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Introduction

  • The gold standard operated from about 1880 to the outbreak of World War I in 1914. An attempt was made to re-establish the gold standard after the war, but it failed in 1931 during the Great Depression. It is highly unlikely that the gold standard will be re-established in the near future—if ever. Nevertheless, it is very important to understand the advantages and disadvantages inherent in the operation of the gold standard, not only for its own sake, but also because they were also true for the fixed exchange rate system (the Bretton Woods system, or gold-exchange standard) that operated from the end of World War II until it collapsed in 1971.
  • Under the gold standard, each nation defines the gold content of its currency and passively stands ready to buy or sell any amount of gold at that price. Since the gold content in one unit of each currency is fixed, exchange rates are also fixed. For example, under the gold standard, a £1 gold coin in the United Kingdom contained 113.0016 grains of pure gold, while a $1 gold coin in the United States contained 23.22 grains. This implied that the dollar price of the pound, or the exchange rate, was R = $/£ = 113.0016/23.22 = 4.87. This is called the mint parity. (Since the centre of the gold standard was London, not Frankfurt, our discussion is in terms of pounds sterling and dollars, instead of Euros and dollars.)
  • Since the cost of shipping £1 worth of gold between New York and London was about 3 cents, the exchange rate between the dollar and the pound could never fluctuate by more than 3 cents above or below the mint parity (i.e., the exchange rate could not rise above 4.90 or fall below 4.84). The reason is that no one would pay more than $4.90 for £1, since he could always purchase $4.87 worth of gold at the U.S. Treasury (the Federal Reserve Bank of New York was only established in 1913), ship it to London at a cost of 3 cents, and exchange it for £1 at the Bank of England (the U.K. central bank). Thus, the U.S. supply curve of pounds became infinitely elastic (horizontal) at the exchange rate of R = $4.90/£1. This was the gold export point of the United States.
  • On the other hand, the exchange rate between the dollar and the pound could not fall below $4.84. The reason for this is that no one would accept less than $4.84 for each pound he wanted to convert into dollars because he could always purchase £1 worth of gold in London, ship it to New York at a cost of 3 cents, and exchange it for $4.87 (thus receiving $4.84 net). As a result, the U.S. demand curve of pounds became infinitely elastic (horizontal) at the exchange rate of R = $4.84/£1. This was the gold import point of the United States. The exchange rate between the dollar and the pound was determined at the intersection of the U.S. demand and supply curves of pounds between the gold points and was prevented from moving outside the gold points by U.S. gold sales or purchases. That is, the tendency of the dollar to depreciate, or the exchange rate to rise above R = $4.90/£1, was countered by gold shipments from the United States. These gold outflows measured the size of the U.S. balance-of-payments deficit. On the other hand, the tendency of the dollar to appreciate, or the exchange rate to fall below R = $4.84/£1, was countered by gold shipments to the United States. These gold inflows measured the size of the surplus in the U.S. balance of payments. Since deficits are settled in gold under this system and nations have limited gold reserves, deficits cannot go on forever but must soon be corrected. We now turn to the adjustment mechanism that automatically corrects deficits and surpluses in the balance of payments under the gold standard.

The Price-Specie-Flow Mechanism

  • The automatic adjustment mechanism under the gold standard is the price-specie-flow mechanism. This operates as follows to correct balance-of-payments disequilibria.
  • Since each nation’s money supply under the gold standard consisted of either gold itself or paper currency backed by gold, the money supply would fall in the deficit nation and rise in the surplus nation. This caused internal prices to fall in the deficit nation and rise in the surplus nation. As a result, the exports of the deficit nation would be encouraged and its imports would be discouraged until the deficit in its balance of payments was eliminated. The reduction of internal prices in the deficit nation as a result of the gold loss and reduction of its money supply was based on the quantity theory of money. This can be explained by using Equation ,

MV = PQ

where M is the nation’s money supply, V is the velocity of circulation of money (the number of times each unit of the domestic currency turns over on the average during one year), P is the general price index, and Q is physical output.

  • Classical economists believed that V depended on institutional factors and was constant. They also believed that, apart from temporary disturbances, there was built into the economy an automatic tendency toward full employment without inflation (based on their assumption of perfect and instantaneous flexibility of all prices, wages, and interests). For example, any tendency toward unemployment in the economy would be automatically corrected by wages falling sufficiently to ensure full employment.
  • Thus, Q was assumed to be fixed at the full-employment level. With V and Q constant, a change in M led to a direct and proportional change in P. Thus, as the deficit nation lost gold, its money supply would fall and cause internal prices to fall proportionately. For example, a deficit in the nation’s balance of payments and gold loss that reduced M by 10 percent would also reduce P by 10 percent in the nation. This would encourage the exports of the deficit nation and discourage its imports.
  • The opposite would take place in the surplus nation. That is, the increase in the surplus nation’s money supply (due to the inflow of gold) would cause its internal prices to rise. This would discourage the nation’s exports and encourage its imports. The process would continue until the deficit and surplus were eliminated.
  • Note that the adjustment process is automatic; it is triggered as soon as the balance-of-payments disequilibrium arises and continues to operate until the disequilibrium is entirely eliminated. Note also that the adjustment relies on a change in internal prices in the deficit and surplus nations. Thus, while adjustment under a flexible exchange rate system relies on changing the external value of the national currency, adjustment under the gold standard relies on changing internal prices in each nation.
  • Adjustment under the gold standard also relies on high price elasticity of exports and imports in the deficit and surplus nations, so that the volumes of exports and imports respond readily and significantly to price changes.
  • David Hume introduced the price-specie-flow mechanism in 1752 and used it to demonstrate the futility of the mercantilists’ belief that a nation could continuously accumulate gold by exporting more than it imported. Hume pointed out that as a nation accumulated gold, domestic prices would rise until the nation’s export surplus (which led to the accumulation of gold in the first place) was eliminated. The example Hume used to make this point is unsurpassed: That is, it is futile to attempt to raise the water level (the amount of gold) above its natural level in some compartment (nation) as long as the compartments are connected with one another (i.e., as long as nations are connected through international trade). Passively allowing the nation’s money supply to change for balance-of-payments considerations meant that nations could not use monetary policy for achieving full employment without inflation.
  • Yet, this created no difficulties for classical economists, since (as pointed out earlier) they believed that there was an automatic tendency in the economic system toward full employment without inflation. Note, however, that for the adjustment process to operate, nations were not supposed to sterilize (i.e., neutralize) the effect on their money supply of a deficit or surplus in their balance of payments.
  • On the contrary, the rules of the game of the gold standard required a deficit nation to reinforce the adjustment process by further restricting credit and a surplus nation to expand credit further.

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