Economics "Ask the Instructor" Clip 35 Transcript
When people in one country buy goods from people in another country, how do they pay?
The system used to make international payments has undergone a lot of change in the last 100 years.
Between 1879 and the beginning of WWI, the major countries of the world operated under the so-called gold standard. Under this arrangement each country held gold as a backing for its money. And each country’s money was defined in terms of so many ounces of gold and was convertible into gold. The U.S. dollar, for example, was equal to one-twentieth of an ounce; the British pound was equal to one-fourth of an ounce. This meant that one British pound was equal to five U.S. dollars.
Under the gold standard, any country buying more from foreigners than it sold to foreigners would tend to lose gold. Why? Let’s illustrate. Suppose that the U.S. imported more from Britain over the course of a year than it exported to Britain. This would mean that the British exporters, taken as a whole, would end up with more U.S. dollars than they needed for the purchase of U.S. goods. They would tend, therefore, to convert the excess dollars that they had earned into gold at the official rate of $20 an ounce. Another way to put it, because the U.S. did not export enough goods to pay for its imports, it would have to export gold. Why gold? Because gold was the agreed upon international currency.
The gold standard embodied an automatic adjustment process that eliminated prolonged periods of balance of trade surpluses and deficits. We just saw that a country running a trade deficit would lose gold to countries running surpluses. The loss of gold had the effect of reducing the price level thus making its exports more attractive. In contrast, the influx of gold into the country running a trade surplus resulted in an expansion of its money supply causing the price level to rise, reducing the attractiveness of its exports.
Many countries abandoned the gold standard during or after WWI. The gold standard was officially replaced by the U.S. dollar standard in 1944 at a series of meetings held at Bretton Woods, N.H.. Under this new system, each non-communist country defined its currency in terms of the dollar. The dollar, in turn, was defined as one-thirty-fifth of an ounce of gold. (Notice that the dollar had implicitly been devaluedcompared to the years prior to WWI). The U.S. had most of the world’s supply of gold and promised to convert dollars held by foreign monetary authorities (like the Bank of England) into gold at the rate of $35 to an ounce. This seemed to work pretty well during the 1950s and 1960s. However, countries running persistent trade deficits were permitted to devalue and they sometimes did it. For example, a country that previously said its currency was worth one-half U.S. dollar might declare a lesser value of, say one-fourth of a dollar. These devaluation’s often took place over the weekend and the surprises were quite disruptive. The expectation of devaluation had often led currency traders to sell off the “weak” currency, which tended to full-fill the prophecy.
Free market economists like Milton Friedman had long argued that it was silly to fix the price of currencies. They advocated flexible or floating exchange rates. They got their wish on August 15, 1971. On this Sunday evening, President Richard Nixon announced that the U.S. would no longer convert dollars held by foreign monetary authorities into gold. And that was the end of the so-called Bretton Woods international monetary system, which was based on a fixed rate exchange and it was the beginning of today’s floating system..
The world’s trading partners continue to operate under a generally flexible exchange rate system. From time to time, however, countries attempt to nudge a currency either up or down. They do this by having their monetary authority (in the case of the U.S., it would be the FED) either buy or sell their currency. This practice has led to the expression “dirty” float, but the official term is managed float system.