Thursday, December 1, 2011

gold standard and capacity of central banks to control FX rate

Q3: For a freely traded currency, how does the CB (central bank) save it?
A: basically CB need to spend their "reserve" to buy the currency. There might be other means (capital control...), but this is the primary means.

Q3b: can this CB ask another CB (say Chinese CB) to help?
A: yes but the other CB must spend its reserve too. Nothing free.

When a currency is under pressure, hedge funds basically assumes [1] CB has limited capacity to save it. Note a CB can't easily print money. Under attack, a CB has no legal power to print other country's currencies. If CB prints its own, it weakens further. In other crises, printing money also has serious consequences. Printing money is a sign of hollowness and desperation. Investor Confidence!! Investors (domestic/foreign) will sell or short-sell the currency.

Gold-standard is good simplification with educational value...

[1] (Exception to that assumption) Central banks of smaller economies often protect their currency with another form of "gold standard" -- dollar-peg backed by foreign reserve -- basket of hard currencies. A hard currency refuses to weaken "randomly", because that CB has reason and "gold reserve" to maintain it....

"Gold" standard prevents a run on the currency. Remember each SGD owned by a foreigner is a "claim" on Singapore's reserve. If there's obviously enough reserve, then no run.

Gold-standard obviously forbids lavish money-printing.

Gold-standard is a discipline on gov spending, productivity, export growth, wage control, inflation ...

"Gold" standard shows why US trade deficit means more dollars flowing to China (claim on US gold...) so "effective US gold reserve" shrinks and dollar holders worry about that reserve -- since Fed may print money and devalue the dollar.

"Gold" standard debunks the naive impression that a CB can freely raise the value of its currency so its citizens become richer when visiting overseas. Without gold standard, a CB can print money and give to citizens, but immediately purchasing power drops.

"Gold" standard is the simplest (simplistic but fairly true) explanation why hard currencies forex rate appear to be "anchored" despite gigantic daily trading volumes. The anchor is the "gold reserve".

Gold-standard illustrates the fundamental impact of import/export on forex rates. Does private import/export doesn't go through CB? I think it does since the currency used to pay for import ultimately comes from CB. (However money earned by export doesn't go back to CB! )

Gold-standard clarifies that bank lending can't increase money supply as a CB can...

"Gold" standard answers the FAQ why everyone somehow believes paper money represents real buying power.

"Gold" standard sheds lights on how paper money is "backed" by CB...

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