Question

Today international finance is based on ( \(\mathrm{LO3})\) a) the gold standard b) mainly a relatively free-floating exchange rate system c) fixed rates of exchange

Short answer

Today's international finance is based primarily on a relatively free-floating exchange rate system (option b), where currency values are determined by market forces, with minimal intervention from governments and central banks. The gold standard (option a) is an outdated system no longer practiced, and fixed rates of exchange (option c) are not predominantly used in today's international finance.

Step-by-step solution

Overview of Options

To answer this question, let's first look at the three options provided: a) The gold standard b) Mainly a relatively free-floating exchange rate system c) Fixed rates of exchange Now, we will analyze each of these options to determine which one best represents the basis for today's international finance.

Gold Standard

The gold standard is a monetary system in which a country's currency is directly linked to a specific amount of gold. Under this system, countries agreed to convert paper money into gold at a fixed exchange rate. The gold standard has not been in use since the early 20th century and has been replaced by other systems that have evolved over time.

Free-Floating Exchange Rate System

A free-floating exchange rate system, also known as a floating exchange rate system, is a currency exchange system in which the exchange rate between currencies is determined by the market forces of supply and demand. In this system, governments and central banks generally do not intervene to set the exchange rates. Instead, exchange rates change constantly due to market factors like trade, investment, and economic sentiment.

Fixed Rates of Exchange

A fixed exchange rate system, also known as a pegged exchange rate system, is a currency exchange system in which a government or central bank sets the value of its currency against another currency, usually a group of currencies, or a commodity like gold. The government or central bank must maintain its currency at the pegged value by buying or selling foreign currency in the international market. Fixed exchange rates were more common in the past, such as during the Bretton Woods system which ended in the early 1970s.

Conclusion

Considering the information above, it is clear that option (a) - the gold standard is not applicable today as it is an outdated system that is no longer practiced. Option (c) - fixed rates of exchange are also not predominantly used in today's international finance. Therefore, the correct answer is option (b) - mainly a relatively free-floating exchange rate system. Today's international finance is based primarily on a system where currency values are determined by market forces, with minimal intervention from governments and central banks.

Key concepts

Free-Floating Exchange Rate System

In a free-floating exchange rate system, the value of a currency is not fixed to any other currency or commodity. Instead, it changes organically based on supply and demand in the foreign exchange market. This fluidity means that currency values can fluctuate based on factors such as geopolitical events, economic reports, and market sentiment.

This system provides a country with more flexibility as its currency is not tied to the economic policies or conditions of another country. However, it also exposes the country to potential volatility as its currency can rapidly appreciate or depreciate, affecting trade and financial stability. Countries with strong economic fundamentals and transparent financial practices typically fare better in a free-floating system.

Gold Standard

The gold standard is a historical monetary system where a country's currency or paper money had a value directly linked to gold. Countries that operated under this standard would fix their currency's value to a specific amount of gold and were committed to converting notes to gold at that rate upon request.

The use of gold standard became widespread in the 19th century but it started to decline during the Great Depression and was eventually abandoned. It provided long-term price stability, but it also limited a country's ability to adjust its monetary policy to respond to economic changes. The gold standard represents a fixed exchange rate system and is no longer used in international finance today.

Fixed Exchange Rates

Fixed exchange rates, also known as pegged exchange rates, are when a country's currency value is tied to another major currency, such as the US dollar or the euro, or to a basket of currencies. Sometimes, a currency may also be pegged to the value of a valuable commodity.

Governments and central banks endeavor to maintain the fixed rate by intervening in the foreign exchange market. They achieve this by managing their currency reserves and actively buying or selling their currency to align with the pegged rate. Fixed exchange rates can provide stability for small economies that trade extensively with a large partner but reduce the flexibility of the government's monetary policy and can lead to balance of payments problems if the fixed rate is not maintained at a realistic level.

Currency Exchange Systems

Currency exchange systems can be thought of as the framework within which currencies are bought, sold, and exchanged. This includes both the aforementioned free-floating and fixed exchange rate systems, as well as hybrid systems like managed float regimes.

In managed floats, a currency's value is primarily market-driven, but the central bank may intervene occasionally to stabilize or steer the economy. Another variant is the currency board arrangement, where a country's currency is backed one-to-one by foreign reserves. The choice of exchange rate system can significantly impact a country's monetary policy, inflation rates, and overall economic growth. Each system has its benefits and trade-offs, with specific suitability depending on a country's economic structure and objectives.