CHAPTER 2 INTERNATIONAL MONETARY SYSTEM
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
2. Explain the mechanism which restores the balance-of-payments equilibrium when it is disturbed under
the gold standard.
Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow
mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium
will be corrected by a counter-flow of gold. Suppose that the US imports more from the UK than it
exports to the latter. Under the classical gold standard gold is the only means to settle international
payments. Since in our example the US owes money to the UK gold must flow from the U.S. to the UK
As a result, the US (UK) will experience a corresponding decrease (increase) in money supply. This
means that the price level will tend to fall in the US and rise in the UK Consequently, US products
become more competitive in the export market, while UK products become less competitive. This change
will improve US balance of payments and at the same time hurt the UK balance of payments, eventually
eliminating the initial BOP disequilibrium.
3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at
12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be two francs per
pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this
situation? What would be the effect of shipping costs?
Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in the
foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for
12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12
francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course,
you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The
arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs more
than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit. 4. Discuss the advantages and disadvantages of the gold standard.
Answer: The advantages of the gold standard include: (i)) since the supply of gold is restricted, countries
cannot have high inflation; (ii) any BOP disequilibrium can be corrected automatically through cross-
border flows of gold. On the other hand, the main disadvantages of the gold standard are: (i) the world
economy can be subject to deflationary pressure due to restricted supply of gold; (ii) the gold standard
itself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economic
policies (like de-monetization of gold) that are incompatible with the gold standard.
5. What were the main objective