a fixed exchange rate system
In a fixed exchange rate system, the government or central back attaches the value of its currency against the value of different measures of value such as gold, another currency, or a basket of currencies. Although some nations such as Cuba, Bahrain, and Libya still apply the system, it was most popular during the international gold standard when currencies were made of gold and were turned into gold at a defined rate (Siddiqui, & Armstrong, 2018). These nations have their exchange rates pegged to the U.S dollar that tells the amount in one currency that can be traded for another and concurrently helping in adjusting their balance of payment.
In returning the balance of payment (BOP) to equilibrium, various automatic adjustment mechanisms are used under a fixed rate system. From the economic theory, the classical approach is the first mechanism used in the adjustment process (Gibson & Thirlwall, 2016). The approach focuses on changes in price levels between nations as a force to restore the balance of trade. It reflects the Ricardian system that emphasizes on changes in prices, the flexibility of costs, and the quantity theory of money (Shiozawa, Oka, & Tabuchi, 2017). The modern approach is the second automatic adjustment mechanism used in returning the BOP to equilibrium. The mechanism involves changes in the levels of national income. It reflects the Keynesian theory of determining income that emphasizes the changes in income using multiplier effects (Sebastiani, 2016). Unlike the classical approach that acts directly through an alternation in prices between nations, the modern approach is indirect and involves changes in the exchange rates between the currencies involved.
Even though the United States has a floating exchange rate system, the two automatic adjustment mechanisms are still applicable in returning its balance of payments to equilibrium. The mechanisms enable the government to control its economic activity through trade regulations on imports and exports, enabling it to maintain its balance of payment. The fixed exchange rates are effective as it eliminates exchange rate risk, promoting international trade. More specifically, the U.S uses the modern approach in its international trade to establish the right countries to expand services and goods.