Explain the fixed exchange rate system

A fixed exchange rate regime was followed prior to World War 1. In the fixed exchange regime the currencies of the world were valued with respect to a particular underlying asset. This kept the exchange rate to be stable and move in a smaller band amongst the nations. Hence, the exchange rate gave an impression of being fixed. There were several fixed exchange rate systems followed by the world. We’ll look at them one by one.

The Gold Standard and the Mint Par of Exchange:
The Gold Standard system was followed before World War 1. Under this exchange rate system currencies were either in gold or were printed by keeping gold as the underlying asset. The exchange rate in such a system was determined by undertaking the money value of gold in perspective. For example, if the value of gold per gram in India is rupee 50 and in the United States of America is $10, then we can see that the US dollar is 5 times stronger than Indian rupee. We can divide 50 by 10 to get the answer 5 (50 ÷ 10 = 5). This is known as the mint par of exchange. However, the currency values can differ to the extent of transportation cost of gold. For example if the cost of export is rupee 2 then the currency can vary in price up to 52 (.i.e. 50 + 2 = 52). Such variations are called as gold point. As the variation occurs because of exports, such deviations are termed as export gold points. If the variations were in terms of imports then it’s called as import gold points. Countries in the gold standard system were forced to follow certain rules. These restrictions imposed on the nations led to automatic adjustments in the exchange rate. Such automatic adjustments were called as the Price – Specie flow Mechanism.

The IMF Dollar Standard / The Bretton Woods system
In 1944 the International Monetary Fund was incorporated, which gave the rise to the Bretton Woods system. A conference held at Bretton Woods (New Hampshire, USA) was attended by a group of 44 countries, led to the emergence of dollar as the dominant currency in the world. In this system dollar was made as the reserve asset instead of gold. The dollar on the other hand kept gold as its reserve assets. The United States of America promised to buy or sell unlimited amount of dollar reserves to the member countries. The member countries were allowed to convert the gold at the rate of $35/ounce of gold. This made dollar the vehicle currency. However, the expenditure of the American government surpassed that of the gold reserves. The system was based on the promise to buy or sell unlimited amount of gold at any given time which the United States was not able to fulfil. The gold reserves were only worth 11 billion as against the expenditure of 40 billion. The expenditure was more that 300% of the reserves. Hence, many countries like West Germany and Japan refuse the USA’s request to revalue the currency. The Dollar was thus devalued to $38/ ounce of gold in the Smithsonian Agreement. This led to massive outflow of capital outside the USA. President Nixon the then president was forced to suspend the dollar convertible system.
Apart from the above exchange rate system there are other fixed or pegged exchange systems that the world has seen.
 The Euro is a prime example. A union of European countries have accepted a common currency called the euro. The exchange rate of euro with the member countries is fixed. This makes the euro zone to work as one big family.
 Currency Board Arrangements are another example of fixed exchange system. When a particular nation fixes its home currency with a foreign currency we call it as a CBA. Such agreements are made by the countries when they are in financial crisis. Countries like Hong Kong, Argentina, Bulgaria etc have such agreements
 Countries like Ecuador, El Salvador have accepted the US dollar as their own legal tender. When a country uses a foreign currency as its legal tender its called as dollarization.

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