This system is the first international monetary system out of three global systems that have emerged over the past 150 years.
An international monetary system governs the determination of exchange rate policy in major countries and restrictions on the movement of capital and thus on monetary policy in these countries.
How did this system work? 1. This system did not have an international institution governing it or setting its rules, but rather it was a conventional system, meaning that all countries knew the rules of the game without signing formal agreements.
2. The basis of this system is the fixation of the major countries’ exchange rates against gold, and therefore against each other. An ounce of gold = $20 in America and an ounce of gold = 4.2 GBP in England, so the exchange rate of 1 GBP = $4.8.
3. To ensure confidence in the fixed exchange rate system for gold, countries were required to exchange the local currency for gold on demand (convertibility).
And here lies the very important link between exchange rate policy and monetary policy within the country. To ensure that there is the sufficient gold cover, the central banks adhered to a very conservative policy of printing banknotes to the extent that inflation rates during the period were around zero.
The principle is very easy If there is gold, there are banknotes. If there is no gold, there are no banknotes.
4. There were no restrictions on the movement of gold between countries for the purpose of investment (no capital controls). Therefore, there were no discrepancies in interest rates, because in this case and in the absence of restrictions on transfers, raising the interest rate in England, for example, to a higher level than America would lead to the exit of gold stock from America to England and the rise of the GBP against the USD.
5. Trade was completely free and free of restrictions, so the price of the commodity in almost all countries is similar after taking into account the exchange rate.
Of all these details, the most important characteristic of the system is the following:
If the prices of goods in a country within the system are higher than their counterparts abroad, the country will not be able to reduce the exchange rate to restore external competitiveness because there is an obligation to fix the exchange rate.
But the system would fix the defect in a country as follows: 1. Due to the high price of the commodity compared to its counterpart abroad and in the presence of free trade, the country’s imports of goods rise due to the cheaper price of the importer then the local one.
2. A deficit in the trade balance = the exit of gold from the country to pay the value of net imports.
3. Gold exit = monetary tightening because there is no banknote in the absence of the gold cover.
4. The interest rates rise due to the scarcity of banknotes and the prices fall again (deflation) due to the weakness of lending by the banks and the state regains its external competitiveness again without moving the exchange rate.