How Does Exchange Rates Works Under Gold Standard System.When two countries are on the gold standard system, the determination of the rate of exchange between their currencies is comparatively easier. It will be in the proportion of the gold contents of one unit of a currency expressed in terms of the gold contents of one unit of another currency. Let us assume that Pakistan and America are on the gold standard. One rupee contains one unit of gold of 11/12 fineness and one dollar contains 90 units of gold of the same fineness.
How Does Exchange Rates Works Under Gold Standard System.
Then the rate of exchange between dollars and rupees is $1 = Rs. 90. This rate is known as the equilibrium rate of exchange or the ‘Mint Par of Exchange’. The Par of Exchange has been defined as “the number of units of the one currency which should legally contain the same amount of pure metal as does, legally, a given number of units of the other currency”.
The fluctuations in the rate of exchange under the gold standard system are limited and it always comes back to the equilibrium level viz., the mint par. Let us examine how the forces operate to make the market rate equal to the mint par.
Suppose A in Pakistan is importing goods worth $ 1,000 from the USA. A can settle this transaction either by sending 90,000 units of gold (assuming that the mint par is $ 1 = Rs. 90) or by purchasing $ 1,000 from an exchange dealer. Let us assume that the exchange dealer quotes an exchange rate of $ 1 = Rs. 105 in other words, A has to spend Rs. 105,000 to purchase $ 1,000. In that case he will prefer to send 90,000 units of gold to the USA, where the exporter in that country can change it for $ 1,000. This is because A can purchase 90,000 units of gold with Rs. 90,000 whereas his total expense will be Rs. 105,000 if he purchases dollars. This will decrease the demand for dollars in Pakistan. The exchange dealers will be compelled to bring down the market rate of exchange. This process will go on till the market rate becomes equal to the mint par.
This, however, is subject to one modification. Sending gold involves certain expenses like packing charges, shipping charges; loss of interest-when the gold is in transit, insurance charges, refining charges, etc. To continue our previous example if A wants to send gold worth $ 1,000 he will have to purchase 90,000 units of gold by spending Rs. Q0,000.
Then he will have to pack it and send it by sea or air, thereby incurring the freight charges. Further, he should see that the gold is refined so as to bring it on a par with the fineness gold obtainable in the USA. This involves refining charges in the same way during the course of transportation gold is locked up in an idle manner. Furthermore, A has to incure insurance charges connected with the insurance of gold transported. Suppose that all these expenses together amounted to Rs. 4,000.
This means to send $ 1,000 units of gold A has to incur Rs. 94,000. Thus, though the mint par of exchange is $ 1 = Rs. 94, the rate as far as A is concerned comes to 1 = Rs. 94 when he used gold as the medium of exchange. If the market rate of exchange is above then he will prefer to send gold. The resulting decrease in demand for dollars will compel the exchange dealers to bring down the market rate to $1 = Rs. 94. This point is known as the Gold Import Point from the point of view of Pakistan and the Gold Export Point from the point of view of America.