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Saturday, 4 August 2012

What is the rate of exchange and how it is determined under gold standard

Rate Of Exchange :-
It is the rate at which the currency of one country can be converted in to another. For example if we want to purchase one dollar of USA. To buy one USA dollar we have to pay 90 Rs. So the rate of exchange will be Rs 90 $ 1.

Now if we want to purchase dollar against one rupee, then Rs 1 = 0.01111 will be the rate of exchange. There are different kinds of exchange rate like official rate, buying & selling rate, time rate, forward rates and fee rate.


The rate of exchange between currencies of the countries on gold standard depends on the relative amount of gold in each currency unit Suppose gold is the monetary standard in the world. The British gold pound contains the same amount of gold which is found in 4.87 dollars of USA. Thus the rate of exchange between these two countries will be 1 $ 4.87.

The mint par represents the ratio between the pure gold quantity found in two currencies. We can calculate the mint par ratio by the following formula.

Gold quantity in U.K = 113.0016 grams of fine gold.
Gold in USA $ = 23.22 grams of fine gold.

Mint Par : 113.0016 / 23.22 = 4.87
or   1 Pound = 4.87 Dollar

The mint par ratio may differ with market ratio. The market rate can freely fluctuate around the mint par ratio due the changes in demand and supply of foreign exchange. Fluctuation are controlled within gold import and export points, determined by the cost of transportation of gold between the countries. The extreme points of variation in the exchange rate are know specie or gold points.

Explanation :-
To make it more clear we can explain it by the following example. Suppose the rate of exchange between England and USA is 1 $ 4.87 dollars according to the gold quantity in both currencies. Further suppose that America increases its imports from U.K In other words the demand of pound will increase then its supply. So the USA currency will depreciate. The Americans will have to pay more than 4.87 dollars to get 1 in England. If the rate of exchange is determined 5 Dollars to one pound, then American can make the payment in two ways.

1. Export of Gold
2. Sending a Bank draft.

The gold export point for a country is the mint par plus the cost of transpotation of gold while the gold import points the mint par minus the cost of transportation.

Gold export point ( USA : $ 4.87 + $ 0.02 = $ 4.89
Gold import point ( USA : $ 4.87 + $ 0.02 = $ 4.85

According to this example, If America wants to make the payment by gold then cost will be $ 4.89 for every 1 ( one pound ). If a bank demands more than $ 4.89 for one pound, then American importer would make payment by export of gold instead of purchasing draft. So price for purchasing bank draft will fluctuate between $ 4.87 & 4.89 $.
After this discussion we conclude that when two countries are on full gold standard, the gold points set the limits within which the rate of exchange can fluctuate. It does not go beyond the gold points because in that case gold will flow one country to another country.

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