Exchange Rate is a convertible rate. It is rate at which the currency unit of a country is exchange into the currency unit of another country. Suppose 60 rupee are paid for dollar, the rate of exchange:
1 Dollar = 60 R.S
1 Riyal = 20 R.S
When two countries are on the gold standard the exchange rate shell be determine at a point where the gold contents of their coins are equal. So it is known as gold or special point. Suppose a rupee coins weigh one gram gold. The weight of dollar is 40 gram gold. The exchange rate is 1 dollar = 40 RS under the gold standard. Both the countries will follower the following rules.
- They have full bodies coin. Paper currency is convertible into gold.
- Inflow and out flow of gold is allowed for payment and receipts.
- There is co- relation between the quantity of gold and quantity of money.
- Economy is flexible
- International trade is free
The rate of exchange between Pakistan and USA will be stable ate the gold point.
If 1 Dollar = 60 RS
Imports = exports
Payment = Receipt
Demand = Supply
The exchange rate is stable only under static conditions. Since the economy is dynamic the rate of exchange is always changing. Suppose
Pak Imports = 12 Billion
Exports = 10 Billion
Pak Payment > Receipts
Pak Imports > Exports
A dollar will not be available at rupee 60. Pakistani trade has tow option
- To move then 60 Rs for a dollar
- To exchange gold to U.S.A
Export of gold involves the cost of transport. Suppose the cost of transport of 60 gram gold. So it means of Pakistani trader pay 60 RS at the cost for dollar. At this point gold may outflow of Pakistani. It is the gold export out for Pakistani and gold import coin for USA. It is also upper gold coin (60+1) for Pakistan and lower gold coin (60-1) for USA. The exchange rate will move upper between the upper gold coin and low gold coin the long period. So in the short period the exchange rate will be changes. Because it will change daily and move along the gold.
With outflow of gold money supply will deflate in Pakistan and inflate in USA. With inflow of gold goodwill will be cheaper in Pakistani and clear in USA. So it will promote our export and discourages our imports and receipts will increase and payment will fall.