The gold standard is a monetary system that fixes the domestic currency against a specific amount of gold. That means you can exchange the currency for a set amount of gold, and the government guarantees it. In the late 19th century and early 20th century, you could buy an ounce of gold at $20.67 in the United States and ₤4.24 in the United Kingdom and one British Pound for $4.86.
The United Kingdom was the first country to officially adopt the gold standard in 1819. The United States shifted from a bimetallic standard to the gold standard in 1834 following the Gold Standard Act’s enactment. Many other countries adopted this standard in the 1870s.
While investors and financial analysts still consider the gold standard important, no government uses the standard today.
History of The Gold Standard
The use of the gold standard dates back to 1821 when the United Kingdom first put it into operation. Initially, silver was the world’s primary monetary metal. While various countries occasionally used gold for coinage, this precious metal wasn’t a reference metal against which various governments adjusted their currencies and other mediums of exchange.
Between 1820 and 1870, many countries except the United Kingdom used a bimetallic standard of silver and gold. During the 1870s, however, countries like the U.S., France, and Germany adopted a monometallic gold standard. One reason for the shift is the increase in gold supply due to gold discoveries in western North America.
During the international gold standard period, you could buy or sell gold in unrestricted amounts at a pre-determined price in paper money per unit weight of the precious metal. This period lasted only last until 1914 when World War I began.
About 14 years later, the gold standard was virtually back into full operation, but most governments adopted a gold-exchange standard since the precious metal had become quite scarce. The gold-exchange system involved supplementing a nation’s central-bank gold reserves with currencies that were convertible to the precious metal at a stable exchange rate.
The 1930s’ Great Depression saw the collapse of the gold-exchange standard, and no nation was using the international gold standard by 1937. The U.S. set a new minimum dollar price for gold for foreign central banks to use for sales and purchases.
Industry professionals refer to this practice as “pegging” the price of gold, which promoted the restoration of an international gold standard after World War II. Governments usually pegged exchange rates to gold or the U.S. dollar in the post-WWII gold standard.
1958 saw the re-establishment of a gold standard. Under this standard, most European nations ensured their currency was freely convertible into dollars or gold to facilitate international transactions. In 1971, however, the U.S. suspended the free convertibility of its currency into gold at pre-set exchange rates due to the decreasing gold reserves and an increasing deficit in its balance of payments.
Two Aspects of The Gold Standard
The gold standard has two primary functions: domestic and international aspects of the gold standard.
Domestic Aspect of The Gold Standard
The gold standard helps regulate a country’s currency volume, a function known as the domestic aspect of the gold standard. It helps stabilize the internal value of the currency and allows for exchanging currency notes for gold of equivalent value.
That means gold reserves fully support the note issue and keep the growth of the fiduciary note issue in check. Under the gold standard, a country’s gold reserves regulate its total currency.
International Aspect of Gold Standard
The gold standard helps regulate and stabilize the exchange rate between the gold standard nations. We refer to this function as the international aspect of the gold standard. This monetary system requires every member country to fix its currency value in terms of a particular weight and purity of gold.
Additionally, each nation’s monetary authority offers an undertaking to buy or sell the precious metal in unlimited amounts at the official fixed price. These conditions promote a stable relationship between the money units of various gold standard nations, and the free movement of gold helps ensure stable exchange rates.
Rules of The Gold Standard
For the efficient functioning of the gold standard, stakeholders must fulfill several conditions known as the “rules of the game,” a phrase first used by economist John Maynard Keynes in the 1920s. Let’s explore the rules:
Free Movement of Gold
There should be no restrictions on the movement of precious metals between the gold standard countries. The countries can freely import or export gold.
Flexible Price System
Gold standard nations should have a flexible price-cost system to ensure that a rise or fall in money supply due to gold inflow or outflow results in the rise or fall of prices, wages, or interest rates.
Elastic Money Supply
Governments need to expand currencies and credits when gold is coming in and contract currencies and credits when the precious metal is going out. The governments can ensure an elastic money supply by keeping a fixed proportion of gold reserves based on the amount of non-gold money in circulation.
Unrestricted Movement of Commodities
Goods and services should move without any restrictions between the gold standard countries. Under this monetary system, price variations between countries are expressed through excess of imports or exports of one country over the other. The excess of imports or exports is adjusted through gold inflow or gold outflow. Therefore, import or export restrictions disrupt the gold standard’s automatic functioning.
No International Indebtedness
Gold standard member countries need to shun international indebtedness. If a country’s external debt rises, it should increase its exports to pay off the interest and the principal.
No Speculative Capital Movements
Gold standard countries should avoid large movements of capital between themselves. However, small short-term capital movements are essential to cover the international payments gap, fixing the disequilibrium in the balance of payments (BOP).
For a nation with a negative BOP, the monetary authority can increase interest rates, attracting revenue from other member nations. This approach will help the government fix its BOP status. Conversely, large capital movements due to political or economic instability can undermine the gold standard’s efficient functioning.
Correct Gold Distribution
There should be adequate gold reserves and proper distribution among the gold standard countries to ensure this monetary system’s streamlined functioning.
Merits and Demerits of The Gold Standard
The Merits
Below are some of the advantages of the gold standard:
1. Simplicity
According to many investors and financial experts, the gold standard is a simple monetary system. It is easy to understand and saves you the complications of other monetary standards.
2. Public confidence
The gold standard enjoys the full confidence of the public since the precious metal is universally accepted.
3. Automatic working
This monetary standard works automatically and requires no government intervention. The supply of cash depends on the volume of gold reserves. Money supply can change according to the changes in the volume of the gold reserve.
4. Stable Forex rates
Unrestricted export and import of precious metals under the gold standard ensure foreign exchange rates’ stability, promoting international trade.
5. Stable Prices
Gold supply is often consistent, so the gold standard helps prevent frequent fluctuation of gold prices.
The Demerits
These are the major disadvantages of the gold standard:
1. Lack of independent monetary policy
Under the gold standard system, a country lacks the power to adopt a monetary policy that best suits its internal economic situation when its monetary policy is exposed to international challenges.
2. No elasticity
The monetary system doesn’t have elasticity under the gold standard. The gold reserves influence the money supply, and it’s challenging to increase the gold reserves. That means the money supply isn’t flexible enough to be changed to suit a country’s changing needs.
3. Expensive
The gold standard is a costly monetary system since it involves an expensive metal as the medium of exchange. This financial system is also wasteful due to the wear and tear of the precious metal during circulation.
4. Fair-weather craft
The gold standard system is a fair-weather craft in that it can only work when players observe the rules of the game. Failure to fulfill the necessary conditions often leads to the system’s abandonment.
Conclusion
The gold standard is the most popular monetary standard that’s ever existed. It’s the monetary system in which a government defines its currency’s value in terms of gold and operates under the “rules of the game.” As with any financial system, it has its benefits and drawbacks.
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