international finance - international monetary system 6-10

5
Mint Parity Theory Under this system, the currency in use was made of gold or was convertible into gold at a fixed rate. The value of the currency unit was defined in terms of certain weight of gold, that is, so many grains of gold to the rupee, the dollar, the pound, etc. The rate at which the standard money of the country was convertible into gold was called the mint price of gold. If the official British price of gold was £6 per ounce and of the US price of gold $12 per ounce, they were the mint prices of gold in the respective countries. The exchange rate between dollar and pound would be fixed at $12/£6 =2, Suppose the shipping cost of gold from the US to Britain is 5 cents. So the US importers would have to pay $2.05 per £1. In theory, all nations should have an optimal balance of payments of zero, i.e. they should not have either a trade deficit or trade surplus.

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International finance - gold standard mint parity

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Page 1: International FInance - International Monetary System 6-10

Min

t P

ari

ty T

he

ory

•U

nd

er

this

sys

tem

, th

e c

urr

en

cy in

use

wa

s m

ad

e o

f g

old

or

wa

s co

nve

rtib

le in

to g

old

at

a f

ixe

d r

ate

.

•T

he

va

lue

of

the

cu

rre

ncy

un

it w

as

de

fin

ed

in t

erm

s o

f ce

rta

in w

eig

ht

of

go

ld,

tha

t is

, so

ma

ny

gra

ins

of

go

ld t

o t

he

ru

pe

e,

the

do

llar,

th

e p

ou

nd

, e

tc.

•T

he

ra

te a

t w

hic

h t

he

sta

nd

ard

mo

ne

y o

f th

e c

ou

ntr

y w

as

con

vert

ible

into

g

old

wa

s ca

lled

th

e m

int

pri

ce o

f g

old

.

•If

th

e o

ffic

ial B

riti

sh p

rice

of

go

ld w

as

£6

pe

r o

un

ce a

nd

of

the

US

pri

ce o

f g

old

$1

2 p

er

ou

nce

, th

ey

we

re t

he

min

t p

rice

s o

f g

old

in t

he

re

spe

ctiv

e

cou

ntr

ies.

Th

e e

xch

an

ge

ra

te b

etw

ee

n d

olla

r a

nd

po

un

d w

ou

ld b

e f

ixe

d a

t $

12

/£6

=2

,

•Su

pp

ose

th

e s

hip

pin

g c

ost

of

go

ld f

rom

th

e U

S t

o B

rita

in i

s 5

ce

nts

. So

th

e

US

imp

ort

ers

wo

uld

ha

ve t

o p

ay

$2

.05

pe

r £

1.

•In

th

eo

ry,

all

na

tio

ns

sho

uld

ha

ve a

n o

pti

ma

l ba

lan

ce o

f p

aym

en

ts o

f ze

ro,

i.e

. th

ey

sho

uld

no

t h

ave

eit

he

r a

tra

de

de

fici

t o

r tr

ad

e s

urp

lus.

Page 2: International FInance - International Monetary System 6-10

Go

ld S

tan

da

rd in

op

era

tio

n

•W

ith

th

e o

utb

rea

k o

f th

e F

irst

Wo

rld

Wa

r in

19

14

, th

e in

tern

ati

on

al

tra

din

g s

yste

m b

roke

do

wn

an

d n

ati

on

s va

lue

d t

he

ir c

urr

en

cie

s b

y fi

at

inst

ea

d,

i.e

. g

ove

rnm

en

ts t

oo

k th

eir

cu

rre

nci

es

off

th

e g

old

sta

nd

ard

an

d s

imp

ly d

icta

ted

th

e v

alu

e o

f th

eir

mo

ne

y.

•Fo

llow

ing

th

e w

ar,

so

me

na

tio

ns

att

em

pte

d t

o r

ein

sta

te t

he

go

ld

sta

nd

ard

at

pre

-wa

r ra

tes,

bu

t d

rast

ic c

ha

ng

es

in t

he

glo

ba

l e

con

om

y

ma

de

su

ch a

tte

mp

ts f

uti

le.

•B

rita

in,

wh

ich

ha

d p

revi

ou

sly

be

en

th

e w

orl

d's

fin

an

cia

l le

ad

er,

rein

sta

ted

th

e p

ou

nd

at

its

pre

-wa

r g

old

va

lue

, b

ut

be

cau

se it

s

eco

no

my

wa

s m

uch

we

ake

r, t

he

po

un

d w

as

ove

rva

lue

d b

y

ap

pro

xim

ate

ly 1

0%

. C

on

seq

ue

ntl

y, g

old

sw

ep

t o

ut

of

Bri

tain

, a

nd

th

e

pu

blic

wa

s le

ft w

ith

va

lue

less

no

tes,

cre

ati

ng

a s

urg

e i

n u

ne

mp

loym

en

t.

•B

y th

e t

ime

of

the

Se

con

d W

orl

d W

ar,

th

e in

he

ren

t p

rob

lem

s o

f th

e

go

ld s

tan

da

rd b

eca

me

ap

pa

ren

t to

go

vern

me

nts

an

d e

con

om

ists

alik

e.

Page 3: International FInance - International Monetary System 6-10

Go

ld-E

xch

an

ge

Sta

nd

ard

•Fo

llow

ing

the

seco

nd

wo

rld

wa

r,th

eIn

tern

ati

on

al

Mo

ne

tary

Fun

d

rep

lace

dth

eg

old

sta

nd

ard

as

am

ea

ns

for

na

tio

ns

toa

dd

ress

ba

lan

ceo

f

pa

yme

nts

pro

ble

ms

wit

hw

ha

tb

eca

me

a"g

old

-exc

ha

ng

e"

sta

nd

ard

.

•C

urr

en

cie

sw

ou

ldb

ee

xch

an

ge

ab

len

ot

ing

old

bu

tin

the

pre

do

min

an

t

po

st-w

ar

curr

en

cie

so

fth

ea

llie

dn

ati

on

s:B

riti

shst

erl

ing

,o

rm

ore

imp

ort

an

tly,

the

U.S

.d

olla

r.

•U

nd

er

the

ne

wIn

tern

ati

on

al

Mo

ne

tary

Fun

da

pp

roa

ch,

go

vern

me

nts

ha

d

am

ore

pro

no

un

ced

role

inm

an

ag

ing

the

ire

con

om

ies.

Ide

ally

,

go

vern

me

nts

wo

uld

ho

ldd

olla

rsin

"re

serv

e.

•If

an

eco

no

my

ne

ed

ed

an

infl

ux

of

mo

ne

yb

eca

use

of

ab

ala

nce

of

pa

yme

nts

de

fici

t,th

eg

ove

rnm

en

tco

uld

exc

ha

ng

eit

sre

serv

ed

olla

rsfo

rit

s

ow

ncu

rre

ncy

,a

nd

the

nin

ject

this

mo

ne

yin

toit

se

con

om

y.

•H

ow

eve

r, t

he

y w

ere

exc

ha

ng

ea

ble

fo

r d

olla

rs.

Be

cau

se d

olla

rs w

ere

sti

ll

exc

ha

ng

ea

ble

fo

r g

old

, th

e "

go

ld-e

xch

an

ge

“ st

an

da

rd b

eca

me

th

e

pre

vaili

ng

mo

ne

tary

exc

ha

ng

e s

yste

m f

or

ma

ny

yea

rs.

Page 4: International FInance - International Monetary System 6-10

Pa

pe

r C

urr

en

cy S

tan

da

rd &

Pu

rch

asi

ng

Po

we

r P

ari

ty

•W

ith

th

e b

rea

kdo

wn

of

the

go

ld s

tan

da

rd d

uri

ng

th

e p

eri

od

of

the

Fi

rst

Wo

rld

Wa

r, g

old

pa

riti

es

an

d f

ree

mo

ve

me

nts

of

go

ld c

ea

sed

, th

ere

fore

th

e m

int

pa

r o

f e

xch

an

ge l

ost

sig

nif

ica

nce

in t

he

exc

ha

nge

m

ark

ets

.

•T

he

ba

sic

ide

a u

nd

erl

yin

g t

he

pu

rch

asi

ng

po

we

r p

ari

ty t

he

ory

is

tha

t th

e f

ore

ign

cu

rre

nci

es

are

de

ma

nd

ed

by

the

na

tio

na

ls o

f a

co

un

try

be

cau

se i

t h

as

po

we

r to

co

mm

an

d g

oo

ds

in it

s o

wn

co

un

try.

•Fo

r, w

he

n t

wo

cu

rre

nci

es

are

exc

ha

nge

d,

wh

at

is e

xch

an

ged

, in

fa

ct,

is t

he

inte

rna

l pu

rch

asi

ng

po

we

r o

f th

e t

wo

cu

rre

nci

es.

•th

e P

urc

ha

sin

g P

ow

er

Th

eo

ry (

PP

T)

see

ks t

o e

xpla

in t

ha

t u

nd

er

the

sy

ste

m o

f a

uto

no

mo

us

pa

pe

r st

an

da

rd t

he

ext

ern

al v

alu

e o

f a

cu

rre

ncy

de

pe

nd

s u

ltim

ate

ly a

nd

ess

en

tia

lly o

n t

he

do

me

stic

p

urc

ha

sin

g p

ow

er

of

tha

t cu

rre

ncy

re

lati

ve t

o t

ha

t o

f a

no

the

r cu

rre

ncy

.

Page 5: International FInance - International Monetary System 6-10

Ab

solu

te V

ers

ion

of

Pu

rch

asi

ng

Po

we

r

Pa

rity

•T

he

ab

solu

te v

ers

ion

of

the

pu

rch

asi

ng

po

we

r p

ari

ty

the

ory

str

ess

es

tha

t th

e e

xch

an

ge

ra

tes

sho

uld

n

orm

all

y re

fle

ct t

he

re

lati

on

be

twe

en

th

e in

tern

al

pu

rch

asi

ng

po

we

r o

f th

e v

ari

ou

s n

ati

on

al c

urr

en

cy

un

its.

•To

illu

stra

te t

he

po

int,

let

us

ass

um

e t

ha

t a

re

pre

sen

tati

ve c

oll

ect

ion

of

go

od

s co

sts

Rs.

9,6

25

/-in

In

dia

an

d U

S$ 1

95

in U

SA.

As

pe

r th

e A

bso

lute

PP

P

the

ory

, th

e e

xch

an

ge r

ate

be

twe

en

US$

an

d I

nd

ian

R

up

ee

is t

he

ra

tio

of

two

pri

ce in

dic

es.

•Sp

ot

(in

Ru

pe

e)

= 9

62

5/1

95

= R

s.4

7.5

12

8