value. The competitive gold advertisement caused drastic local consequences as the central banks amplified their interest rates while the commercial banks were failing at thousands. The nominal interest rates remained down during this period, which encouraged central banks in the deflationary policies based on the expected depression while the real interest rates were very high (Seddon, 2020, p. 16). Due to the burden of public debt, banks were forced to collapse due to panic and bank runs, making others fail. The downfall led to decreased investments, employment rates, and output where a deflation followed during the great depression; monetary failures became common causing tension in banks which would have been averted if at all the policies were well strategized.

The introduction of paper money happened in the 16th century using debt tools given by private parties. As the gold and silver business dominated the money system, it was not until the eighteenth century that the paper method started to rule (Ljungberg and Ögren, 2019, p. 1). The struggle between gold and paper money would lead to a situation where gold standard might be considered, and the two would have to be interchanged. The 1789 Constitution in 1789 allowed coin money to be used and held power to control its value. Creation of a uniform currency led to a standardization of money system that consisted of circulating coin which was mostly the silver. The growing silver business prohibited gold from dominating the standard across the US. As WWII came to an end, the US had achieved the monetary gold of the world and the dollar being backed by gold directly.

Details of Mexican Peso crisis, investigation of the Portfolio Balance Model

In 1995, Mexico was in the grip of the financial crisis, and the foreign investors flew the Mexican nation regardless of the high-interest rates on its security, undervalue of the currency, and the fiscal indicators which showed the solvency in the long-term. The investors were afraid of defaulting and the probability of explosive inflation in the following months, which resulted in the collapse of the peso (Monras, 2020, p. 3040). Although the worries resulted from panic, economists argued that it was still the cause of the failure. However, the economy was not entirely accounted for the crisis, but debtors did not talk of insolvency risk, the percentage of GDP, and exports (Morales-Castroi, Ramírez-Reyes and Sanabria-Landazábal, 2020, p. 32). The exchange rate between the pesos and the dollar depreciated to six in one and led to Mexican currency depreciating beyond any corrected competition of the purchasing power.

The crisis was not caused by fiscal behaviours, unlike other countries in Latin America. The private sector borrowed more than the public sector as the latter one was involved in the situation by sterilizing the monetary effects of capital influx by giving the short-term securities for pesos and also for dollars. The main challenge was the risks involved in financial collapse as the investors were afraid of looming default on short-term debts especially the dollar one, banking system collapse, due to swift buildup of increased public debt and the spiral ruin of exchange rate (Martini, 2019, p. 2). Fears started lingering during the time of recording the worst fears to get over with the peso currency and the stock market. The doubts led to increased interest rates signalling the market expectations of a high evasion and additional depreciation.

Despite the implementation of North American Free Trade Agreement (NAFTA), Mexico’s macroeconomic was instable due to excess BOP deficits leading to the misalignment of the exchange rate of the peso-dollar. As the exchange was adopted, the fluctuation was abandoned because of the hypothetical attacks, and the floating rate was formed a 15% depreciation (García, Saucedo and Velasco, 2018, p. 33). After the formation of NAFTA, the inflows and trade from the direct investment went up critically. The 2000-2001 recession was caused by the downturn in economic operations in the US, resulting in a decline in the exchange rate of the peso-dollar. This indicated a target of the exchange rate reflecting the significant macroeconomic stability (García, Saucedo and Velasco, 2018, p. 33). The borrowing of the large amounts subject to Gross Domestic Product (GDP) did not imply a consumption binge nor was the nation getting into a dangerous new level of overall foreign indebtedness.

To understand Mexican panic’s roots is by tracing the evolution of its government liquid assets and liabilities during 1994. Research concerning the crisis was characterized into a short-run portfolio model and the portfolio balance model assuming imperfect the substitution level between local and foreign assets. Using the equations on reduced-form of exchange rate estimates a log-linear version of an equation which is the same as the one for mark-dollar exchange rates. The degrees can be compared to the balance model, although other factors are not significant about the first-order residual autocorrelation with the exclusion of the US’s money supply.

Regarding the capital account, Mexico’s law changed to allow investors to hold government bonds and purchase shares in different components of the economy. The changes in the policies combined with Mexico’s changing perception had to generate a capital inflow, which is the significant aspect in the short-term. The central bank had to sterilize the incursions through the issuance of short-term peso debt. The total domestic debt increased in 1994 under an absolute magnitude or a multiple of reserves (Tooze, 2018, p. 199). A panic situation happens when creditors believe that it is the government’s responsibility to default on the liabilities and bring to an end government lending. The disability of the government to roll over short-term credits and has to push for a more fulfilling default.

In pegged exchange rates, the risk of panic is exacerbated as the centre can lend the government credit to meet the domestic liabilities and keep the nation out of default. As the credit is being expanded, the exchange rate is undermined, implying that something needs to be given, known by markets. There is room to suggest that pegs exchange rates abs can render countries extremely vulnerable, even with the virtuous fiscal policies on the domestic level (Puaschunder, 2018, p. 226). Pegging is critical in stabilizing the economy, and to anchor expectations to permit remonetization is a priority. It is essential to stabilize an economy and get out of the exchange rate at a particular time. It is equally important to note that to either contend by a party; it saw the Mexican peso crisis to be a bellwether of troubles involved in emerging economies.

Other studies use a condensed portfolio rate of exchange of the balance model, which has been overwhelmed by theoretical uncertainties. They are caused by a specified small country, unreliable international bilateral data, irresponsible utilization of money, and the financial asset differences. The model determines the approach of the exchange rate to improve the model. The government had to intervene in the liquidity crisis by undervaluing pesos, which led to the unleashing of the financial uproar using the world scale (García, Saucedo and Velasco, 2018, p. 33). After that time, events were being examined, which were surrounding the peso’s devaluation with an intense impact rather than resolving the debate on managing the crisis in the overall economies. Economists argue that the government and economic institutions have the most significant role in preventing or stemming financial implosions.

Investors and free marketers have to reaffirm the fundamental conviction that domestic policies echo market forces, which are the most effective remedy to deal with the situations and discipline personnel. Regardless of the essential guidelines’ stable contention, interventionists found crucial common grounds for the peso crisis agreeing to develop countries (Boshkov, 2018, 87). The country should be alert over the budget and trade deficits, free bank credits, inadequate domestic savings, and excessive dependence on fueling domestic consumption, which is contrary to capital formation. The agreement is that the global community and private investors should demand higher openness on the monetary concerns to developing countries and that the worldwide institutions must improve the surveillance.

Reference List

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