This is “Overview of Fixed Exchange Rates”, section 22.1 from the book Policy and Theory of International Economics (v. 1.0).
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This chapter begins by defining several types of fixed exchange rate systems, including the gold standard, the reserve currency standard, and the gold exchange standard. The price-specie flow mechanismA description about how adjustments to shocks or changes are handled within a pure gold standard system. is described for the gold standard. It continues with other modern fixed exchange variations such as fixing a currency to a basket of several other currencies, crawling pegs, fixing within a band or range of exchange rates, currency boards, and finally the most extreme way to fix a currency: adopting another country’s currency as your own, as is done with dollarizationCurrency fixing by adopting the U.S. dollar as one’s currency. or euroization.
The chapter proceeds with the basic mechanics of a reserve currency standardA currency standard in which all countries fix to one central reserve currency, while the reserve currency is not fixed to anything. in which a country fixes its currency to another’s. In general, a country’s central bank must intervene in the foreign exchange (Forex) markets, buying foreign currency whenever there is excess supply (resulting in a balance of payments surplusThe balance on the balance of payments when the central bank sells domestic currency and buys foreign currency.) and selling foreign currency whenever there is excess demand (resulting in a balance of payments deficitThe balance on the balance of payments when the central bank buys domestic currency and sells foreign reserves.). These actions will achieve the fixed exchange rate version of the interest parity condition in which interest rates are equalized across countries. However, to make central bank actions possible, a country will need to hold a stock of foreign exchange reserves. If a country’s central bank does not intervene in the Forex in a fixed exchange system, black markets are shown to be a likely consequence.
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”