On the business cycle diffusion process under the gold standard and flexible exchange rate

On the Business Cycle Diffusion Process

under

The Gold Standard and Flexible Exchange Rate System

 

Abstract

 

This article, based on a rigorous dynamic microeconomic foundation, analyzes how the business cycle diffusion process under the gold standard differs from that under the flexible exchange rate system.

As Keynes (1922) asserts, gold standard systems completely rely on confidence in the value of gold. I define confidence by the relative stability of the price level to a unit of gold. That is, gold preserves confidence, if and only if every individual believe that a unit of gold can always purchase some fixed amount of goods.

Whenever confidenceis maintained, the price level or the inflation rate becomes independent of the amount of gold which a country hoards. Thus, a kind of endogenous price stickiness emerges based on the rational extraneous belief with respect to gold.

Once business in foreign countries downturns and exports stagnate, gold outflows by the same amount as the deficit in balance of payments . Although the outflow is partly abosorbed by the fall of the price level, the legal tender, which is fixed in terms of gold, prominently shrinks. Hence, money becomes excessively dear and the domestic business is also heavily downturned. This is the international business cycle diffusion process in the gold standard.

 Under the flexible exchange rate system, in which gold ceases to be confident, the world economy is released from such a strenuous monetary contraction. Since monetary policy becomes free from the imbalance of the current account and the real exchange rate almost absorbs such an imbalance, at least in the long run, the residual effect of the downturn in foreign countries is confined to the progress of disinflation.

Whenever the real exchange rate depreciates and imported goods become dear, we can formally show that disinflation progresses in the domestic economy. This is because workers should be compensated by the improvement in the rate of return for domestic money to keep their incentives to participate.

Based on previous emprical analyses, the effect of disinflation on consumption is not so serious. Accordingly, the diffusion of business cycles under the flexible exchange rate system is rather mitigated compared with that under the gold standard as the historical evidence suggests.