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QUESTION TWO [30] Read the extract below and answer the questions that follow: Commentary: Should the US return to the gold standard? No Fifty years ago next month, with inflation rising and growing trade deficits, President Richard Nixon suspended the conversion of the U.S. dollar into gold. This decision effectively ended the Bretton Woods system - the final attempt at an international gold standard - and ushered in a new era of floating exchange rates between major currencies, rather than rates fixed by policymakers. The end of gold-backed money and fixed exchange rates has been controversial, but it remains the right decision. Ron Paul, a former U.S. congressman and presidential candidate, decided to first enter politics because of his disappointment with Nixon's decision. Some commentators have argued that floating exchange rates are a major source of instability and seek a return to some sort of Bretton Woods- style arrangement. Many argue that as a rules-based monetary policy, a new gold standard would constrain central banks (including the Federal Reserve) from creating inflation, and fiscal policymakers (including Congress) from running unhealthy budget deficits. While central banks should pursue a more accountable, rules-based approach to monetary policy, a new gold standard would do much more harm than good. In 1944, representatives from the Allied powers developed Bretton Woods for the postwar era. Their goal was to create a regime that produced exchange rate stability in a tumultuous world, while also giving each nation's central bank latitude to pursue their own policies. The dollar was set at $35 per ounce of gold. Other currencies, such as the British pound and German mark, were pegged to the dollar, but these pegs could be adjusted. It took nearly 15 years to get the system running, and even then, it suffered from major flaws that gave it a short lifespan. Challenges in the United States ultimately led to Bretton Woods' demise. Large trade deficits with West Germany and Japan and large budget deficits under the Johnson and Nixon administrations led to more U.S. dollars held abroad. Eventually, there was not enough U.S. gold to redeem those dollars. Recognising this, speculators sold their dollars, causing "runs" on the currency and making it even more difficult for the United States to maintain its exchange rates with other countries. Nixon suspended the dollar's conversion into gold, and although he announced that the suspension would be temporary, the system was never salvaged Page 2 of 5

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While one can argue that Bretton Woods used a poorly designed gold standard - giving too much room to governments to pursue monetary and fiscal policies and creating tension within the system - this does not mean we should return to another gold standard, even one like the relatively well- functioning pre-World War I "classical gold standard." The classical gold standard period was an era where central banks either did not exist or had much less discretion, where prices were more flexible, and where the public did not expect governments to provide modern social services. These conditions simply do not exist today. In at least some respects, central banks are already taking steps toward a more rules-based monetary system. Beginning in the 1990s, many began targeting 2% inflation, and inflation since then has generally been low across the developed world (the recent uptick notwithstanding). Last year, the Fed modified this goal by targeting 2% inflation on average over time, which means making up for past misses of the target. An even better goal would be to target total dollar spending in the economy, or nominal gross domestic product. Among the differences in this approach is that it allows inflation to rise temporarily in response to recessions. This reduces the severity of debt burdens and stimulates the economy's recovery. It also allows inflation to fall during economic booms, helping consumers. Moreover, nominal gross domestic product targeting can be rules-based, making policy more predictable and constrained. While a gold standard has appealing features in the abstract, implementing it is another story altogether. The Fed should instead focus on smoothing out business cycles here in the United States, and letting markets determine exchange rates. (Source: no/article 497f0939-fee6-5f42-9798-2704dff97674.html) 2.1 Taking the benefits of a flexible exchange rate system into consideration, defend the claim that returning to the gold standard would not be a good idea. (15) 2.2 Discuss the qualities of an efficient international monetary system that US should work towards. (15)

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Answer & Explanation
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Question 1

A flexible exchange-rate system is a monetary system that allows supply and demand to decide the exchange rate.

Every currency area must decide on the type of exchange rate system that will be used. They have distinct implications for the level of participation of national governments in foreign exchange markets. Post-Bretton Woods exchange rate regimes are divided into three categories based on their degree of flexibility: "fixed-rate regimes" include currency unions, dollarized regimes, currency boards, and conventional currency pegs; "intermediate regimes" include horizontal bands, crawling pegs, and crawling bands; and "flexible regimes" include managed and independent floats. Except for the permanently stable regime, all monetary regimes suffer from time inconsistency and exchange rate volatility, but to varying degrees.


Benefits of a flexible exchange rate system

  • Adjustable exchange rate system: If there is a dis-equilibrium in the BOP, it is automatically addressed with a change in the exchange rate. As a result, BOP will be stable.
  • It makes  foreign exchange unrestrained, currencies can be traded freely, and the bank and government are not required to intervene.
  • A floating exchange rate has a positive macroeconomic influence on the global market and improves company and market efficiency.
  • It is not necessary to hold substantial amounts of foreign currency reserves in order to preserve the exchange rate. As a result, the reserves can be used to help the economy thrive by importing capital goods.
  • Countries with a free exchange rate do not confront the problem of importing inflation due to balance-of-payments surpluses or increased import costs.

It is not a good idea to use the gold standard.

Between the wars, the gold standard posed the greatest threat to financial stability and economic growth.

The Federal Reserve's initial goal is to construct a policy rule and analyze policy in relation to a reference rule. The second tries to return the country to the gold standard in order to foster pricing and financial stability.


Drawbacks of reverting to the gold standard:

  • It will not give flexibility in the supply of money since the production of additional gold will not be sufficient to meet the demands of the global economy.
  • Using the gold standard will make it more difficult for countries to protect their economies against inflation or depression.
  • In order to maintain international exchange rate stability, the gold standard compromises domestic price stability. In fact, under the gold standard, inflation and deflation are unavoidable companions to a favorable and unfavorable balance of payments, respectively.
  • It's also a wasteful standard because gold coins go through a lot of wear and tear when they're in circulation.

Question 2

The International Maritime System (IMS) is a network of internationally agreed-upon laws and institutions that promote international trade between nations.


Bretton Woods System

Almost all major currencies were on the gold standard and used a fixed foreign exchange rate mechanism prior to World War I (1914 18). The IMF's second amendments transform the floating exchange rate system from one of free flexible rates to one of regulated floating rates.


International Gold Standard

The gold standard is a monetary system in which the value of a basic monetary unit, such as the dollar or the pound sterling, is set in gold. To keep the relationship between standard money and gold alive, the monetary authority allows currency to freely convert to gold and vice versa. It will also keep the price of gold stable by selling and purchasing gold as needed.

IMS Characteristics:

  • International Exchange Mediums:

The International Gold Standard is concerned with the currency's external worth and the issues of maintaining foreign exchange stability. As a result, you can swap your currency notes for cash.

  • Exchanges Rates Stability:
    It kept the exchange rate between countries steady. Every country's exchange rate was set in terms of its mint parent or the gold worth of its currency.

Levels of Price Parity:

The international gold standard ensures price parity between different countries throughout the world.

Standard Automated Laissez-faire:

The International Gold Standard has the advantage of being able to function in the absence of any other international authority.

IMS must meet certain criteria in order to be successful.

1. Adherence to the gold standard's rules.

If the game's rules are followed, everything runs smoothly. For the countries, these rules are not complicated, but they are simple to grasp and follow.

2. The effectiveness of IMS depends on maintaining exchange rate stability. Adjustments to the countries' internal price levels could be made to maintain exchange rate stability.

3. Wage flexibility: 

In order to preserve internal price stability, the wage rate should be stable.

4. Free-trade policy:

The success of the international monetary system depends on free trade. Imports from debtor countries are restricted by high tariffs imposed by creditor countries.

5. Debt-free status:

The enforcement of reparations and demand on the recovery of war debts make it harder for IMS weaponry to monopolize the foreign market.

Step-by-step explanation

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