The Gold Standard Monetary Policy

   Under a gold standard, a government would trade dollars for gold at a fixed rate. Under such a policy, the dollar is as "good as gold." Except that the dollar is only as good as the government's credibility to stick with the standard. If a government can go on a gold standard then it can go off it, which leads to speculative attacks by investors. 
  The gold standard was suspended during World War I due to disruptions to trade, international capital flows and because countries need more financial flexibility to finance their war efforts. When the war ended, many countries stayed off gold and experienced chaotic fiscal and monetary policies in the early 1920's. Many people felt that the only way to stabilize the economy was to return to the gold standard. Great Britain was the first country to return to the gold standard (1925) and by 1929 the majority of the world had done so. This was a disaster, because the governments lacked credibility due to weak economies, large government debts, hyperinflation, and the lack of an international leader. Speculators attacked currencies like the British Pound. Demanding gold for their pounds, which lead to the collapse of the Bank of England in 1931. During September and October of 1931, investors converted a substantial quantity of dollar assets to gold, reducing the Federal Reserve's gold reserve. This speculative attack on the dollar helped create and fuel a panic in the U.S banking system. Fearing a devaluation of the dollar, many foreign and domestic depositors withdrew their funds from US banks in order to convert them to gold or other assets. Many depositors became distrustful of banks. In order to stabilize the dollar and preserve the gold reserves, the Fed used contractionary monetary policy. They raised interest rates, on the basis that investors would be less willing to liquidate dollar assets if they could earn a higher rate of return on them. The reconstituted gold standard was much less successful than its predecessor, because it lacked the credibility of investors, there was reduced political support and the need to maintain a fixed exchange rate among currencies forced countries to adopt similar monetary policy. For example, when the Federal Reserve raised interest rates in 1928, it inadvertently forced contractionary monetary policy in other countries. The periods of contractionary policy was followed by a decline in both output and price, which suggests that money/gold standard was more of a cause than an effect of the economic collapse.
  Going off the gold standard is a good idea. Once off the, central banks would be able to pursue expansionary policies to combat deflation. When the currency is not directly linked to the supply of gold, policy makers are free to increase the money supply.

M1 = (M1/BASE) x (BASE/RES) x (RES/GOLD) x PGOLD x QGOLD (1)

where

M1 = M1 money supply (money and notes in circulation plus commercial bank deposits),

BASE = monetary base (money and notes in circulation plus reserves of commercial banks),

RES = international reserves of the central bank (foreign assets plus gold reserves), valued in domestic currency,

GOLD = gold reserves of the central bank, valued in domestic currency = PGOLD x QGOLD,

PGOLD = the official domestic-currency price of gold, and

QGOLD = the physical quantity (for example, in metric tons) of gold reserves.

The equation shows that under a gold standard a country's money supply is affected both by its physical quantity of gold reserves (QGOLD) and the price at which its central bank stands ready to buy and sell gold (PGOLD). An increase in QGOLD or a devaluation PGOLD raises the money supply. However, equation (1) also indicates three additional determinants of the inside money supply under the gold standard:

(1) The "money multiplier," M1/BASE. The total money supply (including bank deposits) is larger than the monetary base. The so-called money multiplier, M1/BASE, is a decreasing function of the currency-deposit ratio chosen by the public and the reserve-deposit ratio chosen by commercial banks. At the beginning of the 1930s, M1/BASE was relatively low (not much above one) in countries in which banking was less developed, or in which people retained a preference for currency in transactions. In contrast, in the United States this ratio was close to four in 1929.

(2) The inverse of the gold backing ratio, BASE/RES. Because central banks were typically allowed to hold domestic assets as well as international reserves, the ratio BASE/RES—the inverse of the gold backing ratio (also called the coverage ratio)—exceeded one. Statutory requirements usually set a minimum backing ratio (such as the Federal Reserve's 40 percent requirement), implying a maximum value for BASE/RES (for example, 2.5 in the United States). However, there was typically no statutory minimum for BASE/RES. In particular, a decrease of gold inflows by surplus countries reduced average values of BASE/RES.

(3) The ratio of international reserves to gold, RES/GOLD. Under the gold-exchange standard of the interwar period, foreign exchange convertible into gold could be counted as international reserves, on a one-to-one basis with gold itself) Hence, except for a few "reserve currency" countries, the ratio RES/GOLD also usually exceeded one. Because the ratio of inside money to monetary base, the ratio of base to reserves, and the ratio of reserves to monetary gold were all typically greater than one, the money supplies of gold-standard countries was far from equalling the value of monetary gold. Total stocks of monetary gold continued to grow through the 1930s; the sharp declines of inside money supplies must be attributed entirely to contractions in the average money-gold ratio.