Gold Standard
What is Gold Standard?
The gold standard was a monetary system in which a currency's value was fixed to and convertible into a specific amount of gold.
It limited inflation and stabilized exchange rates but stripped governments of flexible monetary policy and could deepen downturns. Most countries abandoned it in the 20th century; the U.S. fully left it in 1971.
Gold Standard: a worked example
Two countries fix their currencies to gold, one at 50 dollars an ounce and the other at 200 pesos an ounce. The exchange rate follows arithmetically: 200 divided by 50 gives 4 pesos per dollar, and it cannot drift far, because any gap would let traders buy gold cheaply in one market and redeem it in the other. Now give the dollar country a trade deficit that ships out 100,000 ounces, worth 100,000 times 50, or 5 million dollars of reserves. Suppose law requires 40 percent gold backing for currency in circulation, so every dollar of gold supports 1 divided by 0.40, or 2.50 dollars of currency. Losing 5 million dollars of gold forces the money supply down by 5 million times 2.50, or 12.5 million dollars. Tighter money pushes prices and wages down, exports become cheaper abroad, and the deficit corrects itself through deflation and unemployment.
The mistake students make with gold standard
Students picture one dollar of gold sitting behind every dollar of money, so they expect a country losing 5 million dollars of gold to lose exactly 5 million dollars of money supply. Backing requirements are fractional. At 40 percent cover each dollar of gold carries 2.50 dollars of currency, so the outflow above contracts the money supply by 12.5 million. The gearing works in both directions, which is why a gold link transmits reserve movements into the domestic economy with force rather than one for one, and why small trade imbalances produced large swings in spending.
Gold Standard questions
Why did countries abandon the gold standard?
Countries gave up convertibility because it stripped them of monetary policy. Under a fixed peg, defending the exchange rate outranks fighting unemployment, so a central bank facing a slump has to hold money tight while output falls. Gold supplies also grew more slowly than economies did, creating steady deflationary pressure, and reserve outflows could force sudden contractions. Once governments were held responsible for employment, that constraint became impossible to sustain, and countries leaving the peg earlier tended to recover sooner.
Does the gold standard prevent inflation?
Gold convertibility caps long-run money growth at roughly the pace the gold stock grows, so sustained high inflation is hard to produce. Year to year prices are far from stable. A large ore discovery expands the money supply and lifts prices, while a fast-growing economy tied to a fixed gold stock generates deflation, which raises real debt burdens and discourages borrowing. Price stability under gold has usually meant swings up and down that cancel out over decades.
How did the gold standard fix exchange rates between countries?
Fixing exchange rates followed from each country naming a gold price for its own currency. With one currency convertible at 50 dollars an ounce and another at 200 pesos an ounce, the market rate had to sit near 4 pesos per dollar, since any wider gap would let a trader buy gold where it was cheap, ship it, and redeem it where it was dear. Shipping and insurance costs left a narrow band, called the gold points, inside which the rate could wander before arbitrage pulled it back.
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