CHAPTER 2 INTERNATIONAL MONETARY SYSTEM
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain Gresham’s Law.
Answer: Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce)
money out of circulation. This kind of phenomenon was often observed under the bimetallic standard
under which both gold and silver were used as means of payments, with the exchange rate between the
two metals fixed.
2. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed under
the gold standard.
Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow
mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium
will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it
exports to the latter. Under the classical gold standard, gold, which is the only means of international
payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease
(increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the
U.K. Consequently, the U.S. products become more competitive in the export market, while U.K.
products become less competitive. This change will improve U.S. balance of payments and at the same
time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium.
3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at
12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be two francs per
pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this
situation? What would be the effect of shipping costs?
Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in the
foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for
12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only costs you 12
francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course,
you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The
arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs more
than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.
4. Discuss the advantages and disadvantages of the gold standard.
Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted, countries
cannot have high inflation; (2) any BOP disequilibrium can be corrected automatically through cross-
border flows of gold. On the other hand, the main disadvantages of the gold standard are: (I) the world
