Currency Exchange: National currencies, like the dollar or the euro, can be exchanged in an international market. When a Michiganian travels to Canada, for example, they require Canadian dollars to purchase goods and services there. When crossing the border, the traveler exchanges US dollars for Canadian dollars at the current exchange rate. Since currencies are traded on the open market, we can determine how much the US dollar is worth in terms of Canadian dollars, and this exchange rate may change from day to day.
Exchange Rate Systems: Every country chooses which exchange rate system to use. The options (broadly speaking) are:
Float: the currency is valued by market forces
Peg: the country decides on a value for the currency and takes steps to support it at that value.
The United States has used the float method since 1971. Prior to that, a modified gold standard in accordance with the Bretton Woods System was in use.
Considerations for Choosing and Exchange Rate System: Countries must observe the Impossible Trinity: One must choose two of three circumstances to observe, free capital flows, an independent monetary policy, and a fixed exchange rate. It is impossible to have all three. The United States, for example, has an independent monetary policy and free capital flows, and therefore cannot use fixed exchange rates without giving up one of the first two conditions. China has an independent monetary policy and fixed exchange rates and therefore cannot have free capital flows. Hong Kong has free capital flows and a fixed exchange rate and therefore cannot have an independent monetary policy.
Gold Standard: Prior to the First World War (1914-1918), most major countries used a gold standard, in which a fixed exchange rate was used, with currency values stated in gold. The post Second World War (1939-1945) Bretton Woods System (1944-1971) was a modified version of the gold standard. While a number of countries presently use a fixed exchange rate, gold is not the standard for any of them at present. However, the ideas of a gold standard remains popular with some political and economic advocates.
Case Study
Consider the question of whether the United States should adopt a gold standard, remain in the current float-based system, or use some other system. Consider the impossible trinity mentioned above and carefully define all terms and concepts to which you refer. Explain the reasoning behind your answer and not the changes to the US economy and policy that would be required in any change.
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