The Exchange-Rate and Reserve- and Capital-Flows Mechanisms
The exchange-rate and reserve- and capital-flows mechanisms have varied somewhat from the concept of the classical gold standard with fixed ties between gold and countries' units of account, and the wide acceptance of gold as a monetary reserve. However, the principles of an anchor for the monetary unit (such as gold at a fixed price or, more recently, the anchoring of selected currencies to the deutsche mark) and the fractional reserve banking system (as illustrated in Figure 3-6) have not varied much since David Hume ( 1711- 1776) tied such a system to the simplest of the quantity theories of money and the idea that a country's price level was governed in some way by the stock of money.
Starting with gold as the reserve asset of choice, and fixed ties between gold and currency units, results in fixed exchange rates, the gold-flows mechanism, and a set of classical conditions. The fixed rates at which the currencies exchange for one another are the means for extending abroad the prices of goods found in the various countries. Then, allowing for competition in the export of goods and services, the country with the lowest prices is favored, and gold flows in as foreign currencies are exchanged for gold. The inflow of gold increases reserves, and the system of money and credit multipliers comes into play, the money stock expands and, domestic prices rise. As this happens, the conditions are set for a reverse set of changes to occur.
Adding the prospect of substitutes for gold reserves (such as currencies that are as good as gold), the functioning of the gold-flows mechanism does not change much. In the post-World War II years, the U.S. dollar was such a currency for a time, as I will indicate, and then with a history as a "hard