The Interdependence of Macroeconomic Conditions under a Metallic Standard - dummies

The Interdependence of Macroeconomic Conditions under a Metallic Standard

By Ayse Evrensel

Maintaining internal and external balance is challenging under a metallic standard. In addition to the difficulty of maintaining the internal and external balance, a metallic system has other challenging characteristics. One is the interdependence of macroeconomic conditions under a fixed exchange rate system.

The interdependence of macroeconomic conditions implies that the fixed exchange rate regime allows countries to export their macroeconomic problems to other countries. The main channel of interdependence is international trade. A country experiencing lower growth and higher unemployment doesn’t import as much from other countries. The decline in other countries’ exports sectors can create lower growth and higher unemployment in the exporting countries.

If a country experiences higher inflation compared to its trade partners, other countries’ goods become less expensive to domestic consumers (at the given exchange rate). And increased demand for other countries’ goods increases trade partners’ inflation as well.

Note that the only reason for the ability to export one’s own problems to other countries is a fixed exchange rate. The interdependence of macroeconomic conditions is possible because the exchange rate isn’t allowed to change.

Consider the example of the lower-growth country. If exchange rates are flexible and not fixed, the lower-growth country’s exchange rate depreciates, making its exports less expensive and its imports more expensive. This situation then increases the country’s exports and decreases its imports. In the case of the higher-inflation country, and assuming a flexible exchange rate regime, the same events (starting with the depreciation of the currency) happen.

The moral of the story is that if there’s a fixed variable and changes in the economic environment aren’t allowed to affect the fixed variable, frictions will occur. Therefore, the spread of economic problems through international trade can be viewed as a friction that occurs under the fixed exchange rate regime.