The gold standard refers to a monetary system or a monetary standard under which the standard economic unit of account is a fixed weight of gold or the basic unit of a currency in a country is equal in value to and exchangeable for a specified amount of gold.
The system was first adopted in Brazil and later instituted in other countries like; France, United States and Germany in the 1870’s. The system ended in 1914 with the commencement of World War 1, only to be reinstated in 1928.
The period between 1880 to1913 is termed to be the classical gold standard and it featured a number of countries centered to the Bank of England that supposedly adhered to the fixed gold price and continuous convertibility with other nations which were less strict in the adherence to convertibility at a fixed amount of gold paying higher interest in gold denominated currencies, it involved a commitment by these countries to have a fixed equivalence of their domestic currencies and a specific amount of gold.
Gold is a relatively rare resource, an attribute which compelled most countries to abandon the system and convert their gold reserves to currencies like The United States Dollar, or the British Pound.
Some of the gold standard monetary systems included:
- Classical gold standard of 1871 – 1914,
- Bretton Woods system of 1945 – 1972.
Gold was chosen to be the mode of exchange and store of value due to the following properties:
- It is a rare substance, a very important aspect for exchange
- It is highly durable thus can be kept for long time.
- It has a unique color making it easy to identify.
- It is corrosion free, thus able to withstand taste of time.
- It is highly divisible.
These factors made gold to be the most preferred mode of exchange and store of value or wealth by merchants, traders and even historians. The gold standard insures a fixed rate of exchange in international trade by providing a fixed pattern of international exchange rates, it limits the amount of paper currency a central government can use for domestic spending, though it hinders, the ability of a government to control the supply of money and exposes the country to global crisis, like the inflation or depression from their trading partners through restricting their currency supply to gold purchase or mining.
Gold standard marked use of gold as a standard value of money in many participating countries; it harmonized use of money across many countries by establishing a common reference point.
Effects of the International Gold
The gold standard would control the quantity and growth rate of a country’s money transfer, new production of gold used to have very little impact on the volumes of the accumulated gold, this and the fact that, the governments of the day in the participating countries would authorize free convertibility of gold into non gold money, ensured a stable supply of money.
The fact that the system was internationally accepted, rates of exchange between the participating countries would be fixed; this was made possible by fixed price of gold across the countries. For example, the United States fixed the price of gold at $20.67 per ounce, Britain fixed the price at £3 17s.10. 5d per ounce, the exchange rate between dollars and pounds – the per exchange rate- necessarily equaled $4. 67 par pound (Bordo, 2 -17).
Due to fixed per exchange rate, the system synchronized price levels to move together, this would be made possible through price specie – mechanism, which involved an automatic balance of payment adjustment.
The fixed exchange rate used to transmit monetary and non monetary shocks through gold and capital flows between the participating countries, this would have a great impact in many countries in the sense that a shock or a business flaw in one country would affect all other participating countries, a good illustration was the discovery of gold in California state in 1848 which increased United States money supply ultimately raising their domestic price, this made their exports very expensive an aspect that brought deficit in the country’s balance of payment. Their trading partners were also affected in the sense that their money supply increased; a development which raised their domestic expenditures and prices.
The gold standard necessitated the central banks in the participating countries to raise their interest rates to their lending banks in order to facilitate gold inflows and lower the interest rates in order also to facilitate a gold outflow. This would work against a country running a balance of payment deficit considering it would be required to allow enough gold outflow until a par exchange rate is restored with its trading partners, a good illustration was the bank of England which would raise its discount rates whenever the country would be facing a balance of payments deficit, this would ultimately lead to a reduction in overall domestic spending and a fall in the price level. Not every participating country would live by the rule of raising their discount rates to achieve equilibrium with their trading partners, countries like France and Belgium used to sterilize their domestic money from external disequilibrium by appropriately buying or selling domestic stocks for gold, this would either reduce or increase the gold in circulation depending on the action taken. The fact that central banks in these countries would only sterilize capital flows during times of gold outflow than periods of gold inflow reinforces the view that banks were concerned with covering loss of gold and ultimately protect their reserves (Eichengreen, 1 – 2).
The greatest virtue for use of gold as a standard of exchange was the fact that it assured long term price stabilization. Studies have compared average annual inflation rates between periods 1880 – 1914 and 1946 – 1990 to be 0.1 and 4.6 percent respectively (Ford, 170).
Due to the fact that economies of the participating countries under the gold standard were more susceptible to monetary shocks, prices would be highly unstable in the short run; this would be measured through coefficient of variation (Bordo, 2 – 17),
Coefficient of Variation = Standard Deviation of Annual Percentage Changes, Annual Average Percentage Change.
Based on price levels,
The short term instability would depend on the magnitude of the coefficient of variation, the higher it would be the greater the short term instability and vice versa.
The coefficient of variation for the United States between periods 1879 – 1913 and 1946 – 1990 was 17 and as low as 0.8 in the latter, this is because the former period is said to be the classical gold period, which would regulate money value (Bordo, 2 – 17).
Since the gold standard gave the participating countries very little power to exercise their monetary policies, the economies of the participating countries would always be rendered ineffective in counterbalancing both monetary and real shocks in occurrence.
The fact that governments would not have total powers over their monetary policies, the levels of employment would always be high during the gold standard period. This was caused by the fact that every time gold left a country probably to adjust a balance of payment between some countries, the expected balancing effect would not be immediate, but still the country experiencing the balance of payment deficit would not attempt to stimulate the economic growth by probably initiating and putting into place measures aimed at alteration of taxes or increment of expenditures, they mostly chose not to interfere, a choice which would make trade deficits to persist and ultimately high levels of unemployment or even chronic recessions.
Fluctuations in the amount of gold in supply would destabilize economies of the participating countries in the sense that an increase would cause inflation while a decrease in the supply would lead to a deflation and also the system was vulnerable to speculative attacks in cases where government’s financial position would be weak, this would necessitate governments to put large gold reserves in order to compensate for the unpredictable nature of the supply and demand of gold.
Most economists believe that economic recessions can largely be mitigated by increasing money supply during economic downturns (Mankiw, 238- 255). Following a gold standard would imply that, the amount of money would be determined by the supply of gold rendering monetary policies ineffective in stabilizing the economy in times of economic recession (Krugman, 3).
The gold standard also controlled the amount of paper currencies in print and this would effectively limit the countries from inflating prices, a gesture which would in turn promote the level of confidence in the international trading by providing fixed pattern of international exchange rates making convertibility free from government regulation and a competitive environment both domestically and internationally. This ensured the core countries would have no power to control the capitals thus ensuring also settlement of balance of payment deficit would proceed without hindrances.
Under the international gold standard, no country had absolute control over its domestic price level in the long run; but a large country like Britain and United states could influence whether its price level converged toward the world price level or the world prices converged toward the domestic price level (Crabbe, 56).
The gold standard would shift attention to keeping country’s gold reserve other than concentrating on how to put up necessary strategies to improve economic climate in order to get countries back in economic track during major economic crisis like the great depression.
The proposed or thought balancing effect of gold standard was rarely reality in most cases, government interventions in their respective economies and the exchange of reserve currencies remained to be the most effective means of resolving the balance of payment deficits (Monem, 1).
The stability of the supply of money depended mostly on the supply of gold, if the supply changed too quickly, then the supply would be made unstable. With a fast increase in supply, then people would exchange their money for gold, which would lead to treasury running out of gold if the situation persisted. The gold standard would restrict governments from enacting strategies aimed at managing financial status of their countries, a fact which would leave the countries to any kind of financial consequence (Moffatt, 1 – 2 ).
In cases where gold would be transported in order to settle a balance of payment deficit in any of the participating country, exportation and importation costs would come in, which included; freight costs, insurance costs, handling costs, risk premium, and many others which have to be factored in computations of gold export point and gold importation points, this costs would easily be eliminated by adoption of fiat money in this kind of cases.
There have been intensive calls to reinstate the gold standard arguing that it gives real value to the currency instead of the imaginary value with the fiat system and also in order to harmonize both domestic and international trade, but the limitations far away outweigh the benefits making the fiat money more ideal in recent times, though an intrinsically useless good used as a means of payment and a storable object.
Gold standard is too rigid and restricts economic policy in times of financial turmoil, if a country can only print as much currency as they can back with gold, and considering gold supply is never enough, then there is a strong likelihood a shortage of money may occur which leads to hording and ultimately stifle economies as people would be forced to buy and sell less.
The gold standard is good for stabilization of world or international trade, this would be made possible through placement of the participating countries on equal footing by ensuring all their respective currencies are backed up with gold, this would in turn act as an assurance to the trading partners since the fear of devaluation would be eliminated.
Gold standard is an appropriate measure of encouraging productivity amongst countries considering that if a country produces more, then it would be in a position to export more and probably accumulate more gold, which would allow the country to print more money and invest it in bettering their production. This would also strengthen international trade.
Bordo, Michael. D. “The classical gold standard – some lessons for today”. Federal Reserve Bank, St. Louis review 63, no. 5, pp. 2 – 17. 1981.
Crabbe, L. “The international gold standard and US monetary policy from World War 1 to the new deal”. Federal Reserve bulletin. USA. 1989.
Eichengreen, Bary J. “Golden fetters: the gold standard and the great depression 1919 – 1939”. New York, Methuen. 1995.
Ford, A. G. “The Gold Standard”, 1880 – 1914: Britain and Argentina. 1962.
Krugman, Paul. “The Gold Bug Variations”. Web.
Monem, T. Abdel. “What is gold standard, the international Finance and Development,” the University of Iowa, United States of America. 2009.
Moffatt, Mike. “The Benefits and Costs of a Gold Standard”, About.com. 2009. pp. 1 -2 New York, USA.
Mankiw. N. Greg. “Macroeconomics”, 5th edition. Wirth. Pp. 238 – 255. 2002.