Rebuilding the Worlds Economy: The Gold Standard - Essay Example

International Finance Lecturer: Introduction The growth and stability of the world economies is a key concept that every economist desires to see. In a stable economy, there is much room for growth. However, if by one way or the other, this growth is disturbed, the various governments in which these economies were disturbed are responsible for the rebuild of the collapsed economies (Wisman, 2005, p. 900; Chaloupek, 2006, p. 175). Conflicts, including wars are among the highest destabilizers of the economy of the nations. There is no investor with a rational mind who would invest his or her money in a nation which is involved in a conflict. This is because these countries have no way of guaranteeing that this investment will not be lost. War leads to loss of business (Courtney, 2010, p. 16).This paper will take an illumination into two critical economic factors; wars and the purchasing power parity. The investigation of these two topics will be conducted on different platforms to assist in proper evaluation of the same. The first section of the paper will look into the two world wars, World War I and World War II and how the economy was affected by these two wars. In the same breath, it will investigate how the different countries of the world that were largely affected by these wars rebuilt themselves to regain their status as the great economies of the world. The second section will inspect the purchasing power parity theory and offer critical reviews of the same. World War 1 - Rebuilding the world’s economy; The Gold standard Before the year 1914, the Great British Pound (GBP) was the most predominant currency in the world (Rowe, 2002, p. 149). It was the currency that was used as a base currency for all the other currencies that were used to conduct transactions to in the world. This currency formed the basis of stabilizing other currencies in the world. The purchasing power of other currencies were gauged using this base currency. The prominence of the GBP currency was such that it made over 90 % of all the world’s international payments ((Schwartz, 1997, p.15). After the year 1914, the currencies of economies of other nations, namely USA dollars and the French Francs (FRC) gained more popularity and strength against the pound. The reliance of the gold as a standard measure was largely adopted later on for the stability that gold presented as a medium of exchange (Schwartz, 1997, p.20). The world had no effective monetary system to monitor the transactions of the world economies. According to Schwartz (1997, p.21), the use of gold as a standard of value was effected so as maintain the stability of currencies in the world. The currencies of the world, from history, had proven to be volatile and unpredictable when the GBP failed. A new system of stabilizing the world economy had to be devised. UK was the first country to adopt the Gold standard measure. By the year 1871, many other countries had followed the UK in the adoption of this gold bullion standard (Walter-Busch, 2006, p. 248; Abbott, 2006, p. 49). The value of sterling was fixed in gold measurements. The two forms of currency; gold and the sterling could be used interchangeably. People could hold gold instead of sterling and vice-versa. However, the bulkiness of gold as a form of exchange was cumbersome and a more flexible manner of payments had to be devised. Paper money was introduced an adopted by the 1900s ((Day, 2000, p. 15).The flexibility of paper money increased the number of transactions conducted worldwide. In 1925, the UK went back to the gold bullion standard in pursuit of a more stable form of currency. This was done in a bid to return to an international monetary system. Several reserve currencies were identified here. These were the GBP, the USD and the French Francs. The period between the year 1929 and 1931 were years that nations of the currencies of the world were undergoing through a hard time. The rise in the interest rates and the crash of the stock market led to the great depression. UK wasn’t able to maintain the announced parity with gold. World War 2 economic stimulus -The Bretton Woods Agreement of 1944 This was an agreement that was signed at Bretton Woods, New Hampshire. Both the UK and the USA were signatories of this agreement. The main initiative of this agreement was to plan the international monetary system following the Second World War. The international monetary fund was formed from this agreement. The great losses and destruction and depletion of the economies of the world during the world war II left much to be desired. Stability was much desired after this and these nations had to find ways to rise up as superpowers again. Through the Bretton Woods Agreement, the signatories of this agreement had the chance to seek assistance from each other as well as from the USA to rebuild their economies and move on onto a new era. In this agreement, the nations proposed a return to the now more stable currency, the dollar for use as a base currency. The return to the fixed exchange rate system promoted the US dollar to becoming the world’s major reserve currency. The rates were fixed at USD 35 per 1 Oz of gold. The other currencies were rotated around the price of the USD. The international monetary fund came into the picture to regulate these exchanges. To retain the value, each new IMF member had to pay an equivalent of a quota in gold and the IMF was permitted to lend to the countries which experienced deficits (Scammel, 1982, p. 23).Through the regulation by the IMF, order and sanity was returned to the world economy and confidence was returned to the international monetary system. Effect of the Bretton Woods Agreement The Bretton Woods agreement served to help stabilize the economies of the world. With the equivalent of the gold measured in dollars, the world nations had a way to now ensure that there was a stable and strong currency to back up these gold reserves. As a result, the nations of the world, which had played a key role in the war such as Germany, began rebuilding itself through the financial assistance of the USA. However, the Bretton Woods agreement proposed some harsh sanctions against Germany. The country was required to disband its army and pay expensive repatriations to the nations in which it had created chaos. Germany’s economy was deteriorating and these repatriations served to worsen the country economically. The IMF and the World Bank played very critical roles in the revival of these economies. Huge amounts of money were loaned to Germany and other countries who were signatories of the Bretton Woods Agreement from both the allies and the central powers’ sides. The main aim of the IMF and World Bank after this war was to create an enabling environment where an economic stimulus to these nations who had been involved in this conflict (World Bank website, 2013). The IMF and the World Bank offered huge loans to help facilitate the rebuild of the economies of these nations which now lay in tatters. The loans had an extended repayment plan and the countries which took up these loans had to adhere to strict and stringent conditions that were set out by these international monetary organizations aiming at curbing and preventing a disaster as the world wars again. GATT policies were adopted after the Bretton Woods model flopped later on. The GATT policies allowed the movement of goods without payment of taxes and customs in the regions that were members of this organization (Courtney, 2010, p. 19). GATT policies were meant at allowing for a situation where these countries could develop in a faster manner through scraping off trading tariffs between the member nations. Sure enough, the economies of these nations started flourishing and within no time, they were again upon the road to becoming economic superpowers. The success of a GATT made it possible for international finance and trade organizations cropped up. Trade became more effective through the removal of those barriers and the economies of these trading nations started growing. Germany was no left behind in this. Purchasing power parity (PPP) By definition offered by Swarma (1996, p.22) is a theoretical concept that produces an estimation of the amount of the adjustment that is required for the calculation of the exchange rates between two countries taking caution that the exchange must be equivalent to each currency’s purchasing power. Moosa (1994, p. 3) offers a more simplified definition of PPP through usage of an example where he states that PPP offers the exchange rate that is flexible enough so that a particular type of good or service that is identical to another good in another country has the same pricing when it is expressed using the same currency. In finance, PPP is a theory that is used in the prediction of changes in the expected spot rates by comparing two different countries. There are two forms of PPP that have been identified here and they are highlighted in the following discourse. The two forms of PPP are the absolute purchasing power parity theory (APPPT) and the purchasing power parity theory (PPPT). These are different forms of PPP that offer differing degrees of understanding of the concept in response to the understanding of the developers of the theories. Absolute purchasing power parity theory (APPPT) In the absolute purchasing power parity theory (APPPT), the concept of PPP is measured using the power of one product only (Hyrina & Serletis, 2010, p. 119). The developers used the Big Mac index that compared the price of a single MacDonald’s Big Mac burger in different MacDonalds’ restaurants. To estimate the PPP using this form, the prices used must be latest. Old prices bring some sort of deviation and lack of originality in the computation and estimation of the PPP. From this form of PPP measurement, the prices of for a particular product that is identical to another one in form of all criteria such as taste and size should be the same irrespective of the country in which the product is in. for instance; we could take a good example of a bottle of soda from the Coca-Cola Company. Assume that the price of the single bottle of Coca-Cola beverage costs US Dollars 0.75 in the USA. Now suppose that the exchange rate of the USD against a currency such as South African Rands stand at 70 Rands per USD, USD 0.75 would be equivalent to 52.50 Rands. This should the price of the bottle of Coca-Cola in South Africa. Using this concept of Big Mac, the PPP of an identical product like Coca-Cola assumes one price (USD 0.75 = 52.50 Rands) in two different geographic areas. However, in a normal world, this APPPT is not applicable. For this theory to hold, a number of assumptions must be made. One of the assumptions is that there are no capital flows and that products are transferrable from one place to another and from one form to another (Bleaney, 1974). However, there must be no transport involved which is transferred to the end user. Another assumption is that the consumer travels from one place to the other without incurring any travel costs (Hyrina & Serletis 2010, p.117). This is a scenario that is only hypothetical since its applicability is quite challenged by the market dynamics. In our Coca-Cola example, if the South Africans decide to travel to the USA to consume the beverage, and assuming no travel costs, a number of actions occur. There is an upward pressure placed on the demand for dollars as the South Africans purchase the dollars so that they could use them for the purchase of the Coca-Cola drink. In the same breath, a downward supply pressure on the Rands occurs as they sell them to buy the USDs. To prevent this hustle, the Coca-Cola Company in South Africa is forced to lower the price of the beverage to match the price of that of the same in the USA, preventing the people from travelling. Purchasing power parity theory (PPPT) This is a theory that is used to measure the relativity value of two different currencies. This theory applies the concept of the fisher effect. In this theory, the prediction in changes of spot rates by comparing the long-term expected interest rates in two different countries (Sjolander, 2007, p. 257). According to this theory, the nominal interest rates remain in a static state in real times (Beach et al 1974, p. 45). However, the theory gives some room for the allowance of risk (Bleaney, 1974). In the calculation of these nominal rates, price inflation is added to real interest rates to calculate the nominal interest rates. For example, assume that the exchange rate for 70 Rands/USD Suppose then that the current interest rates of the two currencies are 10 % and 5% respectively. The Fisher effect will be instrumental in the measurement and estimation of future exchange rates on the basis of the relationship between the different nominal interest rates. To estimate the spot exchange rate in the future, say after one year from now, the current spot exchange rates are multiplied by the nominal South African interest rates and then dividing this by the nominal USA interest rates. This is shown in the mathematical expression below. 70 × {(1+5%)/ (1+10%)} = 66.82 Rands. In 12 months’ time, it will cost approximately 66.82 Rands to purchase 1 unit of USD. This implies that the expectation of the value of the USD will have depreciated. Validity test When the two forms of PPP are placed for the validity test, the findings are outlined in the following discussion. The absolute purchasing power parity theory has too many assumptions that make the theory become too clustered and difficult to apply in real life situations. The margin of error is too huge in this concept. The purchasing power parity theory through the Fisher effect could be adopted as a more valid way of testing the PPP of different currencies in different nations at a certain time in the future because it does this analysis using real time figures in the present to cater for the future needs of the exchange rates. Conclusion The above discussion has offered a clear, concise and precise review of the issues at hand. From the above discussion, the rebuild of the world economies after the world wars was not an easy process. It was a process that took time, resources and energy. The political structures of most of these nations were thoroughly disrupted. The rebuild after the World War I was largely left to Germany which paid huge losses in form of repatriations, forcing the economy of the country to submerge into high inflation levels. After the World War II, USA assisted Germany and other European nations to rebuild themselves up and start all over again. From the above discussion, there have been identified two forms of PPP; The Big Mac theorem and the Fisher effect. The Big Mac theory proposes the law of one price for identical goods in different markets. The Fisher effect theorem is different in that it calculates the rate of interest that will be present for exchange between the currencies of two different countries at a certain time in the future. References Abbott, R.L 2006. ‘World War I Document Archive’, Reference Reviews, Vol. 20, No. 2: pp. 58-59. Armstrong, S 1998. ‘work, womanpower, and World War II’, reference services Review, Vol. 26, No. 1: pp. 31-36. 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World Bank website 2013. ‘World Bank home-articles’ retrieved February 03, 2013 from www.worldbank.com Read More