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EXCHANGE RATE DETERMINATION

How the rate of exchange is determined when both countries are on the gold standard? Gold standard:
The gold standard is a monetary system in which the standard economic unit of account is a fixed mass of gold. There are distinct kinds of gold standard. First, the gold specie standard is a system in which the monetary unit is associated with circulating gold coins, or with the unit of value defined in terms of one particular circulating gold coin in conjunction with subsidiary coinage made from a lesser valuable metal. Similarly, the gold exchange standard typically involves the circulation of only coins made of silver or other metals, but where the authorities guarantee a fixed exchange rate with another country that is on the gold standard. This creates a de facto gold standard, in that the value of the silver coins has a fixed external value in terms of gold that is independent of the inherent silver value. Finally, the gold bullion standard is a system in which gold coins do not circulate, but in which the authorities have agreed to sell gold bullion on demand at a fixed price in exchange for the circulating currency. There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. If, for example, it is determined that the value of a single unit of local currency is equal to USD 3.00, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank which it can use to release (or absorb) extra funds into (or out of) the market. This ensures an

appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

History:
Beginnings

The gold specie standard was not designed, but rather arose out of a general acceptance that gold was useful as a universal currency.[1] When commodities compete for the role of money, the one that over time loses the least value takes on the role. The use of gold as money dates back thousands of years and the first known gold coins were minted in the kingdom of Lydia in Asia Minor around 610 BC. The first coins minted in China are thought to date around 600 BC. During the middle Ages, the Byzantine gold Solidus, commonly known as the Bezant, circulated throughout Europe and the Mediterranean. But as the Byzantine Empire's economic influence declined, the European world tended to see silver, rather than gold, as the currency of choice, leading to the development of a silver standard. Silver pennies, based on the Roman Denarius, became the staple coin of Britain around the time of King Offa, circa AD 796, and similar coins, including Italian denari, French deniers, and Spanish dineros circulated throughout Europe. Following the Spanish discovery of great silver deposits at Potos and in Mexico during the 16th century, international trade came to depend on coins such as the Spanish dollar, Maria Theresa thaler, and, in the 1870s, the United States Trade dollar. In modern times the British West Indies was one of the first regions to adopt a gold specie standard. Following Queen Anne's proclamation of 1704, the British West Indies gold standard was a de facto gold standard based on the Spanish gold doubloon coin. In the year 1717, master of the Royal Mint Sir Isaac Newton established a new mint ratio between silver and gold that had the effect of driving silver out of circulation and putting Britain on a gold standard.

However, only in 1821, following the introduction of the gold sovereign coin by the new Royal Mint at Tower Hill in the year 1816 was the United Kingdom formally put on a gold specie standard, the first of the great industrial powers. Soon to follow was Canada in 1853, Newfoundland in 1865, and the USA and Germany de jure in 1873. The USA used the Eagle as their unit, and Germany introduced the new gold mark, while Canada adopted a dual system based on both the American Gold Eagle and the British Gold Sovereign. Australia and New Zealand adopted the British gold standard, as did the British West Indies, while Newfoundland was the only British Empire territory to introduce its own gold coin as a standard. Royal Mint branches were established in Sydney, New South Wales, Melbourne, Victoria, and Perth, Western Australia for the purpose of minting gold sovereigns from Australia's rich gold deposits. The crisis of silver currency and bank notes (17501870): In the late 18th century, wars and trade with China, which sold to Europe but had little use for European goods, drained silver from the economies of Western Europe and the United States. Coins were struck in smaller and smaller numbers, and there was a proliferation of bank and stock notes used as money. England In the 1790s, England, suffering a massive shortage of silver coinage, ceased to mint larger silver coins and issued "token" silver coins and overstruck foreign coins. With the end of the Napoleonic Wars, England began a massive recoinage programme that created standard gold sovereigns and circulating crowns and half-crowns, and eventually copper farthings in 1821. The recoinage of silver in England after a long drought produced a burst of coins: England struck nearly 40 million shillings between 1816 and 1820, 17 million half crowns and 1.3 million silver crowns. The 1819 Act for the Resumption of Cash Payments set 1823 as the date for resumption of convertibility, reached instead by 1821. Throughout the 1820s, small notes were issued by regional banks, which were finally restricted in 1826, while the Bank of England was allowed to set up regional branches. In 1833, however, the Bank of England notes were made legal tender, and redemption by other banks was discouraged. In 1844 the Bank

Charter Act established that Bank of England Notes, fully backed by gold, were the legal standard. According to the strict interpretation of the gold standard, this 1844 act marks the establishment of a full gold standard for British money. US The US adopted a silver standard based on the Spanish milled dollar in 1785. This was codified in the 1792 Mint and Coinage Act, and by the Federal Government's use of the "Bank of the United States" to hold its reserves, as well as establishing a fixed ratio of gold to the US dollar. This was, in effect, a derivative silver standard, since the bank was not required to keep silver to back all of its currency. This began a long series of attempts for America to create a bi-metallic standard for the US Dollar, which would continue until the 1920s. Gold and silver coins were legal tender, including the Spanish real, a silver coin struck in the Western Hemisphere. Because of the huge debt taken on by the US Federal Government to finance the Revolutionary War, silver coins struck by the government left circulation, and in 1806 President Jefferson suspended the minting of silver coins. The US Treasury was put on a strict hard-money standard, doing business only in gold or silver coin as part of the Independent Treasury Act of 1848, which legally separated the accounts of the Federal Government from the banking system. However the fixed rate of gold to silver overvalued silver in relation to the demand for gold to trade or borrow from England. The drain of gold in favor of silver led to the search for gold, including the California Gold Rush of 1849. Following Gresham's law, silver poured into the US, which traded with other silver nations, and gold moved out. In 1853, the US reduced the silver weight of coins, to keep them in circulation, and in 1857 removed legal tender status from foreign coinage. In 1857 the final crisis of the free banking era of international finance began, as American banks suspended payment in silver, rippling through the very young international financial system of central banks. In 1861 the US government suspended payment in gold and silver, effectively ending the attempts to form a silver standard basis for the dollar.

International Through the 18601871 period, various attempts to resurrect bi-metallic standards were made, including one based on the gold and silver franc; however, with the rapid influx of silver from new deposits, the expectation of scarcity of silver ended. The interaction between central banking and currency basis formed the primary source of monetary instability during this period. The combination that produced economic stability was a restriction of supply of new notes, a government monopoly on the issuance of notes directly and, indirectly, a central bank and a single unit of value. Attempts to avoid these conditions produced periodic monetary crises. As notes devalued; or silver ceased to circulate as a store of value; or there was a depression as governments, demanding specie as payment, drained the circulating medium out of the economy. At the same time, there was a dramatically expanded need for credit, and large banks were being chartered in various states, including, by 1872, Japan. The need for a solid basis in monetary affairs would produce a rapid acceptance of the gold standard in the period that followed. Japan By way of example, and following Germany's decision after the FrancoPrussian War (1870-1871) to extract reparations to facilitate a move to the gold standard, Japan gained the needed reserves after the Sino-Japanese War of 18941895. Whether the gold standard provided government sufficient bona fides when it sought to borrow abroad is debated. For Japan, moving to gold was considered vital to gain access to Western capital markets. The gold exchange standard (18701914): Towards the end of the 19th century, some of the remaining silver standard countries began to peg their silver coin units to the gold standards of the United Kingdom or the USA. In 1898, British India pegged the silver rupee to the pound sterling at a fixed rate of 1s 4d, while in 1906, the Straits Settlements adopted a gold exchange standard against the pound sterling with the silver Straits dollar being fixed at 2s 4d.

At the turn of the century, the Philippines pegged the silver Peso/dollar to the US dollar at 50 cents. A similar pegging at 50 cents occurred at around the same time with the silver Peso of Mexico and the silver Yen of Japan. When Siam adopted a gold exchange standard in 1908, this left only China and Hong Kong on the silver standard. Adopting the gold standard many European nations changed the name of their currency from Rixdaler (Sweden and Danemark) or Gulden (AustriaHungary) to Crown, since the former ones were traditionally associated with silver coins and the latter with gold coins. Impact of World War I (191425): Governments faced with the need to fund high levels of expenditure, but with limited sources of tax revenue, suspended convertibility of currency into gold on a number of occasions in the 19th century. The British government suspended convertibility (that is to say, it went off the gold standard) during the Napoleonic wars and the US government during the US Civil War. In both cases, convertibility was resumed after the war. The real test, however, came in the form of World War I, a test "it failed utterly" according to economist Richard Lipsey. In order to finance the costs of war, most belligerent countries went off the gold standard during the war, and suffered significant inflation. Because inflation levels varied between states, when they returned to the standard after the war at price determined by themselves (some, for example, chose to enter at pre-war prices), some countries' goods were undervalued and some overvalued. Ultimately, the system as it stood could not deal quickly enough with the large deficits and surpluses created in the balance of payments; this has previously been attributed to increasing rigidity of wages (particularly in terms of wage cuts) brought about by the advent of unionized labor, but is now more likely to be thought of as an inherent fault with the system which came to light under the pressures of war and rapid technological change. In any case, prices had not reached equilibrium by the time of the Great Depression, which served only to kill it off completely. For example, Germany had gone off the gold standard in 1914, and could not effectively return to it as Germany had lost much of its remaining gold reserves in reparations. The German central bank issued unbaked marks

virtually without limit to buy foreign currency for further reparations and to support workers during the Occupation of the Ruhr finally leading to hyperinflation in the 1920s.

Exchange rate:
In finance, an exchange rate (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one countrys currency in terms of another currency. [1] For example, an interbank exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (US$) means that 91 will be exchanged for each US$1 or that US$1 will be exchanged for each 91. Exchange rates are determined in the foreign exchange market,[2] which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as travelers chouse) or electronically (such as a credit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some dealers on the other hand prefer documentary transactions because of the security concerns with cash. Rate of exchange under Gold Standard: When the two countries concerned are on gold standard as already explained their currency units are either gold coins or are convertible into gold at fixed rates. Moreover gold freely moves between the countries. The par of

exchange between such countries is called the mint par of exchange. This is arrived at by equating the amount of gold contained in the currency units of the two countries .There can a silver standard country. For instance, before 1914, England and France were both on gold standard .Their mint par of exchange could be calculated as above. Tl.e mint par between London and Paris was 25.2215 francs to 1.If the exchange is at par, under these conditions a French importer would get 1 in London by paying 25.2215 francs in Paris to meet his liability. An English importer would get 25.2215 francs in Paris by paying 1 in London. Specie points: Now suppose the French people have to make more payments to the English people than the latter have to make to make to the former. The demand for the English currency in France will be greater than its supply. The value of the will has to pay more than 25.2115 francs in order to get 1 in London. How much more will he be willing to pay? We have already said that an importer will send gold if he can get it and thinks it cheaper to send in. Gold standard countries always provide gold in exchange for their currency and allow it to leave the country .But gold involves cost of transport when it has to be sent out. The importer in France will ,therefore only send gold if the rate of exchange is higher than the par to the extent of more than the cost of transporting gold from Paris to London.

One English Sovereign =7.98815grammes of gold 11/12 fine =7.32238grammes of pure gold. One French Napoleon(20 francs)=6.45161grammes of gold 9/10 fine =5.80645grammes of pure gold. Therefore ,one Sovereign =(7.32238*20)/5.80645francs =25.2215 francs.
Suppose the cost of transporting 25.2215 francs worth of gold from Paris to London is .3franc.Then it will be worthwhile sending gold if the exchange

rises above 25.2215 francs to the by more than .3 franc. If exchange actually rises above this point gold will begin to move out from France to England .This point is thus called gold export point from the point of view of France and gold import point from that of England .This point is obtained by adding the cost of transport to the mint par of exchange. It is also called the gold export point or the upper specie point. In the same way, there is a lower specie point or gold import point for France and gold export point for England .This is obtained by deducting the cost of transport from the mint par. In the above example, it will be 24.9215 francs to the . If the exchange falls below this point, the English importers will send gold rather than purchase title to francs. Two limits. Thus ,if gold is available and is allowed to move freely between two countries , the rate of exchange will move between the two limits set by the upper and the lower gold points ,also called the specie points .If , however ,gold is not available , the rate of exchange will pass beyond the specie points .These are tow limits within which the fluctuations will be caused by the changes in supply of and the demand for foreign currency like bills ,drafts ,T.T etc.

Determination of Exchange Rate under Mint Parity Theory:

The mint parity theory states that under gold standard, the exchange rate tends to stay close to the ratio of gold values or the mint parity or par. In other words, the rate of exchange between the gold standard countries is determined by the gold equivalents of the concerned currencies. According to S.E. Thomas, "The mint par is an expression of the ratio between the statutory bullion equivalents of the standard monetary units of two countries on the same metallic standard". Thus, when the currencies of different countries are defined in gold, the exchange rate between such countries is automatically determined on a weight-to-weight basis of the gold content of their currencies, after making allowance for the purity of such gold content of these currencies. For example, before World War I, both England and America were on gold standard. The British pound contained 113.0016 grains of gold and the American dollar contained 23.2200 grains of gold.

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The exchange rate between the British pound and the American dollar was determined on the basis of the mint parity and was equal to the ratio of the gold content of the two currencies.

Exchange between Gold and Silver standards:

The above is a case where both the countries concerned are on gold standard .If however one is on gold standard and the other on silver standard, the par of exchange will be determined by the price of gold in terms of silver in terms in the countries on the silver, and price of silver in terms of gold in the gold standard country. This discussion is now of purely academic interest.

Purchasing power parity (PPP) theory:

Most difficult case is that of countries both having inconvertible paper currencies. Suppose England and France were both on paper currencies inconvertible into metal. Obviously as many as would have the same purchasing power in France as one has in England, if 1 in England purchases a collection of x commodities, the 1 will purchase as many francs in France as will buy the same collection of x commodities in France allowing for the cost of transporting commodities from one countries to the other. Let us suppose that England 1 purchases x commodities and in France, X commodities cost 25 francs. Then the rate of exchange will obviously tend to be 1= 25 francs Now suppose the price level in the two countries remain the same but some how exchange move to 1= 30 francs This means purchasing power of 1 in France is more than 25 francs. It will pay people to convert sterling into francs at this rate , purchase X commodities in France for 25 francs and sell them in England for 1 again, making a profit of 5 francs per worth of transaction. This will create a large demand for francs in England, while supply thereof will be less because very few people export commodities from England to France. The value of the francs in terms of the pound will , therefore , move up until it reaches 1= 25 francs . At that point import from France will not give abnormal profits. 1= 25 francs is called Purchasing power parity between two countries.

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Advantages & Disadvantages of the Gold Standard:

The gold standard is the controversial practice of backing a national currency with the value of gold. Currency on the gold standard could be redeemed for an equal amount of gold at any time since the currency is essentially a promissory note for the precious metal. Advocates of the gold standard say it gives real value to currency instead of the imaginary value of currency today. Detractors say the gold standard is too rigid and restricts economic policy in times of financial turmoil. Inflation: An advantage of the gold standard is that it prevents inflation that can occur when a government prints too much currency. If a nation begins flooding the economy with extra currency, each unit of currency buys less and less. Eventually the currency becomes worthless. Under the gold standard, the government can only print as much money as they have gold in their vaults. The currency always has value because it is backed by gold. Supply: A disadvantage of the gold standard is that there is a limited supply of gold. If nations can only print as much currency as they can back with gold, there could be a shortage of money. History shows that money shortages lead to hording. This stifles economies as people buy and sell less. World Trade: An advantage of the gold standard is that it stabilizes world trade. Different currencies have different values relative to each other. These exchange rates can fluctuate wildly depending on economic conditions. Nations with stable currencies are reluctant to accept less stable currencies for fear that they will be devalued. The gold standard places all nations on equal footing. If all currencies are backed by gold, all trading partners know that they can redeem the gold in lieu of the currencies. There is no fear of devaluation.

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Economic Policy: A disadvantage of the gold standard is that it restricts the ability of governments to make economic policy. A common practice during tough economic times is to increase the money supply to stimulate the economy. This would not be possible under the gold standard since currency supply is limited by the gold supply. Currency can only be increased as more gold is mined or purchased.