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Exchange Rate Management in Gold Standard Era: A Historical Overview

Under the gold standard era, exchange rates were managed not through adjustment in the current account but through changes in the capital account and stock of monetary gold and reserves. Though the exchange rate of a currency was theoretically directly linked to the central bank's stock of monetary gold reserves, the countries that had a greater rate of interest elasticity of capital flows could keep a low stock of these reserves. For these countries, interest rate policy was used to stabilise exchange rates. The rate of interest elasticity of capital flows was dependent upon its currency's use as international money. And the degree of use of a currency as international money was dependent upon the issuing country's economic and political hegemony.


Exchange Rate Management in Gold Standard Era: A Historical Overview

Atulan Guha

Under the gold standard era, exchange rates were managed not through adjustment in the current account but through changes in the capital account and stock of monetary gold and reserves. Though the exchange rate of a currency was theoretically directly linked to the central bank’s stock of monetary gold reserves, the countries that had a greater rate of interest elasticity of capital flows could keep a low stock of these reserves. For these countries, interest rate policy was used to stabilise exchange rates. The rate of interest elasticity of capital flows was dependent upon its currency’s use as international money. And the degree of use of a currency as international money was dependent upon the issuing country’s economic and political hegemony.

This paper is based on part of my PhD thesis. I am indebted to both A Bhaduri and P Patnaik, my supervisors in two different phases. Errors and omissions are my own.

Atulan Guha ( is assistant professor, Institute for Studies in Industrial Development, New Delhi.

Economic & Political Weekly november 17, 2007

his paper discusses how different countries, depending upon their economic and political status in the world, had different mechanisms that kept their exchange rates stable during the gold standard period. The exchange rate of a country is under pressure to change, whenever there is a balance of payments disequilibrium. According to most economists who talk about this period, any disequilibrium in the balance of payments will lead to a change in the exchange rate through changes in the current account. Monetarists say that disequilibrium in the balance of payments will have an impact on money supply and hence, on price. This change in price will bring about a change in the trade account and consequently, the exchange rate will be adjusted. The opposite view says that instead of price adjustment, the adjustment takes place through a change in aggregate demand, which affect output and hence, trade balance. This paper puts forth the view that there were mainly two ways through which countries managed their exchange rate during the gold standard era – first, countries whose currencies had greater use as international money adjusted any mismatch in the balance of payments through adjustment in capital flows by changing the interest rate. Second, countries whose currencies did not have any significant use as international money had to depend foreign exchange and monetary gold reserves to adjust any mismatch in the balance of payments. The western developed countries, who had substantial dominance over world trade and finance were in the first set of countries. Britain was the most prominent among them. The imperial nature of many of these countries also helped them follow this adjustment process. The underdeveloped, dominion and colonial countries were in the second set of countries. Britain and other developed countries were not needed to keep reasonably high foreign exchange and monetary gold reserves because of their high interest elasticity of capital flows. This paper begins with a historical analysis of the gold standard era in Section 1. It is followed by Section 2, which describes a theoretical formulation of the argument put forth through a historical analysis of the gold standard system and a concluding note.

1 Gold Standard Era in History

The basic structural features of the gold standard system were

(1) interconvertibility between domestic money and gold at a fixed official price; (2) freedom for private citizens to import and export gold; and (3) a set of rules relating the quantity of money in circulation within a country to the country’s gold stock.

The exchange rates among national currencies were decided on the basis of the relative amount of gold promised against the


currency notes by the respective central banks. In other words, and monetary gold reserves and changing the rate of interest to the exchange rate of a country depended on its central bank’s change the capital flows. The underdeveloped, dominion and copromise of the amount of gold to pay in exchange of one unit of lonial countries, in general, had to keep sufficiently large foreign currency and this rate was fixed. To honour that promise, central exchange and monetary gold reserves to adjust with any disequibanks were required to keep sufficient monetary gold reserves librium in balance of payments (Table 1). against the money in circulation. The exchange rate of a coun-Britain could keep her exchange rate stable by controlling the try would be destabilised if the claim of foreigners on gold due capital flow mainly by changing the bank rate. As a result, the to holding of that country’s money was more than the monetary gold reserve to money ratio was five to 10 times lower for the

gold reserves of the central Table 1: Composition of Reported Official Reserve in 35 Countries, End 1913 United Kingdom than for other bank. Thus, the balance of pay-(Converted into millions of dollar at 1913 par) capitalist countries (Table 2).

Countries Gold Silver Foreign Total

ments deficit becomes a neces-It was evident from the com-

Exchange Reserve

sary condition for the instability Three main creditors 1122.5 189.4 52.8 1364.7ment of W A Lewis (1978), “The

of the exchange rate. If a particular country has large enough monetary gold reserves to cover United Kingdom 164.9 --164.9 France 678.9 123.9 3.2 805.6 Germany 278.7 65.9 49.6 394.2 Other European countries (consisting of 17 countries) 1757 309.4 610.6 2677 Bank of England kept very little gold (in relation to money supply) – some say gold yielded no
the balance of payments deficit, its exchange rate remains stable. So, for keeping the exchange rate stable, a country Western hemisphere (consisting of 7 countries) 1764.9 525.2 64.8 2354.9 Africa, Asia, Australia 201.8 108.5 403.9 714.2 1 17 European countries were Austria, Hungary, Belgium, Bulgaria, Denmark, Finland, Greece, Iceland, Italy, Netherlands, Norway, Portugal, Rumania, Russia, Serbia, Spain, Sweden and Switzerland. 2 Seven western hemisphere countries were Argentina, Bolivia, Brazil, Canada, Chile, Uruguay and US. 3 The countries in Asia and Africa were Algeria, Ceylon, Egypt, India, Japan, Neth Indes and Philippines. interest while others are more charitable, whatever the reason, the consequence was that the Bank was forced to react to
had three options, namely, 4 Source: Lindert (1969), p 10. slight losses of gold, changing

keeping sufficient monetary gold and foreign exchange reserves; through adjustment in the current account; and through adjustment in the capital account.

In the gold standard system, monetarists argue that if there is any disequilibrium in the balance of payments, the automatic adjustment in the price will bring about the required change in the balance of payments through current account adjustment. According to this theory, disequilibrium in the balance of payments will have an impact on money supply and hence, on price. This change in price will bring a change in the trade account. This adjustment process is based on some critical assumptions, such as that the

(a) complete effect of gold inflow and outflow is on price, not on output; and (b) price change will be sufficient to adjust the trade balance such that the exchange rate remains at its original level.

Questionable Assumptions

These are questionable assumptions. Not all of them were satisfied even in the classic period of the gold standard, and even less in the subsequent period leading to its breakdown in 1914 [Scammel 1985]. The main reason was the possibility of taking routes other than price adjustment to improve the current account, for example, through changes in aggregate demand. A reduction in aggregate demand might lower incomes and price, and that improves the trade balance. The main argument against such an adjustment mechanism is simply that it operated with lags that were too great and too uncertain to account for the remarkably smooth and rapid pace at which exchange rates, international gold flows and gold reserves of central banks seem to have been generally altered during this period [Lindert 1969].

In reality, to adjust any disequilibrium in the balance of payments, countries had either kept sufficient monetary gold and foreign exchange reserves or adjusted through the capital account or followed both. Britain adjusted any disequilibrium in the balance of payments by changing the capital flows through the policy of rate of interest change. France and Germany followed both the options of keeping reasonably large foreign exchange the bank rate an incredible number of times per year.”

In a parallel view, Marcello De Cecco (1984) also pointed out that the Bank of England, “in order to protect its reserves, made use of controlling devices such as the bank rate, gold devices and open market operations”. According to Scammel (1985), bank rate policy became effective as open market operations were having an influence on money supply. Around the turn of the 20th century, the bank rate policy was a more popular tool and the fre-

Table 2: Monetary Gold-Money Ratio

(Selected Countries)

Year France United Kingdom United States
1889 0.256 0.026 0.117
1899 0.267 0.032 0.112
1910 0.304 0.029 0.105

1 Source: For exchange rate – Bloomfield (1963), p 95. 2 For money stock of France – French International Accounts, p 333. 3 For money stock of UK and US – Friedman et al (1982). 4 For Gold Stock – De Cecco (1984).

quency of its use increased over time. In fact, Keynes (1913) said, “the essential characteristics of the British monetary system are, therefore, the use of cheques as the

principal medium of exchange and the use of the bank rate for regulating the balance of immediate foreign indebtedness.”

The question is why, only Britain, and no other country was able to keep her exchange rate stable with having very little monetary gold and foreign exchange reserves? It can be answered with reference to the international financial structure of that time; it gave Britain far greater control over capital flows. Though France and Germany had some influence over capital flows, other countries did not have this advantage. There are several reasons for this. First, Britain was the largest lender country in the world (Table 3, p 69). Second, Britain’s share was the largest in world trade (Table 4, p 69). Third, Britain had an unmatched supremacy in financing world trade. In 1914, Keynes calculated that the international trade bills financed by London stood at 350 million pounds [Aliber 2000].1 Fourth, it also had a large market for gold. Fifth, it had a large empire, which could be forced to make payments such as the home charges in British sterling. Finally, Britain had a large current account surplus throughout this period. Even though it had a trade deficit, it had a current account surplus, due to huge net factor income, mainly from interest

November 17, 2007 Economic & Political Weekly


earning (Table 5). This high interest earning might have been also a major incentive for high foreign lending by Britain.

The combined operation of these factors resulted in two dominant features characterising the international money market of that time. First, the British sterling became the most accepted medium of exchange worldwide. Second, it created international confidence in the stability of exchange rate of sterling vis-a-vis, gold. As a result, on an international scale, the British sterling could function (in practice) as a reserve currency along with gold.

Table 3: Foreign Investment of Major Lending Countries, 1870-1913

(in millions of dollars)

Country 1870 1885 1900 1913

Great Britain 4,900 7,800 12,100 19,500

France 2,500 3,300 5,200 8,600

Germany na 1,900 4,800 6,700

Netherlands 500 1,000 1,100 1,250

USA negligible negligible 500 2,500

Source: Woodruff (1966), p 150, reprinted in Kindleberger (1984).

Table 4: Share of World Trade for Five Major Capitalist Countries, 1860-1913

(% of World Trade)

Years USA UK Germany France Italy

Average of 1860 and 1880 8.3 25.1 9.2 10.7 3.3

1881-85 10.0 19.1 10.4 10.7 3.3

1891-95 10.5 18.0 11.0 9.2 2.6

1901-05 10.5 16.4 11.6 7.6 2.8

1911-13 10.1 14.1 12.2 7.5 3.0

Sources: Kuznets (1966), pp 306-09.

With the British sterling starting to function as reserve currency, central banks of other countries had the option of choosing the composition of the reserve fund, whether it should contain more gold or sterling holding. The reason behind holding the sterling (excluding the US) was that gold did not earn any interest while sterling deposits did. In 1913, the formal and informal British empire, extending over parts of Africa, Asia and Australia further contributed to this process. Together, these countries held about 150 million dollars worth of sterling deposits in London (Table 6, p 70). Apart from these colonies and dominions, independent countries also held sterling deposits in London.

Independent Countries

The Japanese government and Bank of Japan together held deposits in London worth 101.1 million dollars, the National Bank of Greece around 10 million dollars and other European monetary authorities together deposited around 100 million dollars, in 1913. Some historians2 argue that the gold standard system was actually a sterling standard system [Cohen 1977]. But many others oppose this view. They argue that though the British sterling had the highest proportion in the stock of foreign currency denominated assets that were held by central banks as reserve, the proportion of this holding was much smaller than the total monetary gold reserves [Lindert 1969]. Even this evidence cannot detract from the fact the British sterling was the most widely used reserve currency, apart from gold. It showed that other than gold, it was the British sterling that the international money market had the confidence in that its value would be stable and could be easily converted into gold. In short, it had greater liquidity and it helped Britain to have greater money pulling power.

The mechanism by which London pulled money internationally was the interest rate. Higher interest rates in London would

Economic & Political Weekly November 17, 2007

attract short-term capital from abroad or prevent it from going abroad, since the probability of exchange gains was high3 [Lewis 1978]. In fact Keynes (1913) had suggested that this was the reason for the success of the bank rate change policy of Britain to influence capital. He comments,

The drain (gold drain) could only be stopped if we can rapidly bring to bear our counterbalancing claims. When we come to consider how this can best be done, it is to be noticed that the position of a country, which is preponderantly a creditor in the international short-loan market is quite different from that of a country, which is preponderantly a debtor. In the former case, which is that of Great Britain, it is a question of reducing the amount lent; in the latter case it is a question of increasing the amount borrowed. Machinery that is adapted for action of the first kind may be ill-suited for action of the second. Partly, as a consequence of this partly as a consequence of the peculiar organisation of the London money market, the bank rate policy for regulating the outflow of gold has been admirably successful in this country, and yet cannot stand elsewhere unaided by other devices.

Bloomfield (1963) has pointed out there had long been recognition of the fact that before 1914, increases in the Bank of England discount rate were effective in the market, and not offset by corresponding increases in other lending centres. This had an important short-run effect in stemming drains on the gold reserves of the Bank of England (whether external or internal in origin), and even in reversing the flow of gold by inducing equilibrating inflows of capital through unilateral adjustment in the bank rate by the Bank of England. When the Bank of England raised the domestic interest rate, other major countries did not necessarily follow it. In particular, France followed Britain to a lesser extent on rate of interest change. As a matter of fact, during the period 1890-1900, France changed its bank rate only nine times. For Germany it was 39 times, whereas for Britain the figure was 68.4

Table 5: Structure of United Kingdom’s Current Account Balance

(in millions of pounds sterling)

Years 1881-85 1886-90 1891-95 1896-00 1901-05 1906-10 1911-15
Imports 351.6 342.8 371.9 422.1 482.2 566.9 655.2
Exports 295.2 298.5 287.5 303.7 367.2 487.8 593.9
Balance -56.4 -44.3 -84.4 -118.4 -115.0 -79.1 -61.3
Invisible trade payment 8.1 8.0 7.6 8.5 12.9 12.1 14.2
Invisible trade receipt 28.0 27.6 26.9 27.6 25.1 49.0 58.7
Balance 19.9 19.6 19.3 19.1 12.2 36.9 45.5
Shipping payment 6.3 6.1 6.2 7.2 10.9 13.1 14.8
Shipping receipt 45.7 43.1 42.8 45.6 54.9 69.0 77.5
Balance 39.4 37.0 36.6 38.4 44.0 55.9 62.7
Emigrants and tourism balance -11.2 -11.1 -10.0 -10.7 -13.0 -17.6 -22.1
Total invisible items balance 48.1 45.5 45.9 46.8 43.2 75.2 85.1
Trade and services balance -8.3 1.2 -38.5 -71.6 -71.8 -3.9 23.8
Interest and dividend balance 64.8 84.2 94.0 100.2 113.0 151.4 188.0
Total current account balance 56.5 85.4 55.5 28.6 41.2 147.5 211.8

Source: De Cecco (1984).

The essential assumption for the Keynes argument is that Britain was a very big short-term creditor. This is doubtful claim. As Lindert (1969) has pointed out, it has seldom been argued that Britain was a net short-term creditor. From the sources cited by Karl Strasser, Lindert claimed that London’s holding of bills on foreign places were estimated to have fallen far short of the level of foreign-held claims on London. Marcello De Cecco (1984) also contradicted Keynes.5 He argued that Britain used to borrow in the short-run through obtaining reserves of peripheral countries as deposits. She then lent them as long-term credit. In fact, he further argued that this system could have been stable when short-term creditors had absolute confidence in the major country where they kept their reserves. Such a degree of confidence could


be reached when lesser countries were politically or economically subservient. The findings of Peter Lindert also confirm that the Bank of England clearly enjoyed a short-run command over most of the sterling exchanges even without changes in interest rate differential. This was especially true of the exchange rates that related London to centres with very shallow money markets. London also enjoyed hegemony among the three main centres, although it was less pronounced. She had a clear edge over Berlin and a more ambiguous advantage over Paris. The explanation Lindert provided is that even in the absence of changes in international interest rate differentials, London had superior money

Table 6: Reported Foreign Holdings of Major Currencies, End 1913 (in millions of dollars)

Countries England France Germany

Europe (consisting of 10 countries) 52.7 40.3 62.5

Africa-Asia-Australia (consisting of 6 countries) 344.8 13.0 2.0

Source: Lindert (1969), p 19.

pulling power not only over the less developed financial centres in Europe but also over other major centres like Paris and Berlin. When discount rates rose together, the tendency of the banking system to increase the liquidity of their portfolios would almost inevitably lead to a movement of short-term funds towards the largest financial centres. The tendency of banks to become more liquid in periods of increasing tightness suggests that even if each major centre had been neither a net short-term debtor nor a net short-term creditor, flows of capital towards larger and more prestigious centres should have been expected when discount rates rose together. The operation of this international adjustment mechanism depended upon a hierarchy of financial centres. Since London was in the first tier, Berlin and Paris the second while Amsterdam, Vienna, Zurich, Milan and others were in third, naturally, London benefited most from such operations. On the other hand, Lindert himself has pointed out that the available exchange rate figures, at any rate, imply that tighter discount policy in London, even when initiated elsewhere, set off waves of short-run flows of capital toward the centre of international finance from periphery.

So both Keynes and Lindert agreed on one fact, namely, that the interest rate elasticity of capital flow was higher for the countries in the centre. Within the centre, Britain had the highest followed by France and Germany. But there was a disagreement about the reason behind it. According to Keynes, it was because of their short-term creditor position but there was contradictory evidence available on the claim of Britain’s position as a short-term net creditor. So it may be because of greater liquidity of the British sterling denominated assets, which were followed in this respect by assets denominated in the frank and mark, as Lindert has claimed. It also implies that the British sterling had greater use as an international reserve, which implies greater confidence in the stability of the exchange rate, and greater money pulling power.

According to Marcello De Cecco, such a degree of confidence can be reached when lesser countries were politically or economically subservient. These countries were denied the right to choose between gold and the sterling; they had to deposit any surplus, in sterling, in London. At the same time, London-held deposits of independent countries, which could exercise the right to choose between gold and the sterling whenever they wanted. This can be explained by the fact that this dominance had made British sterling the reserve currency there was a confidence in the stability in the value and liquidity of the sterling deno minated assets so that more reserve flowed into London. In effect, it helped Britain to have an effective rate of interest policy to attract money towards it from the continent, which was the source of funds for the shortrun adjustment in British reserve as Lindert mentioned.

In conclusion, the hegemony over world trade and finance and control over economically and politically subservient countries had led to an international arrangement in which the British sterling found wide spread acceptance as reserve currency. All these factors helped Britain to have extraordinary money pulling power on an international scale at the height of the gold standard.

As a result, Britain could sustain the stability of its exchange rate without having large reserves and stability in the exchange rate itself helped it to maintain confidence in the sterling, which helped its use as reserve currency. The gold standard system appeared to be a stable and smoothly adjusting one nevertheless, practice was different from theory.

No Rival for London

Apart from Britain, France and Germany were also lender countries. Yet none of them managed to rival London in the business of accepting and discounting foreign trade bills or in the volume of total foreign lending. France’s share in total world trade was also small compared to that of Britain. The money deposited in these countries by other countries was quite small compared to Britain. In 1912, only 1,235 million francs were deposited in Paris and in Berlin it amounted to only 152.3 million dollars in December 1913. The liquidity of franc denominated and mark denominated assets was less than of those denominated in the sterling. The central banks of these countries had sometimes partially stopped the convertibility into gold. All these were reasons contributing to the lesser international demand for these two currencies as medium of exchange. This, in turn, contributed to the failure in generating such confidence in these currencies that they could be used widely as reserve currencies. Consequently, neither Paris nor Berlin succeeded in matching the international money pulling power that London had. In con-

Table 7: Reichsbank’s Holding of Foreign Bills trast, the extent of the (Excluding Credits) (in pounds sterling)

Years Average for Year Maximum Minimum

use of a currency as an

1895 1,20,000 1,52,000 1,00,000

international medium

1900 12,70,000 35,40,000 1,60,000 of exchange and its 1905 15,80,000 24,90,000 9,70,000

1906 20,60,000 29,90,000 8,30,000

use as a store of wealth

1907 22,23,000 30,00,000 11,30,000

– both these factors

1908 35,44,000 63,66,000 9,77,800 worked together, for 1909 53,62,000 79,78,000 28,24,800

Britain. Though, from 1910 70,32,000 88,55,000 48,93,300 Source: Keynes (1913).

time to time, Germany had tried to use the bank rate device, its extent was limited. The capital inflows were not large enough to solve the balance of payments deficit problem [Bloomfield 1963]. Thus, even France and Germany had to keep large monetary gold reserves, compared to Britain, to defend their currency. This was even truer for countries, which were in the third tier of financial centres.

Keynes (1913) described the situation very well. According to his narration, the majority of the European countries, for example, France, Austria-Hungary, Russia, Italy, Sweden and Holland had a gold currency and an official bank rate. Gold was not the principal medium of exchange and the bank rate was not

November 17, 2007 Economic & Political Weekly


the “habitual support” to prevent outflow of gold in any of these countries. All these countries had three options to maintain the exchange rate parity. First, a very large gold reserve may be maintained; second, free payments in gold may be partially suspended, and third, foreign credits and bills may be kept, which can be drawn upon when necessary. The Bank of France used the first two. Her bank rate was not fixed primarily with a view of foreign conditions, a change in it was usually intended to affect

Table 8: Gold Standard Reserves of India on March 31, 1913 (in pounds sterling )

and purchase of materials in England on the raj’s account. India’s foreign trade was structured in such a way that India had a huge trade deficit with Britain and a huge trade surplus with the rest of the world. Britain, instead of allowing India to follow the gold standard system, allowed her to have only a gold exchange standard system.6 In 1901, India’s gold standard reserve was 34,47,317 pounds, of which 24,39,093 pounds in gold were held in India and 10,08,482 pounds in British government stock were

Gold Deposited at Bank of England Silver in Indian Branch Securities at Market Prices Money Lent at Short Notices Total
16,20,000 40,00,000 1,59,45,669 10,05,664 2,25,71,333
7.17 % of India’s total reserve 17.72 % of India’s total reserve 70.64 % of India’s total reserve 4.45 % of India’s total reserve

Source: Dadachanji (1927).

the domestic economy. Germany tried to bank upon the bank rate to attract capital flows to ease off the pressure from exchange rate parity but it was not very successful. Her gold reserves were not large enough. Free payment in gold was sometimes suspended, like in November 1912. To an increasing extent, Reichsbank depended on variations in her holding of foreign bills and credits had formed an important part of the reserve and it was utilised at the time of stringency (Table 7, p 70). In the third quarter of 1911, the Bank had placed a minimum amount of 4,000,000 pounds gold bills at the disposal of the Austro-Hungarian market in order to support the exchange. In November 1912, Russia had, as foreign bills balances, an amount of 26,630,000 pounds. In the same time three Scandinavian countries, Sweden, Norway and Denmark, held the highest proportion in the form of balances abroad.

The reason for keeping a high portion of reserves as foreign currency denominated assets by these countries was that the money market was not so developed that it could work as a lender or to be at least self-supporting. The central banks, to make them secure, had to enter the international money market as short-term creditors, so that they could take out money at short notice. The only alternative would have been to hold a much larger reserve of gold, the expense of which would have been nearly intolerable.

The question of being able to use currencies of the countries more peripheral to the system as the international reserve currency almost did not arise. In fact, they had to keep a large part of their reserve not as gold but as sterling deposits in London or invest in the security market of developed countries, mainly London. Their role in international finance was to be exploited and by this, serve the interest of the financial centres. Typically they were forced to provide money to the financial centres. Thus India provided money to London, the financial centre. India had been one of the worst exhibitions of imperial exploitation. The reserves, on which the Indian monetary system was based, could be used to supplement Britain’s reserves and to keep them as the centre of the international monetary system. Apart from this, Britain used to have two other channels through which she could improve her balance of payments by using India’s colonial status. The first was the home charges and the second was through the balance of trade. The home charges consisted mainly of interest on debts to England incurred by the British raj, pensions of former Indian civil servants living in England, payments to the war office for the upkeep of the Indian army and of the whole imperial army

Economic & Political Weekly November 17, 2007

held in England. At the end of the first quarter of 1902, the whole reserve was transferred to London and invested in British government securities. This trend continued until 1914. British government securities in the gold standard reserve’s portfolio grew from 3.5 million in the first quarter of 1902 to 16 million pounds in the first quarter of the 1912. In addition, the India office began to keep money from the gold standard reserve, at call and at short notice with finance houses in London. This began in 1908, when 11,31,223 pound sterling was deposited. It grew up to 3 million pounds by the first quarter of 1910 (Table 8).

At the same time, the economically weaker countries (Lewis termed them as less developed countries who are borrowers and among these we are talking about those who were politically independent but economically weaker, like Argentina) could not keep large reserves. This was because keeping large reserves for them was very costly, somewhat similar to “a man borrowing at 6 per cent to keep money in the bank at 3 per cent”. Most of these countries had very underdeveloped banking systems. They could not effectively influence their financial markets. Even if their central banks tried to use the bank rate to cover the deficit on the balance of payments with a view to stabilising the exchange rate,

Table 9: Trade Balances, Capital Flows and Overall Balances of Argentina

(in pounds sterling)

Country Period Trade Balance Capital Flows Overall Balance
Argentina 1911-13 + 37.3 + 320.0 + 10.0
1895-1900 + 27.2 + 30.8 + 1.3

Source: Lindert (1969), p 69.

they were doomed to fail. So, the safe policy options for these countries for currency stability were – keeping a balance of payments surplus as seen in Table 9 for Argentina or to keep a critical level of reserves such that the intervention in the exchange market could be effective.

So how a country would manage the stability of its exchange rate depended on that country’s ability to control capital flows through the rate of interest change. In the next section we shall try to theorise this through a mathematical model.

2 Theoretical Argument

The historical analysis in the previous section shows that countries were managing their exchange rate stability in mainly two ways – either controlling foreign capital flows by changing interest rates or by keeping reasonably high foreign exchange and gold reserves. The countries that had lower interest elasticity of capital flows had to keep higher foreign exchange and gold


reserves. And the countries that had greater interest rate elasticity identical functions for all currencies mck = f (Rk, εk) for all k, of capital flows, need not have kept high amounts of foreign ƒ΄1 p0, ƒ΄2 p0, where, k denotes any currency. exchange and monetary gold reserves. As the equality of risk premium of all countries is required for

Suppose, we have only two assets – money and bonds. The the equilibrium, this means that Rk = h(εk) for all k and h΄ p0, wealth holders can hold currencies and bonds. The expected i e, countries with high interest elasticity of capital flows will return from keeping wealth in say country i will be: have low ratios of reserves to money supply in equilibrium.

And we have enough evidence in our discussion of the previous * *


[(—)e+qb –mb + (— )e –m section that shows that the degree of interest elasticity of capital


P b P c

flows for a country positively depends upon its currency’s use as where, p refers to price, subscript b to the bond, subscript c to the international money. The countries that have greater economic currency in question, superscript e to the expected value, m to and political hegemony are likely to have their currency’s greater the risk premium and q to the rate of return of the bond. use as international money.

If the net rate of return on the bond is denoted by r, what by following Kaldor can be called the “own rate of money interest” 3 Conclusions then in the short period equlibrium for currency i and j, From the preceding discussions we can draw the following

conclusions – first, in exchange rate management, the adjust* )e*)eP P

[rb+(— –m]i = [rb + (— –m]i ment through the current account did not have a reasonably


P b P c important role during the gold standard regime. Second, the

stability of the exchange rate was scarcely dependent on foreign *


where, rb=(—)e +qb – mb exchange and monetary gold reserves in the case of Britain which P b

was the dominant economic power of the time. The stability of If we define the long-run equilibrium as a state characte-the exchange rate of other countries, especially underdeveloped rised by and colonial countries depended upon the stock of reserves they had. Third, this difference in the link between monetary gold re

* )e

P serves and national currency was crucially dependent upon the

— = 0 for both j and i, then [rb – m]i = [rb – m]j


P c ability of a country to control capital flows. Finally, a country,

Following Keynesian tradition, the objective of economic which had more influence on world trade and finance and polipolicy in each country must be assumed to preclude having a tics, got its currency to have greater use as international money. persistently higher interest rate than in the other, for that would And it was correspondingly more able to control international entail lower growth; it follows that policy must be such that capital flows. This gave rise to an apparently paradoxical pattern:

rbi = rbj . Hence, mcj = mcj the more economically powerful a country, the less it needed

Now, if risk premium of the currency is taken as a function of to maintain monetary gold and foreign exchange reserves to the level of reserves to the money supply (R) and of the elasticity back its currency. This pattern is continuing till today with the of capital flows with respect to the interest rate (ε), then, assuming only difference of USA replacing UK.

Notes inevitably imposed a certain discipline and coordina-References tion on monetary conditions in other countries.”

1 Aliber (2000) said, “Traders in foreign exchange need Aliber, R Z (2000): ‘Introduction’ in International Finance,

3 Lewis (1978) said, “Whenever Britain began to recov

an inventory of foreign currencies; they want to Edger Elger.

er from cyclical recession there would come a point

minimise the cost of holding this inventory. The Bloomfield (1963): ‘A Short-Term Capital Movement under

where the Bank began to lose gold…. A financial

costs of holding this inventory could be minimised the Pre-1914 Gold Standard’, Princeton Studies in

crisis could occur… The bank rate would go sharply,

if the currencies are denominated in the currency of International Finance, 11.

and open market operations or equivalent would be

the country identified with low interest rates. Before Benjamin, J Cohen (1977): Organising the World’s Money,

launched. At this point oversees lending would be

the first world war, a large part of international Basic Books, New York.

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to the financial crisis, because the houses promoting Dadachanji, B E (1927): History of Indian Currency and then much of the international trade has been

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such loans would think the moment inauspicious,

and because those who held funds for foreign coun

countries (except primarily the US) need to pay US tries would keep them in London to earn higher De Cecco, M (1984): The Gold Standard Money and Empire,dollars; exporters in these countries receive US

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deposits as part of their inventory. And the developand History, Methuen, New York.

ment of the reserve currency roles of the British 5 According to De Cecco (1984), Britain was the Friedman, M and Anna J Schwartz (1982): Monetary pound and then of the US dollar followed the patterns world’s banker. The smaller countries had to have

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extent in France and Germany. This was seen as

2 In his book Cohen (1977) writes, “The classical gold University of Chicago Press, Chicago.

advantage for Britain and to a lesser extent for

standard was a sterling standard – a hegemonic

Keynes, J M (1913): Indian Currency and Finance,

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regime – in the sense that Britain not only dominat-MacMillan, London.

more abroad, both on the current and capital ac-Kindleberger, C P (1984): A Financial History of Western Eued the international monetary order, establishing

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keep investing in the lesser. The balance between Kuznets, Simon (1966): Modern Economic Growth, Yale but also gave monetary relations whatever degree

of inherent stability they possessed… It did not short-term indebtedness and long run credit was University Press, New Haven.

regard itself as responsible for global monetary stabi-often maintained bilaterally. A major country could invest in a peripheral country to more or less the Lewis, W A (1978): The Evolution of the International

lisation or as the money manager of the world. Yet this is precisely the responsibility that was thrust amount of short-term deposits it received from Economic Order, Princeton University Press. upon it in practice... The widespread international that country. That was often the case with the British Lindert, P H (1969): ‘Key Currencies and Gold 1900-1913’,

use of sterling and the close links between the larg-abroad. Princeton Studies in International Finance, No 24. er financial markets in London and smaller national 6 Gold was not in circulation within the economy. It Scammel, W W (1985): ‘The Working of Gold Standard’ in financial markets elsewhere inevitably endowed was paper money that was in circulation and it was Barry Eichengreen (ed). Britain with the power to guide the world’s monetary backed by the gold reserve, which was deposited in Woodruff (1966): ‘The Impact of Western Max’, p 150, policy. Changes of policy by the Bank of England London. reprinted in C P Kindleberger (1984).

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