1. How does a commodity standard fix exchange rates between countries?

A commodity standard exists when exchange rates are based on the values of different currencies in terms of some commodity. The gold standard, in general use between 1880-1914, fixed the value of countries’ currencies in terms of how much currency was needed to buy an ounce of gold. Fixing the value of currencies in terms of gold also fixes the relative value of all currencies to one another. As long as countries fix the value of their currencies in terms of some commodity, the relative values of those currencies stay the same.

2. What kinds of exchange-rate arrangements exist today?

The gold standard ended with World War I. Since then, many exchange-rate systems have been tried. At the present time, nations use a variety of exchange-rate arrangements, including fixed exchange rates, freely floating exchange rates, and managed floating exchange rates.

3. How is equilibrium determined in the foreign-exchange market?

Equilibrium is determined in foreign-exchange markets the same way it’s determined in other markets: by the intersection of supply and demand curves. The demand for a currency, such as the U.S. dollar, comes from the desire of people in other countries to buy things in the United States; the supply of U.S. currency to the foreign-exchange market comes from U.S. residents’ desire to buy things from foreign countries.

4. How do fixed and floating exchange rates differ in their adjustment to shifts in supply and demand for currencies?

With floating exchange rates, the foreign-exchange market adjusts automatically to shifts in supply and demand, the same way perfectly competitive markets for products adjust. With fixed exchange rates, a government can try to maintain the fixed rate through intervention in the foreign-exchange market, although this is unlikely to work unless the shifts in supply and demand are temporary. A fundamental disequilibrium usually requires a currency devaluation.

5. What are the advantages and disadvantages of fixed and floating exchange rates?

Fixed exchange rates require that a nation match its macroeconomic policies to those of the country or countries to which its currency is pegged; this limits a country’s ability to set its own policies. Floating exchange rates allow countries to follow their own macroeconomic policies.

6. What determines the kind of exchange-rate system a country adopts?

Countries in general can choose what kind of exchange-rate system they want to use. The choice seems to depend on four characteristics: the size of the country (in terms of economic output), the nature of the economy (how large a fraction of the GNP is devoted to international trade), the country’s experience with inflation, and trade diversification.