- In the early days of money, gold coins were used to pay for goods. The money had intrinsic value. Cut a gold coin in half and you had two pieces half its value.
- With a rise in the volume of goods and services produced there was a need for notes and coins.
- The gold standard was a way to fix the value of money by allowing them to be converted into a certain amount of gold. This gave people faith in the new 'paper money'.
- For example, in 1717, United Kingdom fixed £1 to 113 grains (7.32 g) of fine gold.
- Throughout the nineteenth and early twentieth century, other countries also adopted the gold standard. They set their currency at a certain level against gold. Exchange rates were very stable and only moved after an agreed adjustment.
- American Express could print travellers cheque and say exactly how much foreign currency it would buy.
Advantage of Gold Standard
- The advantage of the gold standard is that the amount of gold was relatively stable. It means that governments couldn't print money and create inflation. It also created confidence in the financial system.
- The gold standard also creates stability in exchange rates. This creates greater certainty for international trade. Also, exporters know they can't rely on devaluation to improve competitiveness, encouraging firms to cut costs and increase efficiency.
Breakdown of Gold Standard
- However, in the First world war, the costs of the war were so great countries abandoned the gold standard so they could print more money and pay for war. This led to inflation which persisted after the war.
- After the first world war, countries returned to the gold standard.
- In the early 1920s. Defeated axis powers like Germany, Hungary and Austria couldn't pay their reparations (denominated in gold). Germany printed money causing the famous hyperinflation.
- However, the UK (under Winston Churchill as Chancellor of Exchequer in 1925) rejoined the gold standard at a rate that was too high £1 = $4.85. The UK economy had suffered during the first world war and the attempt to maintain the £ at the prewar rate caused many problems. Keynes was very critical of the decision:
“In truth, the gold standard is already a barbarous relic.”-Monetary Reform (1924), p. 172
- A return to the gold standard meant UK exports were too expensive causing falling demand for UK manufacturers. In the 1920s, because of the gold standard, the UK experienced deflation and a prolonged period of high unemployment (even before the Great Depression)
- On the other hand, the US dollar was undervalued, this contributed to a boom in US economy which led to the credit bubble and stock market crash of 1929.
- In the 1930s, the Great depression caused many to leave the gold standards and allow their exchange rate to devalue. The UK left in 1931.
- After the second world war, Britain had depleted its gold reserves in paying for the war, a return to the gold standard was not practical.
UK in Gold Standard
Note: 1925, rejoined gold standard at pre-war parity. Left gold standard in 1931 and suffered sharp devaluation.
This shows the real interest rates necessary to keep the UK in the gold standard. It was only after 1931 that real interest rates fell.
- See also: UK Economy in the 1920s
- However, to guard against the inflationary potential of floating exchange rates and Central Banks with power to print money, the Bretton woods system was set up.
- This was a fixed exchange rate system where countries pegged their currency to the dollar and the US fixed the price of gold at $35.
- Bretton woods broke down in the 1970s.
Disadvantages of Gold Standard
- However, the gold standard has many drawbacks because of its ability to create deflationary pressures e.g. which harmed the UK economy in the 1920s
- Inflation or deflation could be created by variations in production of gold.
- In recessions, monetary policy becomes ineffective because governments cannot increase the money supply.
- Fixed exchange rates can encourage speculative attacks on the currency. (e.g. it was argued the US was forced to raise interest rates in Great depression to protect value of currency)