gold standard

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Block of metallic gold.

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gold standard, monetary system in which the standard unit of currency is a fixed quantity of gold or is kept at the value of a fixed quantity of gold. The currency is freely convertible at home or abroad into a fixed amount of gold per unit of currency.

(Read Milton Friedman’s Britannica entry on money.)

In an international gold-standard system, gold or a currency that is convertible into gold at a fixed price is used as a medium of international payments. Under such a system, exchange rates between countries are fixed; if exchange rates rise above or fall below the fixed mint rate by more than the cost of shipping gold from one country to another, large gold inflows or outflows occur until the rates return to the official level. These “trigger” prices are known as gold points.

The gold standard was first put into operation in the United Kingdom in 1821. Prior to this time silver had been the principal world monetary metal; gold had long been used intermittently for coinage in one or another country, but never as the single reference metal, or standard, to which all other forms of money were coordinated or adjusted. For the next 50 years a bimetallic regime of gold and silver was used outside the United Kingdom, but in the 1870s a monometallic gold standard was adopted by Germany, France, and the United States, with many other countries following suit. This shift occurred because recent gold discoveries in western North America had made gold more plentiful. In the full gold standard that thus prevailed until 1914, gold could be bought or sold in unlimited quantities at a fixed price in convertible paper money per unit weight of the metal.

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Gold bars.

Courtesy of the United States Mint

The reign of the full gold standard was short, lasting only from the 1870s to the outbreak of World War I. That war saw recourse to inconvertible paper money or to restrictions on gold export in nearly every country. By 1928, however, the gold standard had been virtually reestablished, although, because of the relative scarcity of gold, most nations adopted a gold-exchange standard, in which they supplemented their central-bank gold reserves with currencies (U.S. dollars and British pounds) that were convertible into gold at a stable rate of exchange. The gold-exchange standard collapsed again during the Great Depression of the 1930s, however, and by 1937 not a single country remained on the full gold standard.

The United States, however, set a new minimum dollar price for gold to be used for purchases and sales by foreign central banks. This action, known as “pegging” the price of gold, provided the basis for the restoration of an international gold standard after World War II; in this postwar system most exchange rates were pegged either to the U.S. dollar or to gold. In 1958 a type of gold standard was reestablished in which the major European countries provided for the free convertibility of their currencies into gold and dollars for international payments. But in 1971 dwindling gold reserves and a mounting deficit in its balance of payments led the United States to suspend the free convertibility of dollars into gold at fixed rates of exchange for use in international payments. The international monetary system was henceforth based on the dollar and other paper currencies, and gold’s official role in world exchange was at an end.

The advantages of the gold standard are that (1) it limits the power of governments or banks to cause price inflation by excessive issue of paper currency, although there is evidence that even before World War I monetary authorities did not contract the supply of money when the country incurred a gold outflow, and (2) it creates certainty in international trade by providing a fixed pattern of exchange rates.

The disadvantages are that (1) it may not provide sufficient flexibility in the supply of money, because the supply of newly mined gold is not closely related to the growing needs of the world economy for a commensurate supply of money, (2) a country may not be able to isolate its economy from depression or inflation in the rest of the world, and (3) the process of adjustment for a country with a payments deficit can be long and painful whenever an increase in unemployment or a decline in the rate of economic expansion occurs.