Fixed Exchange Rates, The Gold Standard and The Quantity Theory of Money

Abstract

The analysis of the previous chapter can easily be extended to the case of fixed exchange rates. Instead of relying on exchange variations to restore equilibrium in the foreign exchange market, this system depends upon commodity prices to restore equilibrium in the goods markets. Thus the situation depicted in Fig. 8 involves an excess supply of cloth and an excess demand for wine. The price for cloth will tend to fall while the price of wine tends to rise. The terms-of-trade line will become steeper thereby moving the economy toward equilibrium at D. However, as noted in the last chapter, this analysis does not explicitly take into account the characteristics of the adjustment process over time. This is particularly true for the above situation which requires that cloth manufacturers and wine producers, located in different countries must somehow co-ordinate their price and output decisions so as to bring about an equilibrium terms of trade.