Gold Standard

1. Evolution of International Monetary Systems Before the Gold Standard (550 BC - 1870 AD) (a) Gold Standard (1870 - 1945) (b) Bretton Woods System (1945- 1971) (c) Contemporary Monetary System (1973 - )

Timeline

2. Before the Gold Standard

According to Graham Levy, the earliest known coins were changing h 6th century BC in Anatolia, in the kingdom of Lydia. Around 550 BC Croesus minted metal coins, made from electrum, a natural alloy of go silver found in the River Pactolus that flowed past Sardis, Lydia's cap was 98% gold. A punch and anvil die was used to stamp the coins wit assumed to be the Lydian emblem of a lion, or a lion's paws, cutting t reveal its consistency.

A major hoard of such coins was discovered in 190405 at the sanct Artemis at Ephesus. In ancient and medieval times, national monies w exchanged by weight. Many of today's famous currencies date from th ages when it was important to know the weight of metal contained in (The Hutchinson Family Encyclopedia)

Artemis of Ephesus, Athens Museum of Archeology. Because of the riot of silversmiths who were afraid of losing jobs, Ap found it prudent to leave Ephesus. (Acts 19:23-27)

Gold was a primary means of exchange in the Roman Empire, gold m an important motive for Roman invasion of Britain.

Historic Gold Coins

The original gold coins of Croesus and other historic gold coins. Here with Constantine.

British pound: pound refers to the amount of silver coined into money

lira : pound in Italian peso: weight in Spanish mark: 1/2 pound Why weigh coins? Gresham's law: Bad money drives out good money Thomas Gresham, 1519-1579).

Rialto Bridge, Venice (May 2003). The price of gold was fixed on thi during the Renaissance period.

3. Gold Standard

In the 1850s, the industrial revolution was taking place in England In the United States, the Civil War (1861-1865) was just over. Background

In Japan, the military rule of Tokugawa shogunate (1603-1867) wa over, some ports were opened to trade with European countries, an Emperor Meiji was instituting a major change in Japan.

Admiral Perry of the United States came to Uraga, Japan and force to open up to trade, causing the fall of shogunate and triggering th Restoration.

The second Opium War (1856-1860) was just over and imports of was legalized in China.

Constantinople, Venice's arch rival, was conquered in 1204 after th crusade war. By the early 1500s, Venice had a large shipyard, buil ships and accumulated a huge trade surplus (gold). Also, Genoa be rival, amassing enough wealth to send Columbus to America. Flor became the banking center. For example, bishops and cardinals du Renaissance period commissioned many paintings to show their po

In this painting, some donors and influential people are represented corner.

1870 - 1914

The gold standard has no precise date of origin. It gradually emerg around 1870-1880 when most of the industrial nations of Europe a the gold standard. (Great Britain adopted the gold standard in 1821 Australia in 1852, Canada in 1853, France in 1878, Germany in 18 US in 1879)

It lasted until 1914, before the outbreak of World War I. During th most of the industrial nations linked their currencies to gold and in rates were about 0.1 percent.

No treaty or agreement

When these nations were on the gold standard, there were no form agreements with other nations. No treaty was signed. Each nation its currency in terms of gold. Its treasury or central bank was requi law to buy and sell gold without limit at the stated price. The publ complete confidence in the convertibility of its currency into gold.

3. Process of Adjustment By the Gold Standard Act, 1900(copy) US One dollar was defined to be equal to the value of 23.22 grains of pure gold (1 troy ounce = 480 grains of gold).

The gold content of pound sterling was fixed by Coinage Act of 1816 (copy) at 113 grains of pure gold. UK

Britain adopted the gold standard in 1821. By 1833, Bank of England was obligated to redeem its notes in gold and silver coins. (Bank of England Act, 1833 (copy) Thus the par exchange rate between the dollar and the pound was p = 113/23.22 = $4.866 The cost of shipping gold from London to New York was $0.026 per pound. So the exchange rate was allowed to fluctuate within the limits of $4.866 0.026. Thus, $4.892 = gold import point for UK $4.840 = gold export point for UK If the spot price of pound fell below the gold export point, it is cheaper for Britons to convert into gold, export gold, convert gold into $ and make $ payments.

Gold export point

During the gold standard period, (i) prices were stable, and (ii) so little gold actually moved from between countries. This was because central banks were not passive, but they adjusted the interest rates to prevent the gold flow. For example, when the exchange rate approached the gold export point, the Bank of England raised the bank rate (the interest rate the central banks charge commercial banks, equivalent to the discount rate in the US). This caused investors in New York to shift funds to London, because they could earn a higher interest rate. Long term capital movement also lessened the need for current account adjustments. Current account adjustment requires drastic price changes under fixed exchange rate system. Without long term capital movement, price adjustments could have been deflationary.

4. Problems with the Gold Standard (1) The gold standard is deflationary. In a closed economy under the gold standard, a country's money supply is determined by its stock of gold. To increase its money supply, the government must mine more gold. Economic growth is constrained by the gold supply. Limited gold supply causes deflation. True, inflation is bad, but deflation is even worse. Firms had to lay off workers as price declined. According to the World Gold Council, annual production of gold is about 2,500 metric tons or 80 million troy ounces. This implies that world GDP cannot grow more than about $80 billion (at $1000/oz), had we been on the gold standard today. Thus, the gold standard would cause a severe deflation in the world economy. Unless more gold is mined, the economy cannot grow. When the gold stock is fixed, an increase in real output only causes deflation. (^M = 0 = ^P + ^Y). Thus, in a growing economy, the gold standard is deflationary and retards economic growth. (2) In an open economy, a balance of payments deficit is followed by a

Discipline of gold standard

gold outflow. Thus, a single country's ability to expand money supply is limited by its balance of payments position. An expansion of money supply causes a trade deficit. A gold outflow would set off deflation. (3) Transmission of monetary shocks. A country cannot insulate its economy from external shocks. Discovery of a new gold mine increases the local supply of gold, but does not affect real outputs in the short run. Thus, an increase in gold supply raises prices. Due to fixed links between currencies, inflation or depression in one country is easily transmitted to other countries. (The Great Depression started by the Wall Street crash of 1929 was quickly transmitted to Europe and Asia.) While inflation rates were low during the period of gold standard, prices could have been unstable. For the world as a whole, the growth of money supply is regulated by the flow of newly produced gold. Thus, the growth rate of a country or the world is limited by the growth of new gold production. No new gold production no growth. After the collapse of the Roman Empire in 476 AD, there was no need to pay soldiers or to mine gold and mint gold coins. This halt of gold production caused a decline in the world economy for almost a thousand years, a major economic cause for the advent of Dark Ages. No significant amount of gold was produced until the age of Renaissance. deflation According to Rafal Swiecki, the total amount of gold mined from the earth to the end of 1985 is about 3.85 billion (3.85 x 109) troy oz. Of this amount, 2% was produced prior to 1492, 8% during the period 1492-1800, 20% during the interval 1801-1900, and 70% from 1901-1985 Annual gold production is about 80 million ounces or $80 billion (at $1000/oz).

MV = PY

19195. Fluctuating Exchange Rates, 1919-1926

During World War I the international gold standard ceased to function. Its operation was suspended with the outbreak of war in August 1914 when Archduke Franz Ferdinand, the heir to the Austro-Hungarian Empire (June 1914) was assassinated in Sarajebo. INTERWAR PERIOD, 1918-1940 European economies had been interlocked closely, but they were suddenly cut loose from the connective mechanism by war. Countries diverged and developed in different directions during the war. By the end of war in June 1918, inflation rates varied greatly, because nations printed more money to finance war. Russian revolution occurred in 1917. The structure of world economy was profoundly altered by 1918. It was clear that prewar exchange rates could not be restored. Thus, many countries delayed and were hesitant to fix official par values of their currencies. They allowed their currencies to float more or less freely in the foreign exchange market. Adjust gold parity? These countries did not realize that floating rates were the only viable solution. Instead, there was a universal expectation that floating exchange rates regime was temporary, and that countries would soon return to the gold standard. The main question was not whether to restore the gold standard, but at what parities to restore the gold standard. Some urged that prewar parities should be restored. at what parity? others argued that changed economic conditions had changed equilibrium exchange rates between national currencies, and hence gold parities should be adjusted. If 1914 is taken as the base (= 100), wholesale prices in December 1918 were as follows: US 202 France 355 UK 246 US After the war in 1918, US immediately announced that it would maintain the dollar price of gold at its prewar level. That is, it is

willing to export gold at $20.67 per ounce. It was thought that Britain's national honor was at stake. Failure to restore the prewar parity of pound would undermine confidence in pound. Accordingly, Britain resorted to a deflationary policy (1920-1925). During the Asian Financial Crisis of 1997, South Korea followed the same deflationary policy, causing a spectacular increase in the unemployment rate. Britain Gold Standard Act, 1925 (copy) As prices fell, unemployment remained high above 10%. By April 1925, Winston Churchill announced that the Bank of England would again redeem its notes into gold. Britain was back on the gold standard in 1925 at its prewar parity However, parity. the attempt to reduce prices and wages to support an overvalued pound provoked a general strike.

Deflationary policy and unemployment.

France

French Franc dropped from $0.18 in 1918 to $0.0392 in 1926, which stopped gold outflow from France. France returned to the gold standdard in 1928.

(19256. Gold Standard restored (1925-1931) Under this system, each country holds gold or dollar or pound as reserve asset. (This system was invented due to the limited supply of gold. The scheme was designed to reduce the amount of gold needed for the reserve country.) (i) The United States and Great Britain were to hold only gold as reserve asset. (ii) key reserve currencies, dollar and pound. Nonreserve countries were asked to hold dollar or pound (rather than gold) as reserve asset (Hence, gold exchange standard.) Other currencies are convertible into reserve currencies at fixed parities. (iii) Dollar and pound were freely convertible into gold between central banks, but not for the general public. (iv) Most countries that were on the silver standard also pegged silver to the dollar, except China and Hong Kong. At restored parities, the British pound was somewhat overvalued at $4.866 = ?, whereas FF was undervalued at $0.0392 = Fr 1. Britain had a BP deficit, France had a BP surplus (and gold inflow followed). Under the gold exchange standard, a country has to resort to the classical medicine of deflating the domestic economy when faced with chronic BP

Gold Exchange Standard

deficits. Before World War II, European nations often resorted to this policy, in particular the Great Britain. Even though few currencies were convertible into gold, policy makers thought that currencies should be backed by gold and willingly adopted deflationary policy after WWI. In the decade that followed (1930s), these countries had 3 options to prevent gold outflow: (a) countries tried to manage or stabilize the flexible exchange rates - by raising interest rate, but it did not prevent capital outflow. (b) Some countries devalued their currencies, but many countries already did this without success. (c) others imposed exchange control when faced with capital flight. Gold Standard (Amendment) Act, 1931 copy In 1931, Britain suspended gold payments. This put an end to the vain attempt to restore the gold standard. Many countries followed Britain's lead and abandoned the link to gold. For example, Japan also abandoned gold convertibility in December 1931, after its invasion of Manchuria. In April 1933, President Roosevelt suspended the gold standard. Gold Reserve Act of 1934 (copy) (i) It prohibited gold coinage. (ii) It allowed the President to change the gold content of dollar. In January 1934, President Franklin Roosevelt raised the price of gold from $20.67 to $35.00 per ounce. Devaluation of dollar (40% devaluation of dollar, or 69% increase in the price of gold)

Problem

Policy options

End

France devalued Franc in 1936.