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.
  
• As a result, gold had long been used as a form of money and store of wealth by merchants and traders.
  
• Gold would 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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Brief History of Gold Standard

• To understand the adoption of the international gold standard in the late 19th century, it is important to follow the events of the late 18th century and early 19th. In the late 18th century, wars and trade with China, which sold many trade goods to Europe but had little use for European goods, drained silver from the economies of Western Europe and the United States. Coins were struck in smaller and smaller amounts, and there was a proliferation of bank and stock notes used as money. In the 1790s England suffered a massive shortage of silver coinage and ceased to mint larger silver coins.
• In 1844 the Bank Charter Act established that Bank of England notes, fully backed by gold, were the legal standard. This 1844 act marked 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 (in practice but not by law)
  • 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 (legally)

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Theory of Gold Standard

• Rest on the idea advocated by David Hume, that inflation is caused by an increase in the quantity of money 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 this uncertainty (friction between kinds of currency) which would dramatically benefit the 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.

How it 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.
• For the gold standard to be effective, central banks, were supposed to follow a certain set of rules, much like the Fed's present policies. When the supply of gold was low, due to a slow inflow from foreign countries, these central banks were suppose to raise their discount rates at which the central bank lends money to member banks. This causes investment expenditures to decrease which would then cause a reduction in overall domestic spending and finally, a fall in the price level. As a result, gold inflow increased from foreign buyers. When the supply of gold was high, banks were required to lower their discount rates to facilitate a higher gold outflow as more investment would occur resulting in a higher price level and an overall lower net export. outflow of gold.
• Because 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 adjustment process called the price-specie-flow mechanism. Here is how the mechanism worked: Suppose a technological innovation brought about faster real economic growth in the United States. With the supply of money (gold) essentially fixed in the short run, this caused U.S. prices to fall. Prices of U.S. exports then fell relative to the prices of imports. This caused the British to demand more U.S. exports and Americans to demand fewer imports. A U.S. balance-of-payments surplus was created, causing gold (specie) to flow from the United Kingdom to the United States. The gold inflow increased the U.S. money supply, reversing the initial fall in prices. In the United Kingdom the gold outflow reduced the money supply and, hence, lowered the price level. The net result was balanced prices among countries.

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

Performance of Gold Standard

• Periodic surges in the world's gold stock, such as the gold discoveries in Australia and California around 1850, caused price levels to be very unstable in the short run.
• 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 because other countries had not adjusted to their price level???.

• The exemplar of central bank behavior was the Bank of England, which played by the rules over much of the period between 1870 and 1914. Whenever Great Britain faced a balance-of-payments deficit and the Bank of England saw its gold reserves declining, it raised its "bank rate" (discount rate). By causing other interest rates in the United Kingdom to rise as well, the rise in the bank rate was supposed to cause holdings of inventories to decrease and other investment expenditures to decrease. These reductions would then cause a reduction in overall domestic spending and a fall in the price level. At the same time, the rise in the bank rate would stem any short-term capital outflow and attract short-term funds from abroad.

• Most other countries on the gold standard—notably France and Belgium—did not, however, follow the rules of the game. They never allowed interest rates to rise enough to decrease the domestic price level. Also, many countries frequently broke the rules by "sterilization"—shielding the domestic money supply from external disequilibrium by buying or selling domestic securities. If, for example, France's central bank wished to prevent an inflow of gold from increasing its money supply, it would sell securities for gold, thus reducing the amount of gold circulating.

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 the 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 by increasing interest rates they were actually forcing the market further into a deflationary gap and forcing prices down. The exact opposite of what they wanted to do.
• 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 off 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

Pro's

• Major benefit of the gold standard was that it assured long-term price stability and consequently, a low level of inflation.
• The gold standard prevents a country from printing too much money which prevents inflation.

Con's

• Based on historical events, it can be seen that the gold standard restricts countries from having their exchange rates respond to changing circumstances in countries.
• Severely limits the stabilization (monetary) policies that the Fed can use. Thus countries with gold standard tend to have severe economic shocks as they are less able to avoid or offset either monetary or real shocks.
• Economies under the gold standard were highly vulnerable to real and monetary shocks,so prices were highly unstable in the short run.
• The resource cost of producing gold is high. Milton Friedman estimated the cost of maintaining a full gold coin standard for the United States in 1960 to be more than 2.5 percent of GNP. In 1990 this cost would have been $137 billion.

Dan, i find these links quite helpful. Take a look - Minh
http://www.huppi.com/kangaroo/L-gold.htm

http://www.auburn.edu/~garriro/g4gold.htm

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http://itech.dickinson.edu/wiki/images/1/1e/Goldvsinflation.gif
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.html
• http://www.yale.edu/lawweb/avalon/decad047.html
• http://about.com
• http://pbs.org/wgbh/commandingheights/shared/minitextless_nixongold.html
• http://federalreserve.gov/boarddocs/speeches/2004/200403022/default.html