Class questions: July 3, 2013
Lecture #9
ECON 4322-01
Major topics to be covered on July 8, 2013 include:
o Interwar period
o International comparison of countries using the gold standard during
the Great Depression
o Aspects of Bretton Woods
ƒ Reading coverage: Chapter 2
1. The gold standard and the price specie flow mechanism
a. Suppose the United States employs a classic gold standard. Initially, the
US official settlements balance is zero.
Suppose as a result of a shift in preferences, the demand for imports
increases. To settle the transactions, US importers will ultimately
exchange dollars for gold at the US central bank (say the Federal Reserve)
and exchange gold for imports.
Holding everything else equal, how is the official settlements balance
initially affected as a result? Please discuss.
The Federal Reserve depletes their holdings of official assets, which
ultimately leads to a surplus in their official reserve account. The official
reserve surplus is offset by an official settlements deficit.
b. As gold flows out of the country, how is the money supply and the
inflation rate affected?
As importers exchange dollars for gold and ship it out of the country, the
money supply contracts. A decrease in the money supply causes inflation
to decrease.
c. Refer to your answer in part b. How does the change in the inflation rate
described there affect foreign demand for US exports? As a result, what
happens to the flow of gold?
A decline in aggregate prices in the United States will cause the demand
for US goods and services to increase. Foreign entities will exchange
gold for the goods they buy, causing gold to flow back into the United
States.
d. Please discuss how your answers in parts (a)-(c) are related to what we
defined in class as the price-specie flow mechanism.
The flow of gold will ultimately eliminate any balance of payments
disequilibria (an official settlements surplus or deficit). Above, initially
gold flowed out of the country, which created an official settlements deficit
that was offset by an official reserve surplus. However, as the money
supply declined, inflation fell in the United States, which reversed the flow
of gold, causing gold to flow back into the country. The flow of gold back
into the United States eliminates (or at least mitigates) the original
surplus in the official reserve account in the United States, also
eliminating the official settlements deficit.
With a properly functioning gold standard, where all countries abide by
the rules of the game without sterilizing the flow of gold, the flow of gold
will eliminate balance of payments disequilibria automatically. This
defines what David Hume, a Scottish economist/philosopher that lived in
the 18th century, coined the price-specie flow mechanism. This mechanism
contrasts with the functioning that occurs under a typical fixed exchange
rate system today. As we will see, under a fixed exchange rate system,
when a country experiences a trade deficit that is not offset by the private
flow of capital, the central bank must step in and sell foreign currency.
There is no automatic mechanism that will eliminate an initial official
settlements deficit.