Fixed Exchange Rates in Three Periods

Trade created a global economy in the 1800s and lower transactions costs stimulated trade. An important element was establishment of an acceptable and efficient means of international payment. The development of the Gold Standard (GS) in some ways paralleled the development of national monies but with difference that no state could enforce its use as legal tender.
1897 – 1914:
The GS was established in 1800s by British and followed by other countries such the USA. Countries implementing the GS could convert their currencies into gold from gold into their currencies based on the exchange rate that was fixed. For instance, UK could convert pounds into gold (and vice versa) at 3 pounds 17 shillings and 10.5 pence per ounce, and the US could set the price of gold at $20.67 per ounce in 1834. The exchange rate between any pair of countries on the GS was fixed. Example one pound = $4.857.
Why had to be fixed? Fixed exchange rate could reduce uncertainty in trade. In addition it was easy for automatic adjustment process – the specie-flow mechanism. If the UK had a BOP deficit there would be an outflow of gold this leads to a decrease in money supply, thus price level would go down. This would encourage exports discourage imports. Hence reduce the BOP deficit.
Due to the UK pound at the time was as good as gold, other countries that had their accounts in London could address BOP deficit by running down their accounts while they took adjustment measures. Thus the system worked well to settle BOP imbalances as long as they were not large and there was a trust in London capital markets.
The GS became the international monetary system when the silver boomed and other on silver standard faced accelerating inflation. For instance, Austria and Russia gave up their free coinage of silver and joined the GS in the 1890s. By the 1897 the world economy was based on the GS.
1925 – 1933
Britain returned to GS in April 1925. To maintain exchange rate, the government maintained high interest rate in order to attract capital inflow. Due to high inflation rate the UK, market exchange rate in 1920-1921 was $3.50. UK government ran a contractionary fiscal policy that led to a reduction of wages about 40% the first half of the 1920s. UK pound increased in value over $4.50 by the end of 1924. The implementation of the contractionary policies from 1921 – 1931 had led UK to stagnation. At the time the UK economy grew very slowly – even during the global boom of the second half of the 1920s. It was the decade characterized by political conflict – general strike 1926. The Netherlands returned to the GS 1925 but its economy was less dramatic compare to UK because they had not suffered major fiscal dislocation during the War. In France, government expenditures exceed its revenues in the first half of 1920s (based on expected reparation). By 1926 the situation was verging on hyperinflation (and it was clear that Germany would never pay full reparations). Price increased dramatically (annual rate of 350% in the first half of 1926) and continuous short run debt which became harder to rollover. However, stabilization in 1926 enabled France to collect more tax and reduced government expenditures and increased investment. In 1928, France returned to gold standard at the current exchange rate of 20% of pre-war gold value. It was similar to France, Belgium franc was stabilized in 1926 at the rate of 1/7 pre-war value.
At the time output for Belgium, France, Italy and Germany was better but political conflicts remained. France and Italy were not satisfied with the benefits from winning the war while Germany economy affected by hyperinflation. Other countries, UK, Sweden, Denmark, the Netherlands and Spain, that were not affected by inflation turned to be lower output performance.
There was no problem with the pre-1914 GS because governments accepted automatic adjustment, however after 1919 governments were less willing to give up monetary policy independence. This caused BOP of some countries deficit while other surpluses.
Countries with BOP surpluses accumulated reserves and increased monetary base. This led an increase in price which cause rising in imports and reduced exports until the surplus country sterilizes. USA sterilized and ran BOP surpluses throughout the 1920s. This had attracted huge capital inflow (gold) without increasing price. And that put pressure on BOP deficit countries. Countries with BOP deficit lose reserves which led a decline in money supply and decrease in price. This caused goods in these countries became more competitive and exports had increased while imports declined until the deficit was eliminated. However it is harder for these countries to run deficits for long due to the loss of gold.
High interest rate in UK attracted huge capital inflow but caused unemployment to increase. France and Belgium had unvalued their currencies after 1928.
By 1928 the GS had been restored with some 50 nations on the GS. However, the system was unstable due to global imbalances. The BOP of the US was surplus while British and French deficits were not sustainable. And the system was vulnerable to real shocks. The decline in commodity prices in 1928-1929 drove Australia and other exporters off the GS in 1929. After 1929, lack of automatic adjustment or exchange rate flexibility contributed to making the 1930s depression global.
The decade after 1914 illustrated the potential importance of monetary policy, which allowed governments to increase its expenditures and financed the deficit by increased money supply which led hyperinflation in Germany, Austria and Hungary. Maintaining an overvalued exchange rate had also caused economic stagnation in UK. Lack of cooperation to reduce global imbalances contributed to instability. For instance, sterilization in the US put adjustment pressure on deficit countries, and undervalued French franc = beggar-thy-neighbour policy because not all countries could devalue and French exchange rate policy hurt those that did not like UK.
1958 – 1971
A feature of the post-1945 system was a belief that fixed exchange rate was necessary for a smoothly running global trading system. The designers (White and Keynes) recognized the shortcomings of the GS and of the competitive devaluations of the 1930s and tried to create a cooperative fixed exchange rate system.
Country still maintaining a fixed exchange rate however if a country run into a BOP deficit it could either do i) financing by using reserve assets to buy national currency; ii) controlling foreign exchange by limiting demand for foreign currency; iii) implement macro-policy (deflate by reducing demand for imports and increasing supply for exports and raising interest rate in order to attract capital inflow); and iv) devalue to a new fixed exchange rate.
Under the Bretton Woods ER system country implemented adjustable ERs. IMF lends to countries with short-term BOP problems, while fundamental disequilibria to be resolved by agreed change in ER. The system became operational after 1958 when major European currencies were convertible on current account.
At the time the US$ was convertible into gold at $35 per ounce but by the end of the 1950s US gold reserves were insufficient to cover its official liabilities . In 1968 a two-tier gold market was recognized – the value of gold in Central Bank reserves was decoupled from the market price of gold. Since the US dollar was set as dollar standard this made USA obtained seigniorage from issuing the world’s money.
Fixed ERs were unsustainable because governments were unwilling to allow BOP to rule macro policy. In UK BOP deficits led expectation of devaluation from 1964, and it was realized in Nov 1967. Inflation in France in 1968-9 led to devaluation in 1969 and asked for its US$ reserves to convert into gold, and low inflation in Germany contributed to an expectation of revaluation, and realized in 1969. Germany refused to revaluations in order to maintain export competitiveness and accepted inflationed US$ payments. Germany export-led growth could be sustained without inflation only with capital exports, hence German shift to liberalization of capital movements.

The 1960s loosening of the US monetary policy by printing US$ for Vietnam War and government spending increased dramatically for Great Society domestic programme. Excess US$ flow to export-countries such as Germany. In addition, the US government increase in taxes rates in 1968. All of these led to an increase in money supply which resulted in increase inflation from c2% in mid 1960s to greater than 5% in 1970. BOP deficit was the main reason for expectation of US$ devaluation but unclear how that could happen in the BW system where the dollar was the anchor currency.
Under a fixed exchange rate regime speculation attack was a one-way bet which could be led to quick gains for speculators at the expense of the CB. Although foreign exchange controls on capital account remained there was ways around them and capital markets were becoming more efficient.
In May 1971 DM fluctuating exchange rate and followed by Western European Union currencies. For instance, on May 4, 1971 German Central Bank bought $1 billion to maintain the fixed DM/$ER but the DM was floated in the next day. The CB recognized that it could not go on using its reserves to prop up the ER. In spite of this no one (speculators) who sold dollars to the German CB on May 4 could buy them back the next day at a lower price.
The Bretton-Woods system imposed free trade and trade-balance equilibrium , allowing financial national enclosure and domestic-intended monetary policy.
To maintain a fixed exchange rate systemt, all countries needed to revalue against the US$. On May 15, 1971 the US president, Nixon, announced a package of measures to stop selling gold to the central banks and a 10% surcharge on imports. The package was inttended to bring the other major trading partners to the negotiation table.