1. The Gold Standard Lecture 12 – Tuesday, 20 October 2009J A Morrison Isaac Newton David Hume

2. Admin • Papers Returned • Upcoming Events • 7 PM, Tues, 27 Oct: Screening of Niall Ferguson’s The Ascent of Money (2009) • Thurs, 29 Oct: Deadline for Second Discussion Post

3. The Gold Standard • Leftovers: Exchange Rates in the Balance of Payments • The “Gold Standard” as an Ideal Type • The Reality of the Gold Standard • Conclusion

4. The Gold Standard • Leftovers: Exchange Rates in the Balance of Payments • The “Gold Standard” as an Ideal Type • The Reality of the Gold Standard • Conclusion

5. Last time, we didn’t finish the lecture. So, we have some leftovers…

6. Last Thursday’s Lecture: Int’l Monetary Exchange in Theory • Introductory: Money is Hard • The Basics of Monetary Exchange • The International Connection • The Nth Currency • Exchange Rate Regimes • The Balance of Payments • Managing the Monetary System Cover this Today Moved to Lecture 14

7. Bunsen, I thought we were done with the balance of payments!!! Well, Dewb, I thought you could use a refresher...

8. Remember that the balance of payments (BoP) reconciles all of a country’s financial transactions with the world.This includes trade, remittances, investment, loans, &c.

9. You should also remember that the ER regime determines, in part, how balance in the BoP is maintained.

10. BoP Adjustment where British Pound is Flexible

11. BoP Adjustment where British Pound is Fixed

12.  The ER regime determines whether these adjustments happen through the marketor throughintervention by the monetary authority.

13.  So, again, note that the regime is determined by what the monetary authority actually does, not what it promises to do.

14. The Gold Standard • Leftovers: Exchange Rates in the Balance of Payments • The “Gold Standard” as an Ideal Type • The Reality of the Gold Standard • Conclusion

15. Remember our understanding of an exchange rate: the valuation between the domestic currency and foreign currency/currencies.

16. In theory, the gold standard(GS) was an exchange rate regime that related the member countries’ currencies through their valuations to gold.

17. Gold as an Intermediary $ £ ¥ € Example: £1 = 1 oz gold = $4.86

18. In 1925, Keynes elaborated the “rules of the gold standard game.” The rules were simple: (1) maintain exchange rate stability; (2) maintain convertibility between domestic currency and predetermined amount of gold.

19. The gold standard, as it existed in theory, was an ideal type. It was meant to embody the complete integration of domestic and foreign financial markets. The gold standard was meant to achieve purchasing power parity…

20. II. THE GOLD STANDARD AS AN IDEAL TYPE Purchasing Power Parity The Automaticity of the Gold Standard

21. Purchasing Power Parity (PPP) • Purchasing power: command over goods and services • $919.50 = 1 oz gold • £639.43 = 1 oz gold • PPP: unit of currency enjoys the same purchasing power in every market even after making necessary conversions • Implied PPP (based on gold prices): $1 = £0.695 • PPP can be calculated using any “basket” of goods & services • The Economist uses the Big Mac!

22. PPP versus Market Rates • Implied PPP (from gold prices): $1 = £0.695 • If I can trade $1 for £0.695, I should be able to buy gold at the same “price” in GB and in the US • BUT Market Exchange Rate: $1 = £0.691 • Why the difference? Why doesn’t arbitrage eliminate the difference? •  moving and converting currency is not costless!

23. Valuation • Valuation: the relationship between market price and underlying “value” • Different ways to calculate valuation • Stock: price-to-earnings-to-growth (PEG) ratio • Currency: PPP versus ER • Over and Under • Overvalued: currency purchases less than ER indicates (PPP < ER) • Undervalued: currency purchases more than ER indicates (PPP > ER)

24. Gresham’s Law • Attributed to Sir Thomas Gresham (1519-1579) • The Law: “Bad money drives out good” • In our terms: “Overvalued currency drives out undervalued currency.” • Implication: don’t attempt to maintain official ER vastly different from market ER  This is just a recognition that arbitrage will occur in currency markets, as it does elsewhere.

25. The gold standard ideal was that all currencies would be freely convertible through gold. This would secure purchasing power parity.And PPP would ensure complete market integration.

26. II. THE GOLD STANDARD AS AN IDEAL TYPE Purchasing Power Parity The Automaticity of the Gold Standard

27. The GS was meant to automatically ensure both the quantity of currency and the distribution of currency.

28. GS Regulation of Quantity • Official/Mint Price: price of gold in terms of local currency • Free Conversion: monetary authority should… • Purchase gold with currency at the official price • Sell gold for currency at the official price • Automatic Quantity Adjustment • Overvalued currency  sell currency for gold  decrease in currency and increase of gold • Undervalued currency  sell gold for currency  increase in currency and decrease in gold • Sustained increases in gold price  mining

29. By regulating the quantity of currency automatically, adherence to the GS would theoretically ensure domestic price stability.After all, if the official ER did not match the PPP, currency/gold would be converted.

30. What about the distribution of gold? Who gets how much gold?

31. GS Regulation of Distribution • David Hume’s Price-Specie-Flow Model • Assume: costless int’l transport & conversion Excess Gold in US Rise in US Prices US Imports Increase; Exports Decrease US Prices Fall; BoT Equilibrates US Exports Gold US has BoP Deficits

32. So, assuming no costs and perfect adherence to the “rules of the gold standard game”, everything with the gold standard should have been automatic and markets should have been completely integrated.

33. But that’s not reality.

34. The Gold Standard • Leftovers: Exchange Rates in the Balance of Payments • The “Gold Standard” as an Ideal Type • The Reality of the Gold Standard • Conclusion

35. III. REALITY OF THE GOLD STANDARD Conversion Costs A Brief History of the Gold Standard

36. Remember that we’ve been assuming no conversions costs, that it is costless to move from one currency to another through gold.In the market, however, there are costs to converting currency: transport, risk & insurance, opportunity cost of time.

37. What are the implications of these costs? What does it matter if it costs me 10% to convert my currency into gold and have it converted abroad into foreign currency?

38.  This means that my currency can be over/undervalued by up to 10% before it become profitable for me to convert it through gold into a foreign currency.

39. And what does that mean?

40.  That means that the market exchange rate can fluctuate within a band around parity—the official exchange rate—before the price-specie-flow mechanism prompts adjustment in the quantity of currency & distribution of gold.

41. Gold points are the price points at which it becomes profitable to convert currency into/out of gold.The gold band is the band around parity, bound by the gold points, in which the market ER might fluctuate.

42. What does that matter?

43. I know! It means that “fixed” ERs might still fluctuate in the market.

44. The existence of gold points and gold bands has an extraordinary implication:  even with a “fixed” ER, the market ER might not always be stable!

45. This matters for foreign economic policy.At a minimum, the “gold bands” provide some flexibility to states with a fixed ER.This might be a good or bad thing depending on whether you favor monetary discipline or monetary discretion.

46. Some states deliberately expand the size of the gold bands to provide themselves with even more flexibility.They do this by adding politically-imposed costs to the natural market costs of converting currencies.

47. Politically Imposed Costs • Overt Fees (e.g. seigniorage) • Deliberate delays by monetary authority (Adam Smith on Bank of England) • Exchange for low quality, worn coins • Capital controls (China today)

48. These manipulations are sometimes called gold devices, which are used to move the gold pointsand expand the gold band.

49. III. REALITY OF THE GOLD STANDARD Conversion Costs A Brief History of the Gold Standard

50. Here are a few of the highlights of the emergence and ascent of the GS.