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2. The Flexible Standard
The flexible standard, a development of the period between World War I and World War II, originated from the gold-exchange standard. Its characteristic features are:
1. The domestic standard's parity as against gold and foreign exchange is not fixed by a law but simply by the government agency entrusted with the conduct of monetary affairs.
2. This parity is subject to sudden changes without previous notice to the public. It is flexible. But this flexibility is practically always employed for lowering the domestic currency's exchange value as against gold and those foreign currencies which did not drop against gold. If the downward jump of parity was rather conspicuous, it was called a devaluation. If it was slight only, it was usual to speak of a newly manifested weakness of the currency concerned.
3. The only method available for preventing a currency's exchange value from dropping below the parity chosen is unconditional redemption of any amount offered. But the term redemption has in the ears of the self-styled unorthodox statesman an unpleasant connotation. It reminds him of the past when the holder of a banknote had a legally warranted right to redemption at par. The modern bureaucrat prefers the term pegging. In fact, in this connection pegging and redeeming mean exactly the same thing. They mean that the currency concerned is prevented from dropping below a certain point by the fact that any amount offered for sale is bought at this price by the redeeming or pegging agency.
Of course, this point—the parity—is not fixed by a law under the flexible standard, and the agency is free to decline to buy an amount offered at this rate. Then the price of foreign exchange begins to rise as against this parity. If the government does not intend to adopt the freely vacillating standard, the pegging is soon resumed at a lower level, that is, the price of foreign exchange is now higher in terms of the domestic currency. Such an event is sometimes referred to as raising the price of gold.
4. In some countries the conduct of pegging operations is entrusted to the central bank, in others to a special agency called foreign-exchange equalization account or a similar name.1
- 1. For the reasons that led to the establishment of such foreign-exchange equalization accounts, see Human Action, pp. 458-59.