The gold standard

The gold standard was a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price. England adopted a de facto gold standard in 1 1 after the master of the mint! "ir #saac Newton! overvalued the guinea in terms of silver! and formally adopted the gold standard in 1$1%. The &nited "tates! though formally on a bimetallic (gold and silver) standard! switched to gold de facto in 1$'( and de )ure in 1%** when +ongress passed the ,old "tandard -ct. #n 1$'(! the &nited "tates fixed the price of gold at ./*.0 per ounce! where it remained until 1%''. 1ther ma)or countries )oined the gold standard in the 1$ *s. The period from 1$$* to 1%1( is known as the classical gold standard. 2uring that time! the ma)ority of countries adhered (in varying degrees) to gold. #t was also a period of unprecedented E+1N13#+ ,415T6 with relatively 74EE T4-2E in goods! labor! and capital. The gold standard broke down during 5orld 5ar #! as ma)or belligerents resorted to inflationary finance! and was briefly reinstated from 1%/8 to 1%'1 as the ,old Exchange "tandard. &nder this standard! countries could hold gold or dollars or pounds as reserves! except for the &nited "tates and the &nited 9ingdom! which held reserves only in gold. This version broke down in 1%'1 following :ritain;s departure from gold in the face of massive gold and capital outflows. #n 1%''! <resident 7ranklin 2. 4oosevelt nationali=ed gold owned by private citi=ens and abrogated contracts in which payment was specified in gold. :etween 1%(0 and 1% 1! countries operated under the :retton 5oods system. &nder this further modification of the gold standard! most countries settled their international balances in &.". dollars! but the &.". government promised to redeem other central banks; holdings of dollars for gold at a fixed rate of thirty>five dollars per ounce. <ersistent &.". balance>of>payments deficits steadily reduced &.". gold reserves! however! reducing confidence in the ability of the &nited "tates to redeem its currency in gold. 7inally! on -ugust 18! 1% 1! <resident 4ichard 3. Nixon announced that the &nited "tates would no longer redeem currency for gold. This was the final step in abandoning the gold standard. 5idespread dissatisfaction with high #N7?-T#1N in the late 1% *s and early 1%$*s brought renewed interest in the gold standard. -lthough that interest is not strong today! it seems to strengthen every time inflation moves much above 8 percent. This makes sense@ whatever other problems there were with the gold standard! persistent inflation was not one of them. :etween 1$$* and 1%1(! the period when the &nited "tates was on the Aclassical gold standard!B inflation averaged only *.1 percent per year.

How the Gold Standard Worked

The gold standard was a domestic standard regulating the Cuantity and growth rate of a country;s 31NED "&<<?D. :ecause new production of gold would add only a small fraction to the accumulated stock! and because the authorities guaranteed free convertibility of gold into nongold money! the gold standard ensured that the money

supply! and hence the price level! would not vary much. :ut periodic surges in the world;s gold stock! such as the gold discoveries in -ustralia and +alifornia around 1$8*! caused price levels to be very unstable in the short run. The gold standard was also an international standard determining the value of a country;s currency in terms of other countries; currencies. :ecause adherents to the standard maintained a fixed price for gold! rates of exchange between currencies tied to gold were necessarily fixed. 7or example! the &nited "tates fixed the price of gold at ./*.0 per ounce! and :ritain fixed the price at E' 1 s. 1*F per ounce. Therefore! the exchange rate between dollars and poundsGthe Apar exchange rateBGnecessarily eCualed .(.$0 per pound. :ecause exchange rates were fixed! the gold standard caused price levels around the world to move together. This comovement occurred mainly through an automatic balance>of>payments ad)ustment process called the price>specie>flow mechanism. 6ere is how the mechanism worked. "uppose that a technological #NN1H-T#1N brought about faster real economic growth in the &nited "tates. :ecause the supply of money (gold) essentially was fixed in the short run! &.". prices fell. <rices of &.". exports then fell relative to the prices of imports. This caused the :ritish to 2E3-N2 more &.". exports and -mericans to demand fewer imports. - &.". balance>of>payments surplus was created! causing gold (specie) to flow from the &nited 9ingdom to the &nited "tates. The gold inflow increased the &.". money supply! reversing the initial fall in prices. #n the &nited 9ingdom! the gold outflow reduced the money supply and! hence! lowered the price level. The net result was balanced prices among countries. The fixed exchange rate also caused both monetary and nonmonetary (real) shocks to be transmitted via flows of gold and capital between countries. Therefore! a shock in one country affected the domestic money supply! expenditure! price level! and real income in another country. The +alifornia gold discovery in 1$($ is an example of a monetary shock. The newly produced gold increased the &.". money supply! which then raised domestic expenditures! nominal income! and! ultimately! the price level. The rise in the domestic price level made &.". exports more expensive! causing a deficit in the &.". :-?-N+E 17 <-D3ENT". 7or -merica;s trading partners! the same forces necessarily produced a balance>of>trade surplus. The &.". trade deficit was financed by a gold (specie) outflow to its trading partners! reducing the monetary gold stock in the &nited "tates. #n the trading partners! the money supply increased! raising domestic expenditures! nominal incomes! and! ultimately! the price level. 2epending on the relative share of the &.". monetary gold stock in the world total! world prices and income rose. -lthough the initial effect of the gold discovery was to increase real output (because wages and prices did not immediately increase)! eventually the full effect was on the price level alone. 7or the gold standard to work fully! central banks! where they existed! were supposed to play by the Arules of the game.B #n other words! they were supposed to raise their discount ratesGthe interest rate at which the central bank lends money to member banks

Gto speed a gold inflow! and to lower their discount rates to facilitate a gold outflow. Thus! if a country was running a balance>of>payments deficit! the rules of the game reCuired it to allow a gold outflow until the ratio of its price level to that of its principal trading partners was restored to the par exchange rate. The exemplar of central bank behavior was the :ank of England! which played by the rules over much of the period between 1$ * and 1%1(. 5henever ,reat :ritain faced a balance>of>payments deficit and the :ank of England saw its gold reserves declining! it raised its Abank rateB (discount rate). :y causing other #NTE4E"T 4-TE" in the &nited 9ingdom to rise as well! the rise in the bank rate was supposed to cause the holdings of inventories and other #NHE"T3ENT expenditures to decrease. These reductions would then cause a reduction in overall domestic spending and a fall in the price level. -t the same time! the rise in the bank rate would stem any short>term capital outflow and attract short> term funds from abroad. 3ost other countries on the gold standardGnotably 7rance and :elgiumGdid not follow the rules of the game. They never allowed interest rates to rise enough to decrease the domestic price level. -lso! many countries freCuently broke the rules by Asterili=ationBG shielding the domestic money supply from external diseCuilibrium by buying or selling domestic securities. #f! for example! 7rance;s central bank wished to prevent an inflow of gold from increasing the nation;s money supply! it would sell securities for gold! thus reducing the amount of gold circulating. Det the central bankers; breaches of the rules must be put into perspective. -lthough exchange rates in principal countries freCuently deviated from par! governments rarely debased their currencies or otherwise manipulated the gold standard to support domestic economic activity. "uspension of convertibility in England (1 % >1$/1! 1%1(>1%/8) and the &nited "tates (1$0/>1$ %) did occur in wartime emergencies. :ut! as promised! convertibility at the original parity was resumed after the emergency passed. These resumptions fortified the credibility of the gold standard rule.

Performance of the Gold Standard

-s mentioned! the great virtue of the gold standard was that it assured long>term price stability. +ompare the aforementioned average annual inflation rate of *.1 percent between 1$$* and 1%1( with the average of (.1 percent between 1%(0 and /**'. (The reason for excluding the period from 1%1( to 1%(0 is that it was neither a period of the classical gold standard nor a period during which governments understood how to manage 31NET-4D <1?#+D.) :ut because economies under the gold standard were so vulnerable to real and monetary shocks! prices were highly unstable in the short run. - measure of short>term price instability is the coefficient of variationGthe ratio of the standard deviation of annual percentage changes in the price level to the average annual percentage change. The higher the coefficient of variation! the greater the short>term instability. 7or the &nited "tates between 1$ % and 1%1'! the coefficient was 1 .*! which is Cuite high. :etween

1%(0 and 1%%* it was only *.$$. #n the most volatile decade of the gold standard! 1$%(> 1%*(! the mean inflation rate was *.'0 and the standard deviation was /.1! which gives a coefficient of variation of 8.$I in the most volatile decade of the more recent period! 1%(0>1%80! the mean inflation rate was (.*! the standard deviation was 8. ! and the coefficient of variation was 1.(/. 3oreover! because the gold standard gives government very little discretion to use monetary policy! economies on the gold standard are less able to avoid or offset either monetary or real shocks. 4eal output! therefore! is more variable under the gold standard. The coefficient of variation for real output was '.8 between 1$ % and 1%1'! and only *.( between 1%(0 and /**'. Not coincidentally! since the government could not have discretion over monetary policy! &NE3<?1D3ENT was higher during the gold standard years. #t averaged 0.$ percent in the &nited "tates between 1$ % and 1%1'! and 8.% percent between 1%(0 and /**'. 7inally! any consideration of the pros and cons of the gold standard must include a large negative@ the resource cost of producing gold. 3#?T1N 74#E23-N estimated the cost of maintaining a full gold coin standard for the &nited "tates in 1%0* to be more than /.8 percent of ,N<. #n /**8! this cost would have been about .'** billion.

Conclusion
-lthough the last vestiges of the gold standard disappeared in 1% 1! its appeal is still strong. Those who oppose giving discretionary powers to the central bank are attracted by the simplicity of its basic rule. 1thers view it as an effective anchor for the world price level. "till others look back longingly to the fixity of exchange rates. 2espite its appeal! however! many of the conditions that made the gold standard so successful vanished in 1%1(. #n particular! the importance that governments attach to full employment means that they are unlikely to make maintaining the gold standard link and its corollary! long> run price stability! the primary goal of economic policy.

About the Author

3ichael 2. :ordo is a professor of economics at 4utgers &niversity. 7rom 1%$1 to 1%$/! he directed the research staff of the executive director of the &.". +ongressional ,old +ommission.