3. During the late 19th and early 20th centuries, the U.S. and many other nations adhered

to the gold standard. Under the gold standard, a country aimed to sustain a target

value of currency in terms of gold. In other words, the gold standard is simply a fixed

exchange rate regime, except for pegging the domestic currency to a foreign currency,

the domestic currency is pegged to a unit of gold. For instance, the U.S. may have

pegged the dollar to gold at, say, $35 per ounce. If market forces put upward pressure

on the dollar price of gold, the U.S. would need to intervene by selling gold reserves in

order to increase the supply of gold and reduce the supply of dollars in order to drive the

value of the dollar up the the dollar price of gold down. Thus, the government needs to

have sufficient gold held in reserves in order to maintain the peg. When many countries

simultaneously adhere to the gold standard, then their foreign-currency exchange rates

are also fixed.

(a) By the beginning of World War I the United States had accumulated a majority

of the world's gold reserves. Explain in a few sentences why this forced foreign

countries to abandon the gold standard.

(b) After the gold standard dissolved, many countries instead pegged their currency

to the U.S. dollar. By the end of World War II, most advanced countries, including

the U.S., entered the Bretton Woods system whereby their exchange rates were

fixed and the dollar was convertible to gold. During the 1960s the U.S. economy

was booming above full employment. Through the lense of the IS-LM (Mundell-

Fleming) model we can think of this as a temporary positive demand shock. Was

it possible for the Federal Reserve to cool down the economy and bring it back to

full employment? Justify your answer using a diagram like that in Figure 1.

(c) Based on your answer in part (b), what would be the implications for the relative

inflation rate of the U.S., relative to the rest of the world? Is this consistent with

the data? (Hint: You will also need to make use of relative PPP.) To answer the

last part, look up inflation data from Federal Reserve Economic Data (FRED) to

examine inflation rates in the U.S., Japan, France, and the United Kingdom.