What Is the Gold Standard in Economics?

The Gold Standard

The gold standard is a monetary system where a currency is backed by gold. This means that a country can exchange its currency for a fixed amount of gold. For example, if the U.S. decides the price of gold is $1,000 per ounce, then the dollar would be worth 1/1000th of an ounce of gold. The government sets the price of gold and buys gold at that fixed rate.

Gold was a popular medium of exchange in the past, and it was super effective as a store of value. Although many things have changed, financial analysts and investors are still interested in the gold standard.

History of the Gold Standard

Gold was first minted into a currency at around 600 B.C. Although gold coins continued to be used for trade, this precious metal only became a standard unit in the 19th century. The classical gold-standard era began around 1819 in Britain and other countries such as Germany, France, Belgium, Switzerland, and the United States followed suit. Every country would trade its currency for a given amount of gold.

There were challenges facing the gold standard, especially during times of war. Countries often used more money than their available gold reserves, and it was also difficult to peg their currencies to gold accurately.

The gold standard started disappearing during the 20th century. This happened first in the U.S. when the then-president Franklin D. Roosevelt issued an executive order restricting any private ownership of monetary gold. Through the Bretton Woods agreement, allied countries would later settle on the U.S. dollar as a reserve, instead of gold, after WWII. And in 1971, the United States abandoned the gold standard completely, meaning they could no longer redeem dollars for gold.

How the Gold Standard Worked

A country’s money supply was linked to gold under the gold standard. The amount of fiat currency governments could have in circulation was determined by their gold reserves. Countries worked with a minimum ratio of gold to notes.

Gold was also used to settle any international balance of payments. This meant that nations that had a deficit in the balance of payments would face gold outflows, whereas those with a balance of payment surplus would have gold inflows.

Advantages and Disadvantages of the Gold Standard

One advantage of the gold standard is that it maintains stable prices. Governments are not able to over-supply money, which leads to inflated prices. Therefore, inflation is less likely to happen with the gold standard, and it’s impossible to have hyperinflation. Additionally, the gold standard makes international trade easier by providing fixed exchange rates.

A downside of the gold standard is that countries that don’t produce gold or struggle to acquire this precious metal would be disadvantaged since they have fewer gold reserves. Second, it would be difficult for countries to increase the money supply whenever they need to counter economic decline.

Why Pick Gold?

Gold has many attractive properties that make it the best commodity for use as a medium of exchange. It’s rare, hence, the problem of inflation is unlikely. Gold does not corrode, which means it can’t spoil, and it’s hard to counterfeit in an unnoticeable way. 

Gold Standard vs. Fiat Currency

Unlike the gold standard, in the fiat system, the currency is not tied to any physical commodity. However, the currency is backed by the resources of its issuing government. In this case, the value of the currency depends on factors such as interest rates, total demand as well as supply, and much more.

An advantage of the fiat system over the gold standard is that while using fiat, governments can easily respond to various economic events. For example, if a country needs to increase the supply of money due to higher demand, it will just print more money.

The use of fiat currencies has a few drawbacks. One of them is the possibility of mismanagement, which would lead to an economic crisis. For example, if there is too much supply of money in the economy, a country is likely to fall into hyperinflation.

Related: Are There Gold-Backed Cryptocurrencies?

What Would Be the Consequences of Readopting the Gold Standard?

This is a tricky question to answer; however, there are a few things certain to happen in case of such a scenario. Central banks will no longer be in full control, and they can’t implement policies such as hiking interest rates. One more thing, the amount of money circulating in the economy would be lower.

The Bottom Line

Although the gold standard vanished in the 20th century, there’s still a lot to love about this system. Anyone against handing all the powers to a central bank is attracted to the way the gold standard functions. One would be right to say that it effectively mitigates the fluctuation of global price levels.

RELATED CATEGORIES: Monetary Policy