Automatic Price Adjustment under Gold Standard:
Under the international gold standard which operated between 1880-1914, the currency in use was made of gold or was convertible into gold at a fixed rate. The central bank of the country was always ready to buy and sell gold at the specified price. The rate at which the standard money of the country was convertible into gold was called the mint price of gold.
This rate was called the mint parity or mint par of exchange because it was based on the mint price of gold. But the actual rate of exchange could vary above and below the mint parity by the cost of shipping gold between the two countries. To illustrate this, suppose the US had a deficit in its balance of payments with Britain.
The difference between the value of imports and exports would have to be paid in gold by US importers because the demand for pounds exceeded the supply of pounds. But the transshipment of gold involved transportation cost and other handling charges, insurance, etc. Suppose the shipping cost of gold from the US to Britain was 3 cents. So the US importers would have to spend $ 6.03 ($ 6 +,03c) for getting Â£ 1.
This could be the exchange rate which was the US gold export point or upper specie point. No US importer would pay more than $ 6.03 to obtain Â£ 1 because he could buy $ 6 worth of gold from the US treasury and ship it to Britain at a cost of 3 cents per ounce. Similarly, the exchange rate of the pound could not fall below $ 5.97 in the case of a surplus in the US balance of payments.
Thus the exchange rate of $ 5.97 to a pound was the US gold import point or lower specie point. The exchange rate under the gold standard was determined by the forces of demand and supply between the gold points and was prevented from moving outside the gold points by shipments of gold.
The main objective was to keep BOP in equilibrium. A deficit or surplus in BOP under the gold standard was automatically adjusted by the price-specie-flow mechanism. For instance, a BOP deficit of a country meant a fall in its foreign exchange reserves due to an outflow of its gold to a surplus country. This reduced the country’s money supply thereby bringing a fall in the general price level.
This, in turn, would increase its exports and reduce its imports. This adjustment process in BOP was supplemented by a rise in interest rates as a result of reduction in money supply. This led to the inflow of short-term capital from the surplus country. Thus the inflow of short-term capital from the surplus to the deficit country helped in restoring BOP equilibrium.
Automatic Price Adjustment under Flexible Exchange Rates (Price Effect):
Under flexible (or floating) exchange rates, the disequilibrium in the balance of payments is automatically solved by the forces of demand and supply for foreign exchange. An exchange rate is the price of a currency which is determined, like any other commodity, by demand and supply. “The exchange rate varies with varying supply and demand conditions, but it is always possible to find an equilibrium exchange rate which clears the foreign exchange market and creates external equilibrium.”
This is automatically achieved by a depreciation (or appreciation) of a country’s currency in case of a deficit (or surplus) in its balance of payments. Depreciation (or appreciation) of a currency means that its relative value decreases (or increases).
Depreciation has the effect of encouraging exports and discouraging imports. When exchange depreciation takes place, foreign prices are translated into domestic prices. Suppose the dollar depreciates in relation to the pound. It means that the price of dollar falls in relation to the pound in the foreign exchange market.
This leads to the lowering of the prices of U.S. exports in Britain and raising of the prices of British imports in the U.S. When import prices are higher in the U.S., the Americans will purchase less goods from the Britishers. On the other hand, lower prices of U.S. exports will increase their sales to Britain. Thus the U.S. exports will increase and imports diminish, thereby bringing equilibrium in the balance of payments.
This analysis is based on the following assumptions:
1. There are two countries Britain and U.S.
2. Both are on flexible exchange rate system.
3. BOP disequilibrium is automatically adjusted by changes in exchange rates.
4. Prices are flexible in both the countries.
5. There is free trade between the two countries.
Given these assumptions, the adjustment process is explained in terms of Figure 1 where D is the U.S. demand curve of foreign exchange representing its demand for British imports, and S is the U.S. supply curve of foreign exchange representing its exports to Britain. At P the demand and supply of the U.S. foreign exchange is in equilibrium where the rate of exchange between U.S. dollar and British pound is OE and the quantity of exchange is OQ.
Suppose disequilibrium develops in the balance of payments of the U.S. in relation to Britain. This is shown by a shift in the demand curve from D to D1 and the incipient deficit equals PP2 .This means an increase in the U.S. demand for British imports which leads to an increase in the demand for pound. This implies depreciation of the U.S. dollar and appreciation of the British pound. As a result, import prices of British goods rise in the U.S. and the prices of U.S. exports fall.
This tends to bring about a new equilibrium at p1 and a new exchange rate at OE1 whereby the deficit in the balance of payments is eliminated, The demand for foreign exchange equals the supply of foreign exchange at OQ1and the balance of payments is in equilibrium.
When the exchange rate rises to OE1, U.S. goods become cheaper in Britain and British goods become expensive in U.S. in terms of dollar. As a result of changes in relative prices, the lower prices of U.S. goods increase the demand for them in Britain, shown by the new demand curve D1.
This tends to raise the U.S. exports to Britain which is shown as the movement from P to P1 along the supply curve S. At the same time, the higher price of British goods in terms of dollars tends to reduce demand for British goods and to switch demand to domestic goods in the U.S. This leads to the movement from P2 to P1 along the new demand curve D1. Thus the incipient deficit PP2 in BOP is removed by increase in the foreign exchange supplied by QQ1 and decrease in the foreign exchange demanded by Q2Q1 so that BOP equilibrium is achieved at the exchange rate OE1whereby OQ1 foreign exchange is supplied and demanded.
The above analysis is based on the assumption of relative elasticities of demand and supply of foreign exchange. However, in order to measure the full effect of depreciation on relative prices in the two countries, it is not sufficient for demand and supply conditions to be relatively elastic. What is Â£ important is low elasticities of demand and supply of foreign exchange.
This is illustrated in Figure 2 where the original less elastic demand and supply curves of foreign exchange are D and S respectively which intersect at P and the equilibrium exchange rate is OE. Now a deficit in the balance of payments develops equals to PP2. Since the elasticities of demand and supply of foreign exchange are very low (inelastic), it requires a very large amount of depreciation of the dollar and the appreciation of the pound for the restoration of the equilibrium.
The equilibrium will be established through relative price movements in the two countries, as explained above, at P1 with a very high rate of foreign exchange OE1. But such a high rate of depreciation would lead to very high price changes in the two countries thereby tending to disrupt their economies.
The practical use of flexible exchange rates is severely limited. Depreciation and appreciation lead to fall and rise in prices in the countries adopting them. They lead to severe depressions and inflations respectively.
Further, they create insecurity and uncertainty. This is more due to speculation in foreign exchange which destabilizes the economies of countries adopting flexible exchange rates. Governments, therefore, favour fixed exchange rates which require adjustments in the balance of payments by adopting policy measures.