[MUSIC] In the examples we have used thus far, the value of the various currencies that we discussed, we're allowed to freely move in response to market conditions. This type of monetary system is called a floating exchange rate system. However, not all countries of the world allow their currencies to float. Instead, some use what is called a fixed exchange rate system. In a fixed exchange rate system, a country will peg the value of it's currency tightly to the value of another currency, like the American dollar. Alternatively, a country may peg it's currency to a basket of currencies. Like the US dollar, European's own Euro, Swiss Franc, British Pound and Japanese Yen. Within the constraints of this fixed exchanged rate system, the country will then regularly intervene in the foreign exchange market to maintain the fixed peg it has targeted. For example, it may use its foreign reserve to buy its own currency to boost its value. [MUSIC] So which system is better, a floating or fixed rate system? In fact, both have their virtues and vices. And it is critical, as business executives and global investors, to understand the limitations of each of these systems. It is also essential to understand that in the real world, the international monetary system is a combination of fixed and floating exchange rate countries. And this hybrid mix of two types of systems creates very special problems of their own for the international monetary system. For example, a country that maintains a fixed peg can more easily manipulate its currency to undervalue its currency. And thereby boost its export growth when it is competing against other countries that allow their currencies to float. However, when one country manipulates it's currency, other countries often retaliate and that can indeed create imbalances and instability in the financial system. So, with that as an overview, let's take what should be a very interesting trip through time to explain the evolution of today's modern, global financial system. During this trip we will travel from the 19th century days of a reliance on a fixed exchange rate system based on a gold standard, to today's hybrid system. [MUSIC] Between 1867 and 1933, except for the period around World War I, most of the nations in the world were on the so-called gold standard. Under this fixed exchange rate system, the currency issued by each country had to either be gold or be redeemable in gold. And once a country agreed to be on the gold standard, its currency was convertible into a fixed amount of gold. Referred to as fixed rate parities. For example, during what is referred to as the classical gold standard period between 1879 and 1914, 100 american dollars would exchange for 4.8 troy ounces of gold. Roughly $20 an ounce. Now here's a key point. Within this fixed exchange rate system, if a nation ran a trade deficit, it would be required to use its gold reserves, to buy back some of its own paper currency to prevent the value of that currency from falling. In contrast, if a nation ran a trade surplus, it would accumulate gold. Now, you might wonder why the gold standard was so popular. The answer lies in something called perhaps rather strangely, the Gold Specie Flow Adjustment Mechanism. This monetary adjustment mechanism was first described by the Scottish philosopher and economist David Hume in 1752. The critical insight of Hume's gold specie-flow adjustment mechanism is that trade between countries should always come back into balance in a floating exchange rate system. Where currencies, in this case, gold, is allowed to trade freely. [MUSIC] To illustrate the power of Hume's Gold Specie Flow Adjustment mechanism, in eliminating trade imbalances between countries, let's use this example. Suppose then that both Britain and The United States start with an equal amount of gold reserves. And begin to trade. Suppose further that the US initially runs a trade deficit. And that means it has to ship some of its gold to Britain. Now, if the US continues run such a deficit, it will eventually run out of gold. However, before that can happen, Hume's multi pronged gold specie flow adjustment mechanism takes hold. In the first step of the this adjustment process, the US money supply is reduced by its loss of gold. This leads to a fall in the price level in the US. According to the quantity theory of money we learned about in an earlier lesson. Do you remember the formula for the quantity theory of money? It's a very key part of the exchange rate puzzle and understanding the gold specie flow adjustment mechanism. So let's pause now and see if you can write down the formula for the quantity theory of money before we move on. [MUSIC] [SOUND] Okay, so the Quantity Theory of Money says, that the money supply M, times the velocity of money V, must equal the price level P times real output Q. Where P * Q is a country's gross domestic product in nominal terms. Did you remember that? At any rate, if we assume the velocity of money V and real output Q are constant, the standard assumptions, reduction in America's gold supply as a result of its trade deficit must result in a reduction of the price level in America. Do you see that? If not, take a minute to go back and nail this. So, let's move on. [MUSIC] Now, going back to our example, even as the money supply and price level in America are falling as a result of its trade deficit, the exact opposite is happening in Britain. That is, because Britain is maintaining a trade surplus, it is accumulating gold. Its money supply is increasing and its price level must therefore be rising. Do you see how trade is going to quickly come back into balance as a result of the changes in the money supply and price levels In the two countries? Take a minute now just to describe that adjustment process. When you are ready, let's move on. [MUSIC] Okay, here's how America's trade deficit with Britain should quickly come back into balance because of the gold specie flow adjustment system. On the American side of the Atlantic ocean, American consumers would decrease their purchases of British imports because of the rise in British prices. At the same time, on the British side of the Atlantic, British consumers will buy more American imports because the US price level has fallen, and these imports are now relatively less expensive. Of course, as British imports shrink and American exports expand, trade moves back into balance between the two countries. Thank you, David Hume. [MUSIC] Of course what sounds good in economic theory doesn't always pan out in the real world. So how did the gold standard actually perform over time? To put this another way, did trade always come back into balance in the global system because of David Hume's monetary adjustment mechanism? Let's turn to answering these questions in our next module. So when you're ready, let's move on. [MUSIC]
