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:

The gold standard prevailed among most countries from 1879 to 1914, with gold settling international trade. In theory, the gold standard maintained equilibrium in a country's balance of trade. Countries with a trade surplus accumulated gold, while the gold reserves of those with a 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.

Since 1971, no country has adhered to the gold standard. Instead, most nations utilize fiat currency, wherein the government decrees the currency’s value. Such currency lacks backing from a tangible commodity, and the intrinsic value of the material from which it is made is inconsequential. 

Many economists argue that the gold standard contributed to deflation and the Great Depression because the Federal Reserve raised interest rates to protect gold reserves. Depositors redeemed their currency for gold because they were concerned the banking system had an inadequate supply, 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 allowing the gold reserves to be depleted.

Between 1834 and 1933, gold was $20.67 an ounce. On April 5, 1933, President Roosevelt, empowered by the 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. 

Many world leaders wanted to return to the gold standard after World War II. Representatives from forty-four countries met in Bretton Woods, New Hampshire, and reached the Bretton Woods Agreement, which created the Bretton Woods System. 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. 

Interest in returning to the gold standard increases 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. A study by Michael Bordo of the St. Louis Federal Reserve Bank concluded that prices increased at an average of 1.6 percent between 1880 and 1913, compared to 4.0 percent between 1968 and 2001. However, depleted reserves reduce the money supply, which can lead to deflation and slow economic growth. When prices fall, 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)

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
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Monetary Policy – The Power of an Interest Rate
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