Gold Standard

Overview

The Gold Standard is a monetary system in which the standard economic unit of account is a fixed weight of gold and all currency issuance is regulated by the gold supply. Currencies that are backed by fixed amounts of gold have a constant exchange rate between each other.

Purposes of a gold standard

• To prevent inflationary expansion of the money supply
  
• To maintain a fixed value against which other prices can be measured
  
• To allow wider circulation with greater trust in the stability of money.

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Why Pick Gold As The Standard?

• First known metal. Valuable throughout the ages because of scarcity. High value for its beauty and resistance to corrosion and rust.
  
• Soft and easy to work with (very malleable and can be easily shaped into various forms). As a result, gold had long been used as a form of money and store of wealth by merchants and traders.
  
• Supplant silver as the basic unit of international trade at various times (Islamic Golden Age, peak of Italian trading during the Renaissance, during the 19th century).
  

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How the Gold Standard Works

• The Gold Standard was a domestic standard, regulating the quantity and growth rate of a country's money supply. Because new production of gold would add only a small fraction to the accumulated stock, and because the authorities guaranteed free convertibility of gold into non-gold money, it would assure that the money supply and the price level would not vary much.
• Also an international standard - determining the value of a country's currency in terms of other countrie's currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange between currencies tied to gold were fixed. This would cause price levels around the world to move together. A shock in one country would affect the domestic money supply, expenditure and real income in another country.
• An example of a monetary shock was the California gold discovery in 1848. The newly produced gold increased the U.S. money supply, which then raised domestic expenditures, nominal income, and ultimately, the price level. The rise in the domestic price level made U.S. exports more expensive, causing a deficit in the U.S. balance of payments.
• For the gold standard to work fully, central banks, where they existed, were supposed to play by the "rules of the game." In other words, they were supposed to raise their discount rates—the interest rate at which the central bank lends money to member banks—to speed a gold inflow, and 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 required 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.

http://www.econlib.org/library/Enc/GoldStandard.html

Theory of Gold Standard

• Rest on the idea that inflation is caused by an increase in the quantity of money, an idea advocated by David Hume, and that uncertainty over the future purchasing power of money lowers business confidence and leads to reduced trade and capital investment.
  
• The gold standard would remove uncertainty, friction between kinds of currency, which will dramatically benefit an economy.
• Advocates of the gold standard often believe that the governments are destructive of economic activity, and that a gold standard, by reducing their ability to intervene in markets, will increase personal liberty and economic vitality.

Brief History of Gold Standard

• In 1844 the Bank Charter Act established that Bank of England notes, fully backed by gold, were the legal standard. This 1844 act maked the establishment of a full gold standard for British money.
  
• Other major countries joined the gold standard in the 1870s. The period from 1880 to 1913 is known as the "classical gold standard". During that time the majority of countries adhered to gold. It was also a period of unprecedented economic growth with relatively free trade in goods, labor and capital.
• Dates of adoption of Gold Standard:
  • 1871: Germany
  • 1873: Latin Monetary Union (Belgium, Italy, Switzerland, France)
  • 1873: United States de facto
  • 1875: Scandinavia by monetary Union: Denmark, Norway and Sweden
  • 1875: Netherlands
  • France internally
  • 1876: Spain
  • 1879: Austria
  • 1897: Russia
  • 1897: Japan
  • 1898: India
  • 1900: United States de jure

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The Gold Standard and the Great Depression

• Uncertainity in the market beginning in the late 1920's caused demand for gold to increase.
• Increased demand forced prices for gold to go up, but dollar was unable to adjust to the increased price for gold. The dollar had to remain at a set price. One dollar equaled five ounces of gold.
• The U.S. experienced a strong run on the dollar between September and October of 1931 when the British Pound failed. The failure of the pound caused alarm and brought people to banks seeking to ensure their assests in gold.
• In response to the increased demand on gold the U.S. raised interest rates to try and increase the value of the dollar. This pushed the market into a deflationary gap. Further attempts to solve the monetary crisis had a conctractionary effect on the economy.
• When raising the interest rates on money the Federal Reserve did not account for the fact that increased money supply already on the market had caused price expectations by workers to be off. This had occurred because interest rates had previously been low encouraging investment in the stock market and in loans, which had the effect of increasing the money supply. The increased money supply is what caused the run on the dollar when investors began to wonder if the U.S. really had enough gold to back up the dollars already out on the market.
• By raising interest rates, the Federal Reserve was acting as if the U.S. economy was in an inflationary gap when in fact it had been in a deflationary gap due to reduced prices and a decreased agregate demand.
• The pattern of conctractionary fiscal policy in order to prevent runs on national currency was followed by several nations during the late 1920's and early 1930's. These policies caused a world wide decline of 15% in output during this period for countries who remained on the gold standard.
• One reason that the Great Depression affected the whole world was due to the fact that smaller economies on the Gold Standard had to follow what larger economies were doing. If the U.S. raised interest rates, but investors wanted gold to back up their dollars they could convert their currency for foreign currency and demand payment in gold. This potential force economies to all follow contractionary policies; even if the policy was not good for the national economy. The general pattern that occurred during the depression was an increase in interest rates decreased output and prices.
• Countries that removed themselves off of the gold standard generally noticed an increase in output and a stabilization of national currency.
• Stabilization occurred because countries currencies could float on the market. This made adjustment to economic conditions much easier and allowed for expansionary as well as contractionary fiscal policy.

Bretton Woods Conference

• Held by the allies to determine the economic structure of the world after World War II
• Policies led to an era known as the "30 Glorious Years"
• Put U.S. back on Gold Standard after it had come off of it in 1933.
• Three general principles learned from the Great Depression affected the conference attendees:

 *Need an iron clad backer to support Gold Standard
 *Need a system that allows for periodic exchange rate adjustments
 *Need more than a central bank.  International institutions necessary to support world economy

• Leasons led to the creation of the International Monetary Fund and World Bank and placing the U.S. as the leader of the new economic order.
• High in inflation during the 1960's was accepted by the U.S. in order to keep the alive the flexibility in the international monetary system.
• Richard Nixon finally took the U.S. off the Gold Standard because of the inability of the U.S. to further accept policies that were in fact hurting U.S. economic growth. The U.S. dollar was allowed to float.
• It was finally realized when the U.S. went of the Gold Standard that countries generally do better if they can manage their own fiscal policy instead of having to react to other countries' policies in order to proctect their economies.

Pros and Cons of Gold Standard

Dan, i find these links quite helpful. Take a look - Minh
http://www.huppi.com/kangaroo/L-gold.htm
http://economics.about.com/cs/money/a/gold_standard_2.htm
http://www.auburn.edu/~garriro/g4gold.htm

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Group: Minh, Dan, Nick

Works Cited

• http://en.wikipedia.org/wiki/Gold_standard
• http://www.econlib.org/library/Enc/GoldStandard.html
• http://delong.typepad.com/sdj/2005/12/jim_hamilton_on.html
• www.webforum.org/pdf/initiatives/IMCP_Berkeley_deLong_NBER.pdf
• http://www.econbrowser.com/archives/2005/12/the_gold_standa.html
• http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm