How the exchange rate is determined when two countries are based on gold standard
When two countries have their currency based on gold standard, then in such a case the exchange rate determined between the two countries is referred to as the ‘minted rate of exchange’. Countries who have their currency based on gold standard exhibit the following characteristics :
(i) Gold coins circulate in these countries or the value of their legal tender is fixed in terms of gold.
(ii) There is free minting of currency.
(iii) Any other currency in circulation is convertible in gold.
(iv) There is no restriction on export and import of gold.
The government of the countries in which gold coins are in circulation declares that the currency in circulation contains a given percentage of gold. To as certain the exchange rate, the ratio of percentage of gold is ascertained and on this basis, the exchange rate is computed. According to Thomas, “Minting ratio is that ratio which is based on a metal and expresses the standard monetary units in terms of that metal.”
For example, let us assume that in two countries ‘X’ and ‘Y’ gold coins are in circulation. One unit of currency of country X contains 4 gms of gold and 40 units of currency of country Y contains 4 gms of gold, i.e. 1 unit of currency of country X= 4 gms of gold 40 units of currency of country Y = 4 gms of gold So, it follows that, 1 unit of currency of country X= 40 units of currency of country Y So, the exchange rate between country X and Y will be 1/40, i.e. 1unit of currency of country X will be equal to 40 units of currency of country Y.
The gold standard system was prevalent in the world before the first world war. During that period, one American dollar contained 23.22 grains of pure gold and one British pound contained 113.0016 grains of pure gold. So, on this basis, the exchange rate between British pound and American dollar was £= $4.8665.
Fluctuations of Exchange Rate in Gold Standard
The minting rate of exchange represents the basic character of the exchange rate. The actual rate of exchange can be different from this rate of exchange. Subject to certain limits, the exchange rate is allowed to fluctuate. The limits are decided on the basis of gold points or species. The exchange rate fluctuates between the upper gold point and the lower gold point. The upper gold point determines the upper limit which cannot be exceeded by the exchange rate. This point is also referred to as ‘gold export point’ because beyond this point, gold is exported from the country. The lower gold/specie point determines the lowest limit of the exchange rate beyond which the exchange rate cannot fall. This point is also referred to as ‘gold import point’ because beyond this point, gold is imported into the country. While deciding the above limits the transportation cost, packing and insurance cost of gold is also considered. Now we will discuss in detail about these two limits.
Upper Limit of Exchange Rate or Gold Export Point
As discussed above, before world war I, the exchange rate between pound and dollar was £= $5.8665. Now let us assume that trade exists between America and Britain and the cost of sending one pound worth of gold from America to Britain is 0.02 dollar. If this expenditure is added to the exchange rate then the upper limit can be computed which will be, £ 1 = $4.8665 +0.02, which will be £ 1 = $ 4.8865.
Now let us further assume that the quantum of exports from Britain to America tend to rise and exports are more than imports. Because of this, the demand for pound will rise and the dollar/pound exchange rate will rise, i.e. now pound will not be available for $ 4.8665. How much more is required to be paid depends upon the export cost of gold. We have just seen that to send one pound worth of gold from America to Britain the cost is $0.02. So, a trader in America is required to pay $4.8865 dollars for one pound. If the price of pound rises beyond this point, then America will start exporting gold and Britain will start importing gold. So, from the view point of America, this is the gold export point and from the view point of Britain, this is the gold import point.
Lower Limit of Exchange Rate or Gold Import Point
Keeping the above example in view, if the exports from Britain to America are less than the imports, then to make payments, the demand for American dollar will rise. Now one pound will not be able to fetch $4.8665. If the transportation expenses are still $0.02, then the lowest limit will be $4.8665-$0.02 $4.8465. The exchange rate should not be allowed to fall below this limit. If the rate of exchange falls below this limit, then from the view point of America, this is the gold import point and from the view point of Britain, this is the gold export point.
When there are changes in the minting rate, then such forces start to operate which tend to restore equilibrium in the rate of exchange. This is due to the price specie slow mechanism.
Importance of Gold Points-To determine exchange rate as per the gold standard gold, points play an important role as they help as to ascertain the limits of fluctuations.
