Brief notes on Fluctuations in Exchange Rate

Mint rate is a long run phenomenon. In the long run, the forces of demand and supply of foreign exchange tend to be in equilibrium and the exchange rate has the tendency to become equal to the ratio of gold values, or the mint parity.

In reality, the demand and supply forces experience changes, and as a result, the market rate of exchange may differ from the long run mint parity equilibrium. This variation in the exchange rate is within the well-defined limits, called gold points.

Thus, gold points refer to the limits within which the market rate of exchange between two countries on gold standard fluctuates from the mint parity equilibrium level. The upper gold point indicates the upper limit and the lower gold point indicates the lower limit.

The gold points are determined by the costs of shipping gold (such as, transportation, packing, insurance charges) from one country to another.

For example, an American importer willing to buy pounds with dollars to pay for his imports from England will pay a price above the mint parity (i.e., more than 4.866 dollars per pound) if necessary. But that price must not be greater than the cost of buying gold in America and shipping it to England to acquire pounds.

Similarly, an American exporter willing to sell pounds for dollars will be ready to accept a price below the cost of using his pounds to import gold from England and then sell this gold in America to acquire dollars.

Thus, the upper gold point is determined by adding the cost of shipping gold to the mint parity rate of exchange and the lower gold point is obtained by deducting the cost of shipping gold from the mint parity rate of exchange.

The upper gold point is also called gold export point because it refers to the critical rate of exchange above which gold will be exported.

Similarly, the lower gold point is called gold import point because it indicates the critical rate of exchange below which gold will be imported. Under the gold standard, the exchange rate between two currencies cannot vary above the upper gold point and below the lower gold point. It will remain within there two limits.

Thus, under gold standard, since the limits to exchange rate variation are very narrow, we can talk in terms of a fixed exchange rate.

In Figure 2, curve DD represents demand for pounds (or supply of dollars) and curve SS represents supply of pounds (or demand for dollars). OM (i.e., f 1 = $4,866) is the mint rate and it costs $0.02 to ship $1 worth of gold between America and England.

Thus, £1 = $4,866 (OU) is the gold export point and £1 = $4,846 (OL) is the gold import point. Since the market exchange rate cannot raise above gold export point (OU) or fall below the gold import point (OL), the demand and supply curves become in­finitely elastic at the gold points.

Hence, the demand curve for pound becomes UABC, and the supply curve for pound becomes LPQR, instead of DD and SS respectively.

Thus, cost of shipping gold determines the upper and lower limits (OU and OL respectively) beyond which the exchange rate cannot move.

As long as the shifts in demand and supply schedules remain within the limits of gold points (i.e. the demand for pounds changes within range and supply of pounds changes within ss1 range), the market rate of exchange will diverge from the mint rate (OM) and the variation will remain within the limits of upper gold point (OU) and lower gold point (OL).

If the shifts in demand and supply curves are substantial and go beyond the limits of gold points (i.e., the changes in demand and supply of pound exceed the dd1 and ss₁ ranges respectively), there will be gold flow which, in turn, will restore equilibrium in the exchange market and keep the exchange rate within the limits of gold points.

For example, if in America, as a result of deficit balance of payments with England, the demand for pounds increases beyond point d , the American buyers of pounds instead of purchasing pounds at a rate higher than £1 = $ 4.886, will find it profitable to meet this excess demand by exporting gold to England.

Thus, the exchange rate will not rise beyond the gold export point OU. Similarly, if, in America as a result of surplus balance of payments with England, the supply of pounds increases beyond point s_p the American sellers of pounds, instead of selling the pounds at a rate lower than £1 = $4,846, will prefer to use the pounds to import gold from England.

Thus, the exchange rate will not fall below the gold import point OL. Hence, under the gold standard, the market rate of exchange fluctuates within the limits set by the gold points and never crosses them.