Gold standard

Under the gold standard, the government authorities commit to exchange local money for gold at a certain price. In essence, the domestic currency is backed by gold. The same is required of the government authorities of the other countries participating in the gold standard regime.

Under the gold standard, the exchange rates of the participating countries are fixed. For example, if 1 dollar = 3 ounces of gold and 1 French Franc = 2 ounces of gold, then 1 dollar = 3/2 = 1.5 Francs. In other words, if the individual currencies are fixed to gold then they are also fixed to each other.

Pros: The gold standard ensures low inflation since each banknote in circulation has to be backed by a certain amount of gold. The government cannot print money unless it has more gold reserves and therefore rapid money growth and high inflation are less likely. The low inflation and fixed exchange rates are good for international trade and international investment which, in turn, is good for economic growth.

Cons: The gold standard also has negatives. The central bank cannot freely expand money supply to stimulate the economy when necessary. Therefore, recessions could be longer and deeper. Also, as the economies of the world expand they need more cash to make transactions. However, under the gold standard, the amount of cash in circulation is limited by the amount of gold available. The limited supply of currency is a drag on the economy.

To illustrate, see that the U.S. money supply doubles every 10 or so years. If the U.S. was on the gold standard, it would need to double its gold reserves as well. Since that is impossible for lack of enough gold in the world, the supply of money would have to grow more slowly. If the supply of money does not expand fast enough to meet the demand for credit by households and firms, then interest rates would increase. That would slow down the economy as fewer consumers and companies use credit for purchases and investment.

The golds standard was in place for much of history as counties either used gold and silver coins or printed fiat (i.e. paper) money that was backed by gold. However, the problems outlined above gradually made the gold standard obsolete. Countries opted to have more flexibility with un-backed paper money. Although the gold standard has supporters, its return as actual policy is very unlikely.

Moving gold between countries

We can describe how international payments were settled as follows. A U.S. company wants to buy wine and cheese from a French producer. It goes to the U.S Treasury and exchanges dollars for gold. Then it exchanges gold for French Francs at the French Treasury and pays the producer of wine and cheese.

Notice that in the process, gold moved from the U.S. Treasury to the French Treasury. If a French company wants to buy products from the U.S. the gold is moved back from France to the U.S. Hence, a country would lose gold if it runs a trade deficit and would gain gold if it runs a trade surplus.


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