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The existence and argument for these types of fixed rates is that the fixed
exchange rate facilitates trade and investment between the two countries with
the pegged currencies. It can be especially beneficial for the smaller country,
which depends more heavily on international trade.
A fixed exchange rate also has its weaknesses; once pegged to a larger countrys
currency, the smaller country can lose some control over its domestic monetary
policy.
HISTORY:
In 1821-1914 Most of the Worlds currencies were redeemable into gold. (i.e.
you could "cash in" your paper notes for predefined weights of gold
coin).Britain was the first to officially adopt this system in 1821 and was
followed by other key countries during 1870s. The result was a global economy
connected by the common use of gold as money. Close to the end of World War
II, the Bretton Woods Agreement was signed. Since the impact of the Great
Depression was still fresh in the minds of the policymakers, they wanted to shun
all possibilities of a similar fiasco. The Bretton Woods Agreement founded a
system of fixed exchange rates in which the currencies of all countries were
pegged to the US dollar, which in turn was based on the gold standard. By 1970,
the existing exchange rate system was already under threat. The Nixon-led US
government suspended the convertibility of the national currency into gold. The
supply of the US dollar had exceeded its demand. In 1971, the Smithsonian
Agreement was signed. For the first time in exchange rate history, the market
forces of supply and demand began to determine the exchange rate.
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This occurs when the government seeks to keep the value of a currency between
a band of exchange rate. In other words, the exchange rate can fluctuate within a
narrow band .
Example; Exchange rate mechanism (ERM) that was a semi fixed exchange
rate where EU countries sought to keep their currencies fixed within certain
bands against the D-mark .The ERM was the forerunner of the Euro.
BRETTON WOODS SYSTEM:One of the important system in fixed exchange rate system is that Bretton
woods system.
After world war II , governments were determined to replace the gold
standard with a more flexible system.They set up the Bretton woods system ,
which was a system with fixed exchange rates. The innovation here was that
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exchange rates were fixed but adjustable.When one currency got too far out of
line with its appropriate or fundamental value , the parity could be adjusted.
The Bretton woods system functioned effectively for the quartercentury after World War II. The system eventually broke down when the dollar
became overvalued. The United States abandoned the Bretton woods system in
1973, and the world moved in to the modern era.
INTERVENTION: -
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Under the gold standard, a countrys government declares that it will exchange
its currency for a certain weight in gold. In a pure gold standard, a countrys
government declares that it will freely exchange currency for actual gold at the
designated exchange rate. This "rule of exchange allows anyone to go the
central bank and exchange coins or currency for pure gold or vice versa. The
gold standard works on the assumption that there are no restrictions on capital
movements or export of gold by private citizens across countries.
Because the central bank must always be prepared to give out gold in exchange
for coin and currency upon demand, it must maintain gold reserves. Thus, this
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system ensures that the exchange rate between currencies remains fixed. For
example, under this standard, a 1 gold coin in the United Kingdom contained
113.0016 grains of pure gold, while a $1 gold coin in the United States
contained 23.22 grains
Price specie flow mechanism:The automatic adjustment mechanism under the gold standard is the price
specie flow mechanism, which operates so as to correct any balance of
payments disequilibrium and adjust to shocks or changes. This mechanism was
originally introduced by Richard Cantillon and later discussed by David
Hume in 1752 to refute the mercantilist doctrines and emphasize that nations
could not continuously accumulate gold by exporting more than their imports.
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trading partner. For example, suppose India decided to fix its currency to the
dollar at the exchange rate E/$ = 45.0. To maintain this fixed exchange rate,
the Reserve Bank of India would need to hold dollars on reserve and stand
ready to exchange rupees for dollars (or dollars for rupees) on demand at the
specified exchange rate. In the gold standard the central bank held gold to
exchange for its own currency, with a reserve currency standard it must hold a
stock of the reserve currency
The fixed exchange rate system set up after World War II was a gold-exchange
standard, as was the system that prevailed between 1920 and the early 1930s.
[15]
All non-reserve countries agree to fix their exchange rates to the chosen
reserve at some announced rate and hold a stock of reserve currency assets.
2 http://www.goldmoney.com/gold-research/alasdair- macleod/a-history-of-exchange-rate-
systems.
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The reserve currency country fixes its currency value to a fixed weight in
gold and agrees to exchange on demand its own currency for gold with other
central banks within the system, upon demand.
3. Keep inflation Low. Governments who allow their exchange rate to devalue
may cause inflationary pressures to occur. This is because AD increases, import
prices increase and firms have less incentive to cut costs.
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BY
J.RAM VIGNESH
BA0140047
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