Gold Standard

This article focuses on the gold standard. It provides a description and analysis of the pre-World War I gold standard and the post-World War I gold exchange standard. A historical overview of the United States' involvement in the international gold standard will be explored. The United States' current flat monetary system is discussed. The differences between fiat currency and gold currency are addressed. The relationship between the gold standard and exchange rate regimes is also described.

Keywords Bretton Woods; Business Cycle; Deficit; Depression; Economic Contraction; Economic Expansion; Exchange Rate Regimes; Federal Government; Fiat Currency; Fiscal Policy; Flat Monetary System; Gold Currency; Gold Exchange Standard; Gold Standard; Inflation; Monetary Policy

International Business > Gold Standard

Overview

Currency, which refers to a medium that can be exchanged for goods and services, facilitates economic activities such as trade, accumulation of wealth, and purchase of goods and services. Two types of currencies predominated throughout the nineteenth and twentieth century: Fiat currencies and gold currencies.

  • Fiat currency refers to a currency that serves as legal tender but is not redeemable for a specific commodity.
  • Gold currency refers to a currency that is redeemable for a specific amount of gold.

Currencies linked to the price of gold characterized the global currency system throughout much of the nineteenth and twentieth centuries. The gold standard, which is no longer in use, was a complete, global currency system in which national currencies were redeemable for their value in gold. The gold standard emerged in England in 1821. England was the first country to formally adopt a gold standard as the foundation of their national currency. Germany adopted the gold standard in 1871. In the United States, the gold standard, which was used off and on throughout the nineteenth century, was not formally adopted until 1900 with the passage of the Gold Standard Act.

Metallic Currency Standards

The gold standard is a metallic currency standard. In a metallic currency standard, governments establish the value of their national currency in relation the weight of a metal such as gold or silver. Citizens and nations do not always agree about which metal should be used as a metallic currency standard. In the United States, throughout the nineteenth century, stakeholders debated about the proper place of gold and silver as the economy's currency standard. Governments using the gold standard, or any metallic currency standard, constantly monitored and controlled the weight of metal used in the currency to ensure that the currency was not worth more as melted down bullion than as money in circulation. In the United States, throughout much of the nineteenth century, Congress defined the gold dollar as 24.74 grains of pure gold.

The following conditions are necessary for a metallic standard to operate effectively (Timberlake, 2007):

  • The supply of common money that banks and individuals generate must be related to the quantity of monetary gold in government accounts
  • Market prices must be sensitive to changes in the quantity of money in circulation
  • Gold must be allowed to flow freely throughout the economy.

There are three different types of gold standards associated with different goals, objectives, and periods in history:

  • The traditional or fixed global gold standard, used from the early nineteenth century to 1914, was based on the premise that currency was always redeemable for its equivalent value in gold;
  • The gold-bullion standard, used in Great Britain from 1925 to 1931, operated with a set quantity of gold in circulation;
  • The gold-exchange standard, used from 1934-1971, operated under a scheme in which national currencies are convertible into the currency of a country tied to the gold standard.

The following section provides a description and analysis of the pre World War I gold standard and the post World War I gold-exchange standard. This section serves as a foundation for later discussion on the connection between the gold standard and exchange rate regimes.

Applications

The United States & the Gold Standard

The history of the U.S. economy is full of economic expansion and economic contraction. Following the American Revolution, the individual economies of the states were faltering, paper money had little value, and there was conflict between borrowers and lenders. The original thirteen states came together to draft the U.S. Constitution, in part, to stabilize and strengthen the U.S. economy. The U.S. Constitution established a bimetallic monetary standard for the United States. The U.S. Constitution gives the federal government the power to coin money, regulate the value, and fix the standards of weights and measures. The U.S. Constitution prohibits states from coining money, making bills of credit, or making any thing but gold and silver coin legal for the payment of debts. The following timeline illustrates the evolution of the gold standard in the United States.

  • 1792: Congress legalized gold and silver dollar coins.
  • 1834: Congress changed the amount of gold in a gold dollar coin.
  • 1853: Congress reduced the weight of gold and silver coins so that the coins would be worth more as money than bullion.
  • 1862: Congress revoked the operational gold standard.
  • 1863: Congress passed the National Currency Act that created a national banking system and the National Banking Act.
  • 1873: Congress temporarily omitted the silver dollar from the list of authorized coins to be minted by the U.S. Mint.
  • 1899: Congress passed the Gold Standard Act that established the gold dollar as the standard unit of value over silver.
  • 1913: Congress passed the Federal Reserve Act that established 12 regional Federal Reserve banks.
  • 1914: World War I began and the global gold standard faltered.
  • 1929: The U.S. stock market crashed, the Great Depression begins, and the gold standard collapsed.
  • 1933: President Roosevelt made gold export, without government license or permit, illegal and outlawed significant private gold ownership.
  • 1945: The Bretton Woods currency system, known as the gold-exchange standard, was established.
  • 1971: President Nixon ended the gold-exchange standard.

The Gold Standard During WWI

Nations embraced the gold standard as a means of facilitating capital mobility, trade, low inflation levels, and economic stability. The gold standard fell out of favor during World War I due to the hostility between nations and the unwillingness of multiple nations to engage in acts of economic cooperation. Supplies of money and gold were relatively stable throughout the gold standard years. The system of the gold standard gave national governments little freedom to develop monetary policy and prevented national treasuries from quickly increasing the amounts of money circulating in the economy. For example, the gold standard limited the U.S. Federal Reserve's ability to increase the money supply. As a result, national governments, under the gold standard, were limited in their ability to respond to changing economic and social situations in a country through the use of exchange rate policies. Monetary shocks and recessions were common under the gold standard. The issue of privatization of the economy was also an issue under the gold standard. Individuals could potentially influence the economy by purchasing significant amounts of gold. The gold standard established and controlled the economic relationship between the government and the people, limited the government's control in the economy by limiting the government's ability to make new monetary policy, and was considered a self-regulating entity of the economy.

The Gold Standard Following WWI

Following World War I, the gold standard faltered and collapsed. The U.S. Federal Reserve gradually abandoned the gold standard from World War I through the 1920s. The U.S. Federal Reserve replaced the operational gold standard with the real bill doctrine and the freedom to issue money as necessary (Timberlake, 2007). The Great Depression, the severe economic recession in America that lasted from 1930-1934, was caused by instability of the American economy created, in part, by new mass manufacturing processes, uneven distribution of wealth and profits, and the government's investment in new industries rather than agriculture. The Depression ended when President Franklin D. Roosevelt took office in 1933. Roosevelt's New Deal Campaign outlawed gold coins, set farm quotas, and established government work programs to generate confidence and money into the U.S. economy. In the 1930s, following the Great Depression, the United States government began a program and approach of mixed fiscal and monetary policies in an effort to produce sustained economic growth and stable prices (for goods, services, and natural resources).

The Gold-Exchange Standard Following WWII

Following World War II, the United States and forty-four other nations came together at the Bretton Woods summit to address the problem of international economic instability. The Bretton Woods summit produced a system for international trade and financial activity. The International Monetary Fund (IMF) was established to oversee international rules and regulations governing international exchanges and the newly established international monetary system. The International Monetary Fund, founded in 1945, is an international organization of 185 member countries established to accomplish the following goals and objectives: Promote international monetary cooperation, exchange stability, and orderly exchange arrangements; foster economic growth and high levels of employment; and provide temporary financial assistance to countries in order to help ease balance of payments adjustment.

The Bretton Woods monetary system, put into practice in 1946, made the dollar into the world's currency. The Bretton Woods monetary system was called the gold exchange standard. The gold-exchange standard refers to the system in which governments could change their currencies into gold via the U.S. dollar. Under the Bretton Woods system, the U.S. pledged to exchange all dollars held by foreign countries into gold at the IMF-established exchange rate. The United States could function as the cornerstone of the new global gold exchange standard as the U.S. had most of the world's gold supply after WWI (75% of the world's monetary gold). The Bretton Woods monetary system was considered a success. All International Monetary Fund member nations quickly worked to define the value of their own national currencies in relation to the U.S. dollar.

Twentieth Century Fiscal Policy

In the twentieth century, the United States government, which uses the tools of fiscal policy and monetary policy to achieve its economic and social goals, favored a limited or managed gold standard system. Fiscal policy refers to expenditures by federal, state, and local governments and to the taxes levied to support and fund the federal budget, aid the federal government's social policies, and promote overall economic growth and stability. Monetary policy is a tool used by the federal government to control the supply and availability of money in the economy. A managed gold exchange standard, as seen from 1945-1971, allowed the government to make monetary policy as needed.

The new global monetary system was a fixed or pegged exchange rate system in which currencies were pegged to the U.S. dollar. Under this currency system, $35 U.S. dollars equaled one ounce of gold. The Bretton Woods monetary system lasted until 1971 when the U.S. dollar could not support the fixed exchange rate. By 1971, foreign governments owned more dollars than the United States owned gold. President Nixon ended the practice of trading gold at the fixed price of $35 per ounce. In 1971, national currencies became independent of one another and subject to market forces. Following the end of the gold-exchange standard in 1971, national governments and international governance organizations continued to explore ways to create a global fixed or pegged exchange rate but abandoned those efforts in the mid 1980s.

In the United Sates today, the managed currency system has no ties to a metallic value. Gold, of any amount, is legal to own and trade. Gold is subject to the market forces of supply and demand. With the end of the gold standard in the United States came the increase in the role and power of the U.S. Federal Reserve and central bank to make monetary policy and control the business cycle. Most nations now operate with a form of managed currency or flat currency system. Flat currency refers to money that is given value by government fiat rather than by its metallic content. For example, during the Civil War, North and South financed war through the minting and use of flat money that quickly lost its value after the Civil War.

The Role of Keynes in U.S. Fiscal Policy

U.S. fiscal policy of the twentieth century was strongly influenced by the economic theories of John Keynes, author of The General Theory of Employment, Interest, and Money (1936), that economic problems resulted from insufficient demand for goods and services in society-at-large. Economist John Keynes opposed the gold standard and worked to end the gold standard system in the United States. Keynes believed that the government had to be given the power to manage the business cycle. The gold standard did not give the federal government the discretion to make monetary and fiscal policy at will.

According to Keynesian economics, a vicious cycle results when people do not have sufficient income to buy everything the economy can produce, prices fall, and companies lose money and go bankrupt. Without government intervention, discretion, and management, Keynes said, this vicious cycle would bankrupt the economy. Keynes argued that government could stop economic decline, and promote economic growth, by increasing spending and by cutting taxes. Lastly, Keynesian economics accepted a government deficit as a necessary and acceptable consequence of strengthening the economy. Following the end of the gold standard in 1971, the U.S. government followed the Keynesian approach to economics (characterized by numerous tax cuts and increased spending to stimulate the economy) and, as a result, strengthened the U.S. economy and created a huge national deficit (Conte, 2001). Some Republican economic theorists continue to debate the negative consequences of abandoning the gold standard (Lipsky, 2012; Forbes, 2012).

Issues

The Gold Standard & Exchange Rate Regimes

The economy post-gold standard is regulated with exchange rates. The gold standard, which was in effect worldwide until 1971, was an example of a global fixed exchange rate. Following the collapse of the gold standard in 1971, the majority of global exchange rates are floating. National exchange rates are referred to as exchange rate regimes. Exchange rate regimes, also called currency institutional regime, refer to specific institutional structures designed to produce specific exchange rate outcomes. The main exchange rate regimes, including floating, fixed, and pegged, are characterized by different levels of control and produce different results. Exchange rate regimes are closely connected to international economic policy. The field of international economic policy debates the merits of different exchange rate regimes and international financial architecture. The field of international economic policy is working to identify viable international exchange rate regimes for a wide range of markets. The increase in global capital flows between the 1970s and 1990s has increased international trade, portfolio diversification, and risk-sharing. Countries invested in international trade are increasingly faced with the decision of whether or not to give up their nation's monetary-policy autonomy.

Types of Exchange Rate Regimes

The main exchange rate regimes, including floating, managed, and pegged, vary in their objectives and implementation (Tavlas, 2003):

• Floating exchange rate regimes have no commitment to a specific exchange-rate target. In floating exchange rate regimes, the exchange rate is determined by market supply and demand rather than macroeconomic policy. The U.S. dollar and the Euro tend to have floating exchange rates.

• Managed exchange rate regimes have no constant exchange rate target. Instead, policymakers tweak interest rates to raise or lower the exchange rate as needed. Managed exchange rate regime refers to scenarios in which the central bank intervenes in the currency market to achieve a variable currency target. Policymakers make these adjustments on a daily, weekly, or monthly basis to counteract misalignments in the economy. Misalignments refer to a sustained departure of the exchange rate from what policymakers perceive to be its equilibrium value.

• Pegged exchange rate regimes include a set exchange rate target. Policymakers use monetary policy to maintain the established exchange rate target. Examples of pegged exchange rate regimes include soft peg, adjustable peg, and crawling peg. Adjustable peg regimes tend to include infrequent large adjustments in response to perceived differences between the target exchange rate and the equilibrium rate. Crawling peg regimes operate with a target exchange rate zone rather than a single exchange rate target and tend to include frequent small adjustments to the exchange rate.

Strengths & Weaknesses of the RegimesThese three competing exchange rate regimes have different strengths and weaknesses (De Vita & Kyaw, 2011). Emerging market economies and long established market economies will choose their exchange rate regime based on various factors such as the different economic needs of citizens and government and established economic infrastructure (Russell, 2012). Both freely floating exchange rate regimes and managed floating exchange rate regimes experience depreciations. Depreciations refer to a loss in currency value. Stable fixed exchange rate regimes experience devaluations and revaluations. Devaluation refers to a loss of value forced by market or a purposeful policy action. Revaluation refers to increase of international value. All exchange rate regimes may experience currency crisis. Currency crisis refers to a rupture of fixed exchange rates with an unwilling devaluation or even the end of that regime in favor of a floating exchange rate (Piana, 2001). Ultimately, the gold standard united national currencies and stabilized national currencies but also slowed growth. The end of the gold standard, and its global fixed exchange rate regime, has created opportunity for massive global economic growth.

Conclusion

The gold standard, which was in use as a global currency system until 1971, was a global currency system in which national currencies were redeemable for their value in gold. The gold standard was embraced as a means to prevent inflation and limit government's power to enact monetary policy at will. The gold standard structured currency relations for two hundred years. The collapse of the gold standard in 1971 produced economic opportunity. Strong capital flows, trade, and growth characterize the new post-gold standard global economy.

Terms & Concepts

Bretton Woods: The International meeting held in Bretton Woods, New Hampshire that established a fixed exchange rate backed by gold for all major currencies and established the International Monetary Fund.

Business Cycle: A type of fluctuation found in the aggregate economic activity of nations that organize their work mainly in business enterprises.

Deficit: The amount of money which a government, company, or individual spends which exceeds its income.

Depression: A sustained economic recession.

Economic Contraction: The downward phase of the business cycle.

Economic Expansion: The upward phase of the business cycle.

Exchange Rate Regimes: Specific institutional structures designed to produce specific exchange rate outcomes.

Federal Government: A form of government in which a group of states recognizes the sovereignty and leadership of a central authority while retaining certain powers of government.

Fiat Currency: Currencies that serve as legal tender but are not redeemable for a specific commodity.

Fiscal Policy: The expenditures by federal, state, and local governments and the taxes levied to finance these expenditures.

Gold Currency: A currency that is redeemable for a specific amount of gold.

Inflation: The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.

Monetary Policy: A tool used by the federal government to control the supply and availability of money in the economy.

Bibliography

Bohanon, C., Lynch, G., & Van Cott, T. (1985). A supply and demand exposition of the operation of a gold standard in a closed economy. Journal of Economic Education, 16, 16-26. Retrieved October 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5422397&site=ehost-live

Abrams, B. (2007). Do fixed exchange rates fetter monetary policy? A credit view. Eastern Economic Journal, 33, 193-206.

Crabbe, L. (1989, June). The international gold standard and U.S. monetary policy from World War I to the New Deal. The Federal Reserve Bulletin. Retrieved October 16, 2007, from http://findarticles.com/p/articles/mi%5fm4126/is%5fn6%5fv75/ai%5f7698825

Conte, C. & Karr, A. (2001, February). An outline of the U.S. economy. Retrieved October 16, 2007, from U.S. Department of State Publications Web site. http://usinfo.state.gov/products/pubs/oecon

De Vita, G., & Kyaw, K. (2011). Does the choice of exchange rate regime affect the economic growth of developing countries? Journal of Developing Areas, 45, 135-153. Retrieved on November 19, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=62562654&site=ehost-live

Forbes, S. (2012). Gold standard coming. Forbes, 190, 13-14. Retrieved on November 19, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=80034351&site=ehost-live

Knafo, S. (2006). The gold standard and the origins of the modern international monetary system. Review of International Political Economy, 13, 78-102. Retrieved October 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=19125334&site=ehost-live

Lipsky, S. (2012, August 30). The gold standard goes mainstream. Wall Street Journal - Eastern Edition. p. A15. Retrieved on November 19, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=79442011&site=ehost-live

Mitchell, D. (2000). Dismantling the cross of gold: Economic crises and U.S. monetary policy. North American Journal of Economics & Finance, 11, 77. Retrieved October 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=3677326&site=ehost-live

Piana, V. (2001). Exchange rate. The Economics Web Institute. Retrieved October 6, 2007, from http://www.economicswebinstitute.org

Russell, J. (2012). Herding and the shifting determinants of exchange rate regime choice. Applied Economics, 44, 4187-4197. Retrieved on November 19, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=65365751&site=ehost-live

Tavlas, G. (2003). The economics of exchange-rate regimes: A review essay. World Economy, 26, 1215. Retrieved October 6, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=10763664&site=ehost-live

Timberlake Jr., R. (2007). Gold standards and the real bills doctrine in U.S. monetary policy. Independent Review, 11, 325-354. Retrieved October 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23590911&site=ehost-live

Suggested Reading

Barro, R. (1979). Money and the price level under the gold standard. Economic Journal, 89, 13-33. Retrieved October 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4534227&site=ehost-live

Clark, T. (1984). Violations of the gold points, 1890-1908. Journal of Political Economy, 92, 791. Retrieved October 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5052635&site=ehost-live

Dowd, K. (1991). Financial instability in a 'directly convertible' gold standard. Southern Economic Journal, 57, 719. Retrieved October 16, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4630219&site=ehost-live

Essay by Simone I. Flynn, Ph.D.

Dr. Simone I. Flynn earned her Doctorate in cultural anthropology from Yale University, where she wrote a dissertation on Internet communities. She is a writer, researcher, and teacher in Amherst, Massachusetts.