Gold Standard

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Definition of Gold Standard:

A country has a gold standard when its monetary system is directly linked to gold and the currency can be converted into gold.

Detailed Explanation:

No country has used the gold standard since 1971. Instead, countries have fiat currency. Fiat currency’s value is derived from a government decree or fiat. It is not backed by a commodity and the value of the material the currency is made of is insignificant. Some politicians and economists advocate returning to the gold standard because they feel more comfortable knowing an asset backs the dollar.

The gold standard was used by most countries between 1879 and 1914. Prior to World War I, countries settled their balance of trade in gold. In theory, the gold standard brought a country’s balance of trade into balance. Countries with a trade surplus accumulated gold, while the gold reserves of those with a trade deficit were depleted. When gold reserves increased, the price level rose because of the increase in the money supply. Exports fell because they became more expensive, resulting in reducing the country’s trade surplus. Conversely, countries with a trade deficit experienced a reduction in their price level which boosted exports.

Interest in returning to the gold standard increases during periods when inflation exceeds five percent. Proponents of the gold standard feel uncomfortable with the government controlling the money supply. A gold standard limits the growth of the money supply and inflation because the government would be limited in the amount of money it could print by the corresponding supply of gold. Prices only increased an average of 1.6 percent between 1880 and 1913, compared to 4.0 percent between 1968 and 2001 according to a study by Michael Bordo of the St. Louis Federal Reserve Bank. Diminished reserves reduce the money supply which can lead to deflation and slow economic growth. When prices are falling, consumers may delay purchasing goods and services hoping to pay less if they wait long enough. Deflation occurred 12 times between 1913 and 1971 and only once (2009) since leaving the gold standard. (Federal Reserve Bank of Minneapolis)

Many economists believe the gold standard contributed to deflation and the Great Depression because the Federal Reserve raised interest rates to slow the depletion of the government's gold reserves. Depositors were concerned about the health of the banking system and were redeeming their currency for gold, thus reducing the gold reserves and money supply. To slow the run on banks the Federal Reserve raised interest rates hoping depositors would leave their money in the system. (A piece of gold does not earn interest.) The policy worked, but it also jacked up rates to a point that it discouraged business investment, when the country needed it most. Under the gold standard, the Federal Reserve would be conflicted between raising interest rates to slow the redemption of currency for gold or allow the gold reserves to be depleted.

Between 1834 and 1933, the price of gold was $20.67 an ounce. On April 5, 1933, President Roosevelt, empowered by Emergency Banking Act, made it illegal for Americans to own gold except for jewelry. The Federal Reserve purchased gold from Americans for $20.67 an ounce. Less than a year later Roosevelt raised the price of gold to $35 an ounce. The effect was to increase the money supply by 69 percent. Many countries took advantage of the higher price and sold their gold to the United States. By the end of WWII, the US controlled 75 percent of the world’s gold. 

Following World War II many world leaders wanted to return to the gold standard. Representatives from forty-four countries met in Bretton Woods, New Hampshire, and reached the Bretton Woods Agreement. The Bretton Woods System was included in the agreement. Countries would trade in dollars, but the United States agreed to buy those dollars for gold. The price was fixed at $35 per ounce. Part of the Bretton Woods agreement was that countries would not permit their currencies to fluctuate significantly. In other words, exchange rates would be fixed and ultimately tied to gold. Fixing gold’s price and America’s guarantee to exchange dollars for gold, helped stabilize exchange rates. Many advocates of the gold standard believe this adds to the certainty of international investments. 

The Federal Reserve is charged with using monetary policy to manage inflation and prevent deflation while furthering economic growth and full employment. Most economists believe the gold standard limits the Federal Reserve's ability to use monetary policy to manage the economy, which limits growth, adds to unemployment while increasing the risk of deflation.   

Dig Deeper With These Free Lessons:

What Is Money
Causes of Inflation
Monetary Policy – The Power of an Interest Rate
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