Naked Economics Wheelan, Charles (books to read for 13 year olds TXT) 📖

really answered the basic question at the beginning of the chapter: How many yen should a dollar be worth? Or rubles? Or krona? There are a lot of possible answers to that question, depending in large part on the exchange rate mechanism that a particular country adopts. An array of mechanisms can be used to value currencies against one another:

The gold standard. The simplest system to get your mind around is the gold standard. No modern industrialized country uses gold any longer (other than for overpriced commemorative coins), but in the decades following World War II the gold standard provided a straightforward mechanism for coordinating exchange rates. Countries pegged their currencies to a fixed quantity of gold and therefore, implicitly, to each other. It’s like one of those grade-school math problems: If an ounce of gold is worth $35 in America and 350 francs in France, what is the exchange rate between the dollar and the franc?

One advantage of the gold standard is that it provides predictable exchange ranges. It also protects against inflation; a government cannot print new money unless it has sufficient gold reserves to back the new currency. Under this system, the paper in your wallet does have intrinsic value; you can take your $35 and demand an ounce of gold instead. The “gold standard” has a nice ring to it; however, the system made for catastrophic monetary policy during the Great Depression and can seriously impair monetary policy even during normal circumstances. When a currency backed by gold comes under pressure (e.g., because of a weakening economy), foreigners start to demand gold instead of paper. In order to defend the nation’s gold reserves, the central bank must raise interest rates—even though a weakening economy needs the opposite. Economist Paul Krugman, who earned a Nobel Prize in 2008 for his work on international trade, explained recently, “In the early 1930s this mentality led governments to raise interest rates and slash spending, despite mass unemployment, in an attempt to defend their gold reserves. And even when countries went off gold, the prevailing mentality made them reluctant to cut rates and create jobs.”6 If the United States had been on the gold standard in 2007, the Fed would have been largely powerless to ward off the crisis. Under the gold standard, a central bank can always devalue the currency (e.g., declare that an ounce of gold buys more dollars than it used to), but that essentially defeats the purpose of having a gold standard in the first place.

In 1933, Franklin Roosevelt ended the right of individual Americans to exchange cash for gold, but nations retained that right when making international settlements. In 1971, Richard Nixon ended that, too. Inflation in the United States was making the dollar less desirable; given a choice between $35 and an ounce of gold, foreign governments were increasingly demanding the gold. After a weekend of deliberation at Camp David, Nixon unilaterally “closed the gold window.” Foreign governments could redeem gold for dollars on Friday—but not on Monday. Since then, the United States (and all other industrialized nations) have operated with “fiat money,” which is a fancy way of saying that those dollars are just paper.

Floating exchange rates. The gold standard fixes currencies against one another; floating rates allow them to fluctuate as economic conditions dictate, even minute by minute. Most developed economies have floating exchange rates; currencies are traded on foreign exchange markets, just like a stock exchange or eBay. At any given time, the exchange rate between the dollar and yen reflects the price at which parties are willing to voluntarily trade one for the other—just like the market price of anything else. When Toyota makes loads of dollars selling cars in the United States, they trade them for yen with some party that is looking to do the opposite. (Or Toyota can use the dollars to pay American workers, make investments inside the United States, or buy American inputs.)

With floating exchange rates, governments have no obligation to maintain a certain value of their currency, as they do under the gold standard. The primary drawback of this system is that currency fluctuations create an added layer of uncertainty for firms doing international business. Ford may make huge profits in Europe only to lose money in the foreign exchange markets when it tries to bring the euros back home. So far, exchange rate volatility has proven to be a drawback of floating rates, though not a fatal flaw. International companies can use the financial markets to hedge their currency risk. For example, an American firm doing business in Europe can enter into a futures contract that locks in some euro-dollar exchange rate at a specified future date—just as Southwest Airlines might lock in future fuel prices or Starbucks might use the futures market to protect against an unexpected surge in the price of coffee beans.

Fixed exchange rates (or currency bands). Fixed or “pegged” exchange rates are a lot like the gold standard, except that there is no gold. (This may seem like a problem—and it often is.) Countries pledge to maintain their exchange rates at some predetermined rate with a group of other countries—such as the nations of Europe. The relevant currencies trade freely on markets, but each participating government agrees to implement policies to keep its currency trading within the predetermined range. The European Exchange Rate Mechanism described at the beginning of this chapter was such a system.

The primary problem with a “peg” is that countries can’t credibly commit to defending their currencies. When a currency begins to look weak, as the pound did, then speculators pounce, hoping to make millions (or billions) if the currency is devalued. Of course, when speculators (and others concerned about devaluation) aggressively sell the local currency—as Soros did—then devaluation becomes all the more likely.

Borrowing someone else’s strong reputation. At the end of 1990, inflation in Argentina was more than 1,000 percent a year, to no one’s great surprise given the country’s history of hyperinflation. Is that a