The gold standard is a monetary system where the value of a country’s currency is directly related to physical gold. With the gold standard, participating countries pledged to fix the prices of their domestic currencies in terms of a fixed quantity of gold, meaning paper money could easily be converted to gold and vice versa.
Gold Standard History
Gold and silver have been used to a certain extent as currency since before the medieval period. Britain was the cradle of the modern age of gold. In 1717 England embraced a de facto gold standard after Sir Isaac Newton, the Master of the Royal Mint during the time, overvalued the sterling value of the guinea (one quarter ounce gold coins minted in the U.K. between 1663 and 1814) forcing a large percentage of silver out of circulation. Silver reserves were also depleted by the wars raging on in Europe and trade deficits.
Up until this point, gold and silver standards had been existent, however in 1821 England adopted a gold-only standard. Silver along with gold was still being used in coinage but by this time bank notes were increasingly becoming popular. By 1816, England had officially adopted the gold standard and Bank of England notes were backed by specific quantities of gold.
Meanwhile, the U.S. had started using a bi-metallic silver-gold standard after adopting the 1792 Coinage Act. The aim was to use gold for large denominations and silver for small ones, and this required a gold- to-silver ratio which changed in accordance with market forces. The rate was set at 1 ounce of gold to 15 ounces of silver, with the market rate normally ranging between 15.5 and 16 to 1.
The discovery of more gold mines from 1848 lowered the value of gold in comparison to silver, making silver worth more on the open market than as coinage. The bi-metallic silver-gold standard was used in the U.S. up until 1873 when an informal gold standard was adopted.
The Gold Standard Act of 1900 required the U.S. to maintain a fixed exchange rate on the gold standard with the rest of the world. Due to World War I, this act was put on ice from 1914 to 1919. In 1944 the Bretton Woods Agreement gave birth to the International Monetary Fund (IMF) and the World Bank, and par values for currencies in terms of gold were set. Participating countries were expected to maintain their exchange rate at 1% of the set par value.
In 1968, an increase in the demand for gold prompted a U.S. Congressional repeal of the prerequisite that Federal Reserve Notes be buttressed by gold. In 1971, President Richard Nixon declared that the U.S. would no longer exchange dollars for gold at the official rate. This was only meant to be a temporary measure until they could revalue the U.S. dollar in terms of gold. Other nations did not want to hold the U.S. dollar as it was depreciating; they would rather convert U.S. dollars into gold and this led to U.S. gold reserves being depleted.
In 1972, the amount needed to purchase a Troy ounce of gold was increased from $35 to $38. In 1973 this amount rose to $42.22. This arrangement was still impractical as the U.S. would have to convert a lot of dollars into gold. The U.S. adopted a floating exchange rate, making the U.S dollar a floating currency. In 1975, gold began trading on Chicago and New York exchanges for future delivery.
The glory days of the gold standard had passed, but this did not stop countries like the U.S., India, France, Japan, Germany and China from holding significant amounts of gold.
How the Gold Standard Worked
The gold standard acted as a domestic standard that regulated a country’s money supply in terms of quantity and growth rate. Since new production of gold would only add a small quantity to the already existing stock and since the system guaranteed the free conversion of gold into domestic currency, the gold standard ensured that money supply and the price level would not fluctuate much. However, sporadic surges in the world’s gold reserves as a result of new gold discoveries in Australia and California led to unstable gold prices.
The gold standard was also an international standard that dictated the value of a country’s currency in relation to the currencies of other countries. Since countries that adhered to the gold standard maintained a fixed price for gold, exchange rates between currencies backed by gold were automatically fixed. For instance, Britain fixed the gold price at £3 17s 10½ per ounce and the U.S. fixed the gold price at $20.67 per ounce. Thus, the par exchange rate between pounds and dollars automatically equalled $4.867 per pound.
Since exchange rates were fixed, the gold standard made global price levels to move together. This harmonized movement mainly occurred through a process known as the price-specie-flow mechanism which involved an automatic balance-of-payments adjustment.
Here is how this system worked. Suppose the U.S. experienced economic growth spurt due to some technological advancement. Since the gold supply was essentially fixed in the short run, U.S prices plummeted. Prices of U.S. exports then dropped in relation to those of imports. The British demand for U.S. exports soared while the U.S demand for imports decreased. A surplus in the U.S. balance-of-payments was thus created, causing gold (the specie) to flow from the UK to the U.S. The inflow of gold increased money supply in the U.S. countering the initial fall in prices. The outflow of gold in the UK reduced the money supply, lowering the price level. The end result was well-adjusted prices among the two countries.
The fixed exchange rate also led to both monetary and non-monetary shocks being transmitted through flows of gold and capita between countries. Hence, a shock in one country affected the domestic money supply, price level, real income, expenditure in another country.
Problems with the Former Gold Standards
When we consider gold as a currency, many people support adopting a modified form of the gold standard. The gold standards implemented before 1971 had numerous problems.
One of the major problems was that the system was ultimately dependent on central banks following the set rules. Central banks were required to regulate the discount rate to enable for proper flow of gold (in and out of a country) to maintain the exchange rate at the same level with trading partners. Some countries like France and Belgium chose to disregard the rules, causing the system to fail.
Another problem with the gold standard was that while it did stabilize prices over the long-term, there were still short-term jolts that required to be absorbed by markets.
The 1848 California gold discovery is a good example of a prime price jolt. The discovery increased the money supply leading to an increase in price levels and expenditures. This created instability in the short run. Although this could be counteracted by simply adhering to protocol, it should be noted that various economic disruptions did occur during the gold standard era and all efforts to maintain a gold standard eventually failed.
It’s highly unlikely that the gold standard will be re-introduced in the future, without major revisions being made. It is easy to exchange one currency for another or for gold in a free market world. While some people claim that fiat currencies lack any value other than the psychological belief that the currency has buying power, gold has also proven to be rather unstable in value and hence may not be suitable for backing currencies.