Gold currency Standard, Gold Bullion standard
The gold standard is a monetary system where a country’s currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.
The gold standard is not currently used by any government. Britain stopped using the gold standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system in 1973.1 2 The gold standard was completely replaced by fiat money, a term to describe currency that is used because of a government’s order, or fiat, that the currency must be accepted as a means of payment. In the U.S., for instance, the dollar is fiat money, and for Nigeria, it is the naira.
The appeal of a gold standard is that it arrests control of the issuance of money out of the hands of imperfect human beings. With the physical quantity of gold acting as a limit to that issuance, a society can follow a simple rule to avoid the evils of inflation. The goal of monetary policy is not just to prevent inflation, but also deflation, and to help promote a stable monetary environment in which full employment can be achieved. A brief history of the U.S. gold standard is enough to show that when such a simple rule is adopted, inflation can be avoided, but strict adherence to that rule can create economic instability, if not political unrest.
The gold standard was originally implemented as a gold specie standard, by the circulation of gold coins. The monetary unit is associated with the value of circulating gold coins, or the monetary unit has the value of a certain circulating gold coin, but other coins may be made of less valuable metal. With the invention and spread in use of paper money, gold coins were eventually supplanted by banknotes, creating the gold bullion standard, a system in which gold coins do not circulate, but the authorities agree to sell gold bullion on demand at a fixed price in exchange for the circulating currency.
Lastly, countries may implement a gold exchange standard, where the government guarantees a fixed exchange rate, not to a specified amount of gold, but rather to the currency of another country that uses a gold standard. This creates a de facto gold standard, where the value of the means of exchange has a fixed external value in terms of gold that is independent of the inherent value of the means of exchange itself.
The British Gold Standard Act 1925 both introduced the gold bullion standard and simultaneously repealed the gold specie standard. The new standard ended the circulation of gold specie coins. Instead, the law compelled the authorities to sell gold bullion on demand at a fixed price, but “only in the form of bars containing approximately four hundred ounces troy [12 kg] of fine gold”. John Maynard Keynes, citing deflationary dangers, argued against resumption of the gold standard. By fixing the price at a level which restored the pre-war exchange rate of US$4.86 per pound sterling, as Chancellor of the Exchequer, Churchill is argued to have made an error that led to depression, unemployment and the 1926 general strike. The decision was described by Andrew Turnbull as a “historic mistake”.
The advantages of the system lay in its stabilizing influence. A nation that exported more than it imported would receive gold in payment of the balance; such an influx of gold raised prices, and thus lowered the value of the domestic currency. Higher prices resulted in decreasing the demand for exports, an outflow of gold to pay for the now relatively cheap imports, and a return to the original price level (see balance of trade and balance of payments).
A major defect in such a system was its inherent lack of liquidity; the world’s supply of money would necessarily be limited by the world’s supply of gold. Moreover, any unusual increase in the supply of gold, such as the discovery of a rich lode, would cause prices to rise abruptly. For these reasons and others, the international gold standard broke down in 1914.
During the 1920s the gold standard was replaced by the gold bullion standard, under which nations no longer minted gold coins but backed their currencies with gold bullion and agreed to buy and sell the bullion at a fixed price. This system, too, was abandoned in the 1930s.
Gold exchange standard
gold-exchange standard, monetary system under which a nation’s currency may be converted into bills of exchange drawn on a country whose currency is convertible into gold at a stable rate of exchange. A nation on the gold-exchange standard is thus able to keep its currency at parity with gold without having to maintain as large a gold reserve as is required under the gold standard.
The gold-exchange standard came into prominence after World War I because of an inadequate supply of gold for reserve purposes. British sterling and the U.S. dollar have been the most widely recognized reserve currencies. The requirement of a fixed rate of exchange for the reserve currency has the effect of limiting the freedom of the reserve-currency country’s monetary policy to solve domestic economic problems. The use of gold reserves is now limited almost exclusively to the settlement of international transactions, on rare occasions.
The objective of the gold standard is to prevent inflation and to provide certainty in the market. Basically, the populace can feel confident in the value of a countries currency if the currency represents and can be readily exchanged for a certain amount of gold. In 1933, the US moved away from the Gold Standard. The US population traded in gold currency for fiat currency issued by the US Government. The currency, however, was still backed by the possession of gold. The dollar could readily be exchanged for gold. In 1944, the US formalized this model as a signatory of the Bretton Woods Agreement. This agreement was negotiated among 44 countries to create a new financial and monetary system. In 1971, the truly split from the gold standard. At this point, the US dollar could no longer be exchanged for gold and was no longer pegged to gold prices.