Explaining Exchange Rates

Suppose that under the Bretton Woods system, the dollar is pegged to gold at a rate of $35 per ounce and the pound sterling is pegged to the dollar at a rate of $2 = £1.

If the dollar is devalued against gold and the pegged rate is changed to $40 per ounce, what does this imply for the exchange value of the pound? Explain your answer.

Think it through. 1oz = $35 and $2=L1, so 1oz = L17.5

Now then, if 1oz = $40 and 1oz remains at L17.5 then $40 = L17.5 or 40/17.5 = L1 or $2.286 = L1

To understand the implications for the exchange value of the pound, we need to analyze the relationship between the dollar, gold, and the pound sterling. Here's the step-by-step explanation:

1. Under the Bretton Woods system, the dollar is pegged to gold at a fixed exchange rate of $35 per ounce. This means that the value of the dollar is directly tied to gold.

2. Additionally, the pound sterling is pegged to the dollar at a fixed rate of $2 = £1. This implies that the exchange rate between the pound and the dollar is fixed.

3. Now, let's consider what happens when the dollar is devalued against gold, and the pegged rate is changed to $40 per ounce. This change implies that the dollar is now worth less in terms of gold than before.

4. When the dollar is devalued against gold, it means that the dollar's purchasing power decreases when it comes to buying gold. In other words, it takes more dollars to purchase the same amount of gold as before.

5. Since the pound sterling is pegged to the dollar, any change in the dollar's value against gold will indirectly affect the exchange value of the pound. In this case, as the dollar is devalued against gold, the pound sterling will also be affected.

6. If the dollar is worth less in terms of gold, it would indicate that the pound sterling is now worth more in terms of gold. This means that the exchange value of the pound has increased relative to gold.

In summary, if the dollar is devalued against gold and the pegged rate changes to $40 per ounce, it implies that the exchange value of the pound will increase relative to gold.