THE CLASSICAL GOLD STANDARD SYSTEM

The gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold.

A commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold.

Why GOLD?

GOLD has the desirable properties of money that early writers in economics have stressed. It is durable, easily standardized. Especially important, changes in its stock are limited, at least in the short run, by high costs of production, making it costly for government to manipulate. Because of these physical attributes, it emerged as one of the earliest forms of money.

18751914

CLASSICAL GOLD STANDARD

During this period in most major countries:
Gold alone was assured of unrestricted coinage There was two-way convertibility between gold and national currencies at a stable ratio. Gold could be freely exported or imported.

The exchange rate between two countrys currencies would be determined by their relative gold contents.

For example, if the dollar is pegged to gold at U.S.$30 = 1 ounce of gold, and the British pound is pegged to gold at 6 = 1 ounce of gold, it must be the case that the exchange rate is determined by the relative gold contents:

$30 = 6 $5 = 1

Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Misalignment of exchange rates and international imbalances of payment were automatically corrected by the price-specie-flow mechanism.

The price-level adjustment mechanism under the gold standard is known as the price-specie automatic adjustment mechanism.

Price specie flow mechanism is the adjustment of prices as gold (specie) flows into or out of a country, causing an adjustment in the flow of goods. An inflow of gold tends to inflate prices. An outflow of gold tends to deflate prices.

Thus, price specie flow mechanism of the gold standard could reduce current account surpluses and deficits, achieving a measure of external balance for all countries.

There are shortcomings: The supply of newly minted gold is so restricted that the growth of world trade and investment can be hampered for the lack of sufficient monetary reserves. Even if the world returned to a gold standard, any national government could abandon the standard.

The policy of not allowing a change in reserves to change supply of money is known as STERILIZATION or NEUTRALIZATION POLICY.

The gold standard broke down at the outset of World War I, as countries resorted to inflationary policies to finance the war and, later, the reconstruction efforts.

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