Fixed Rate System: Preview of Results Recall: i – i* =  -  * = Expected deprec of $ When $ can’t depreciate: i = i* … Monetary discipline  =  * … Price (and wage) discipline

Fixed Rate System: How it works Central bank (CB) buys and sells its currency ($) on foreign exchange markets to keep the exchange rate fixed It dips into its reserves of “gold” and foreign currencies to buy $ … keep $ from falling It buys reserves with $ … keep $ from rising When CB buys $ M and M* When CB buys reserves with $ M  and M* 

Fixed Exchange Rate System: Automatic Adjustment of BoP Recall: MV = PQ When S $ > D $ and the Central Bank buys excess $ M  … P  … X  … D $  M  … i  … Capital Inflows  … D $  M  … i  … Q  … Im  … S $  The balance of payments balances

Fixed Rate System: Discipline Wage and price discipline If W  and P  … D $  CB buys $ to keep $ from falling … M  … P  Monetary discipline If M  … P  and i  … X  and Capital Inflows  … D $  CB buys $ … M 

Gold Standard: The Mother of Fixed Rate Systems Money was either gold coin, currency backed by gold issued by central bank, or bank deposits backed by currency Each currency’s value was fixed in terms of gold, e.g., 1 oz. of gold = $22 Gold could flow freely internationally You could redeem your $ for gold, ship the gold to England (or France or wherever), and buy the local currency with the gold

Gold Standard: Automatic Adjustment Mechanisms Humian Mechanism P  … D $  … BoP Deficit … Gold Outflow … M  … P  Interest Rate Mechanism P  … D $  … BoP Deficit Threatens … “Bank Rate”  … Capital In Income Mechanism P  … D $  … BoP Deficit Threatens … “Bank Rate”  … I  Q  Im 