Gold Standard

This is a portal article that will redirect you to specific pages on aspects of the Gold Standard

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For more information please see specific pages describing how the gold standard has played out in practice: 

The History of the Gold Standard

Abandonment of Gold Standard during Inter-War Period

Domestic Politics of International Monetary Order: the Gold Standard

Modes of going back to the Gold Standard

The Gold Standard during the Inter-War Period

Background

The gold standard was the predominant international monetary system between 1880 and 1914. Britain was the first country to adapt the gold standard in 1717. The United States switched to it in 1834, followed by a number of European countries during the 1870s.

The countries joining the gold standard agreed to fix the price of their currency in terms of gold, thus adapting a fixed exchange rate regime. The country’s money could be converted into gold any time at this exchange rate. Joining the classical gold standard meant giving up the possibility of independent monetary policy. If a country on the classical gold standard experienced a balance of payment surplus, the central bank had no choice, it had to increase interest rates to facilitate a gold inflow. Few countries followed completely the rules of the gold standard in practice. Some countries, like France, limited the convertibility of the national money into gold, in order to maintain independent monetary policy.

The gold standard aimed to keep prices stable by regulating the quantity of the money supply. Still, prices were not completely stable under the gold standard. Deflationary pressure developed as the world economy and the supply of real commodities grew, but the supply of money could not increase because of the limited quantities of gold available. Other times it was impossible to avoid inflation, when new gold supplies were discovered, the price level had to adjust. By fixing the exchange rate of gold and various national currencies, the prices all around the world moved together.

Rules of the gold standard and their compliance

For a country to go on the gold standard, it requires two things. First, that it maintains exchange rate stability, and second, that it maintains convertibility between its domestic currency and gold. Out of the four specific ways to achieve a balance of payments, this excludes two. A country cannot adjust the exchange rate or impose capital controls limiting the convertibility of currency according to the formal rules of the gold standard. This leaves three viable options for policymakers to maintain a balance: adjusting reserves, adjusting internal prices and incomes, or the other aspect of exchange controls—commercial policy (tariffs, subsidies, etc). However, Keynes added an “informal” rule that when followed would supposedly make the international gold standard system function properly. It stated that countries should not adjust their reserves to achieve a balance, but rather adjust internal prices and incomes. Eichengreen expounds on Keynes’ informal rule, noting that if a country is experiencing a BOP deficit, then raising the discount rate and other interest rates will attract foreign capital investments and equalize the trade balance.  Keynes’ informal rule is logical because if states continually adjusted gold reserves (to avoid the alternative which would anger constituents), the limited supply of gold could inspire dispute and even war.

Despite these formal and informal rules of the gold standard, states often break them for their own benefit, which is in large part why the gold standard collapsed. Deficit countries frequently adjust their exchange rates and place limitations on currency convertibility. Meanwhile, it is not uncommon for surplus countries to break the informal rule and amass reserves, which they can do virtually without limits. To counter inflation, surplus often undergo sterilization by selling bonds. As these measures serve to win the surplus country a “short term balance”, it also places the burden of adjustment wholly on deficit countries.

References

The Concise Encyclopedia of Economics http://www.econlib.org/library/Enc/GoldStandard.html 10/12/2010