International Finance Theory and Policy
by Steven M. Suranovic

Finance 80-2

The Gold Standard

Most people are aware that at one time the world operated under something called a gold standard. Some people today, reflecting back on the periods of rapid growth and prosperity that occurred when the world was on a gold standard have suggested that the world abandon its current mixture of fixed and floating exchange rate systems and return to this system. (For a discussion of some pros and cons see Alan Greenspan’s remarks on this from the early 1980s. See Murray Rothbard’s article for an argument in favor of a return to the gold standard.) Whether or not countries seriously consider this in the future, it is instructive to understand the workings of a gold standard, especially since, historically, it is the first major international system of fixed exchange rates.

Most of the world maintained a pure gold standard during the late 1800s and early 1900s, with a major interruption during World War I. Prior to enactment of a gold standard countries were generally using a Bimetallic standard consisting of both gold and silver. The earliest establishment of a gold standard was in Great Britain in 1821 followed by Australia in 1852 and Canada in 1853. The US established its gold standard system with the Coinage Act of 1873, sometimes known as “The Crime of ’73. ” The gold standard was abandoned in the early days of the Great Depression. Britain dropped the standard in 1931, the US in 1933.

The rules of a gold standard are quite simple. First, a country’s government declares that its issued currency, it may be coin or paper currency, will exchange for a weight in gold. For example, in the US during the late1800s and early 1900s the government set the dollar exchange rate to gold at the rate $20.67 per troy ounce. During the same period Great Britain set its currency at the rate £4.24 per troy ounce. Secondly, in a pure gold standard, a country’s government declares that it will freely exchange currency for actual gold at the designated exchange rate. This “rule of exchange” means that anyone can go to the central bank with coin or currency and walk out with pure gold. Conversely, one could also walk in with pure gold and walk out with the equivalent in coin or currency.

Because the government bank must always be prepared to give out gold in exchange for coin and currency upon demand, it must maintain a storehouse of gold. That store of gold is referred to as “gold reserves.” That is, the central bank maintains a reserve of gold so that it can always fulfill its promise of exchange. As discussed in section 80-7, a well-functioning system will require that the central bank always have an adequate amount of reserves.

The two simple rules, when maintained, guarantee that the exchange rate between dollars and pounds remains constant. Here’s why.

First, the dollar-pound exchange rate is defined as the ratio of the two currency-gold exchange rates. Thus,

Next, suppose an individual wants to exchange $4.875 for one pound. Following the exchange rules, this person can enter the central bank in the US and exchange dollars for gold to get,

This person can then take the gold into the central bank in the UK, and assuming no costs of transportation, can exchange the gold into pounds as follows,

Hence, the $4.875 converts to precisely £1 and this will remain the fixed exchange rate between the two currencies, as long as the simple exchange rules are followed. If many countries define the value of their own currency in terms of a weight of gold and agree to exchange gold freely at that rate with all who desire to exchange, then all these countries will have fixed currency exchange rates with respect to each other.

Price-Specie Flow Mechanism

The price-specie flow mechanism is a description about how adjustments to shocks or changes are handled within a pure gold standard system. The mechanism was originally described by Richard Cantillon and later discussed by David Hume and John Stuart Mill. Although there is some disagreement as to whether the gold standard functioned as described by this mechanism, the mechanism does fix the basic principles of how a gold standard is supposed to work.

Consider two countries, the US and UK, operating under a pure gold standard. Suppose there is a gold discovery in the US. This will represent a shock to the system. Under a gold standard, a gold discovery is like digging up money, which is precisely what inspired so many people to rush to California after 1848 to strike it rich.

Once the gold is unearthed, the prospectors bring it into town and proceed to the national bank where it can be exchanged for coin and currency at the prevailing dollar-gold exchange rate. The new currency in circulation represents an increase in the domestic money supply.

Indeed, it is this very transaction that explains the origins of the gold and silver standards in the first place. The original purpose of banks was to store individuals' precious metal wealth and to provide exchangeable notes that were backed by the gold holdings in the vault. Thus, rather than carrying around heavy gold, one could carry lightweight paper money. Before national or central banks were founded, individual commercial banks issued their own currencies, which circulated together with many other bank currencies. However, it was also common for governments to issue coins that were made directly from gold or silver.

Now, once the money supply increases following the gold discovery it can have two effects; the first operating through the goods market, the second operating through the financial market. The price-specie flow mechanism describes the adjustment through goods markets.

First, let’s assume that the money increase occurs in an economy that is not growing, that is, with a fixed level of GDP. Also assume that both purchasing power parity and interest rate parity holds. PPP implies an equalization of the cost of a market basket of goods between the US and the UK at the current fixed exchange rate. IRP implies an equalization of the rates of return on comparable assets in the two countries.

As discussed in section 40-14, when the US money supply increases, and when there is no subsequent increase in output, the prices of goods and services will begin to rise. This inflationary effect occurs because more money is chasing (i.e., demanding) the same amount of goods and services. As the price level rises in an economy open to international trade, domestic goods become more expensive relative to foreign goods. This will induce domestic residents to increase demand for foreign goods, hence import demand will rise. Also, foreign consumers will find domestic goods more expensive, so export supply will fall. The result is a demand for a current account deficit. To make these transactions possible in a gold standard, currency exchange will take place as follows.

US residents wishing to buy cheaper British goods will first exchange dollars for gold at the US central bank. Then they will ship that gold to the UK to exchange for the pounds that can be used to buy UK goods. As gold moves from the US to the UK, the money supply in the US falls while the money supply in the UK rises. Less money in the US will eventually reduce prices while more money in the UK will raise prices. This means that the prices of goods will move together until purchasing power parity holds again. Once PPP holds there is no further incentive for money to move between countries. There will continue to be demand for UK goods by US residents, but this will balance with UK demands for similarly priced US goods. Hence, the trade balance reverts to zero.

The adjustment process in the financial market under a gold standard will work through changes in interest rates. When the US money supply rises after the gold discovery, average interest rates will begin to fall. Lower US interest rates will make British assets temporarily more attractive and US investors will seek to move investments to the UK. The adjustment under a gold standard is the same as with goods. Investors trade dollars for gold in the US and move that gold to the UK where it is exchanged for pounds and used to purchase UK assets. Thus, the US money supply will begin to fall causing an increase in US interest rates, while the UK money supply rises leading to a decrease in UK interest rates. The interest rates will move together until interest rate parity again holds.

In summary, adjustment under a gold standard involves the flow of gold between countries resulting in equalization of prices satisfying purchasing power parity (PPP), and/or equalization of rates of return on assets satisfying interest rate parity (IRP) at the current fixed exchange rate. The only requirement for the government to maintain this type of fixed exchange rate system is to maintain the fixed price of their currency in terms of gold AND to freely and readily exchange currency for gold upon demand.

International Finance Theory and Policy - Chapter 80-2: Last Updated on 4/7/05