Gold Standard and Exchange Markets - Essay Example

Gold Standard The Gold standard may be defined as a common monetary standard that is used by several nations, in which the economic unit of account is fixed in terms of a standard measure of gold. Due to the differences in exchange rates between various currencies of the world, the exchange is made in terms of units of gold, which is a favored medium of exchange. The international gold standard was first established when Germany was created as a united country following the Franco-Prussian war (www.en.wikipedia.org). Gold became the universal, stable unit of valuation because its transportability and its acceptance among all nations ensured that it was able to become a monetary standard that could be used globally. This was also aided by the fact that the dominant economy of the United Kingdom had also adopted the gold standard (Baines, 2003). The Gold Standard Act of 1900 also established gold as the standard unit of monetary exchange in the United States and the provisions of the Act state that: “the dollar consisting of twenty five and eight tenths grains of gold nine tenths fine……shall be the standard unit of value and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard.” (www.answers.com) Silver was used earlier as a medium of exchange, however during the late 18th century where there was a major amount of trade between China and the western economies, China had little use for European goods, as a result of which there was a drainage of silver from the economies of western Europe as well as the United States (www.en.wikipedia.com). Moreover, in the 1970’s Britain suffered from a shortage of silver coinage and therefore stopped minting silver coins. In the United States as well, huge debts that were taken on by the Federal Government resulted in solver coins which had been struck by the Government leaving circulation, so that President Jefferson suspended the minting of new silver coins. These were some of the reasons for the adoption of the gold standard (www.en.wikipedia.com). Under an international gold standard, gold is convertible into a fixed amount in a nation’s currency and this becomes the means for making international payments. One of the major disadvantages with using the gold standard lies in the fact that it results in an artificial inflation of the price of gold. For example, while the total amount of gold that has been mined is 125,000 tonnes, when standard gold prices stand at about 20,000$ per kilogram, the total value of the stock would be $2.5 trillion, which is less than the value of circulating gold.(www.en.wikipedia.com). In the early part of the twentieth century, international capital market integration had reached its zenith, but the ideology of the gold standard which still held sway allowed little room for maneuvering. At the same time more democratic polities were emerging, which created a demand for more autonomy than was possible, which led to the demise of the gold standard. The Foreign Exchange market is the largest in the world and daily turnover was estimated at $1,190 billion in April 1995, while the second largest market – the U.S. Government securities was $175 billion. (Kodres, 1996). In 1998, the value of the foreign exchange market was estimated to be over $2.5 trillion dollars (www.econ.iastate.edu) and in April 2001, it was estimated to be $1210 billion dollars.(www.flash.lakeheadu.ca). The Foreign exchange market takes place between brokers and dealers in financial centers all around the world, across different time zones, where traders and brokers express their bids for different currencies. The foreign exchange market has expanded considerably with scope for profits escalating since President Nixon closed the gold window, with currencies left afloat as compared to other currencies, so that speculators as well as banks could profit from their exchange transactions. The foreign exchange market functions on two levels – the inter bank market and the retail market. The transactions which take place in the inter bank market are generally those involving large transaction amounts such as multiple million dollars, whereas in the retail market, exchange transactions generally involve smaller amounts. Transactions in the interbank market may be spot transactions where deliveries take place on the second business day following the day after the transaction takes place or they may be deliveries posted later. Other kinds of transactions are swap transactions, where there is a simultaneous purchase and sale that takes place, often conducted with the same counter party. There are five different kinds of participants in the foreign exchange markets – they are (a) banks and non bank foreign exchange dealers (b) individuals and firms that conduct commercial and investment transactions (c) speculators and arbitrageurs (d) central banks and treasuries and (e) foreign exchange brokers. (www.flash.lakeheadu.ca) The foreign exchange markets perform some important functions. It enables a transfer of purchasing power, it enables the financing of inventory in transit and it also provides for hedging facilities. Since firms involved in international trade are often involved in foreign exchange currency risks, hedging is the practice by which firms try to offset their risks through hedging, which involves the taking of a position by purchasing a contract, an asset or a cash flow that will either rise or fall in value and thereby help to offset the rise or fall in value of an existing position.(Mahmod et al, No date). The advantage of using the gold standard is that it allows for a uniform standard of exchange that can also be readily transported and individual currencies can be defined in terms of so many grains of gold. One of the biggest disadvantages with using the gold standard in the foreign exchange market is the limited supply of gold. Moreover, not all countries have equal quantities of gold and the total amounts of gold cannot expand fast enough to keep pace with the ever increasing volume of international trade. Moreover, the difficulties inherent in using the Gold Standard were already experienced once before during the Great depression in 1939, when the gold standard had to be removed due to inability to cope with increased volumes of trade. References: * Baines, D, 2003. “Economic History in the 20th Century” London: University of London external programme at chapter 4. * Eitman et al, “The Foreign Exchange market” [online] retrieved September 30, 2007 from www.flash.lakeheadu.ca/~pgreg/assignments/4079chapter4n.pdf * Gold Standard. [online] Retrieved September 30, 2007 from: http://en.wikipedia.org/wiki/Gold_standard#_ref-0 * Gold Standard Act of 1900. [online] retrieved September 30, 2007 from: http://www.answers.com/topic/gold-standard-act * James, Harold, 2001. “The End of Globalization: Lessons from the Great Depression” Harvard University Press. * Kodres, Laura E, 1996. “Foreign Exchange markets: Structure and systemic risks.” Finance and Development, 22. * Mahmod, Dalia Garca, Rubil, Goran and Sibhatu, Temesgen, No Date. “Difference in foreign risk exchange management between family and non family owned firms.” Jankoping International Business School. [online] Retrieved September 30, 2007 from: www.diva-portal.org/diva/getDocument?urn_nbn_se_hj_diva-150-1__fulltext.pdf Read More