Historical Perspective on Currency Regimes

The classical gold standard operated by what is called the price-specie-flow mechanism.

As countries experienced a trade surplus, they accumulated gold as payment, their domestic money supply expanded by the amount dictated by the fixed parity, prices rose, and exports fell.

When a country ran a trade deficit, there was an automatic outflow of gold, a contraction of the domestic money supply, and a fall in prices leading to increased exports.

Effect of the classical gold standard on overall macroeconomic stability.

On the one hand, monetary policy was tied to trade flows, so a country could not engage in expansionary policies when there was a downturn in the non-traded sector.

On the other hand, tying monetary policy to trade flows kept inflation in check.

The Bretton Woods system.

The United States, Japan, and most of the industrialized countries of Europe maintained a system of fixed parities for exchange rates between currencies.

Periodic realignments were viewed as a part of standard monetary policy.

The European Exchange Rate Mechanism (ERM)

Initially, the system called for European currency values to fluctuate within a narrow band called “the snake.”

A common currency for most Western European countries, without Switzerland or the United Kingdom, called the euro.

The common currency would increase transparency of prices across borders in Europe, enhance market competition, and facilitate more efficient allocation of resources.

The drawback, of course, is that each member country lost the ability to manage its exchange rate and therefore to engage in independent monetary policy.