What is Gold Standard

The gold standard was a fixed exchange rate system that operated as the primary monetary regime of the international economy from the late 19th century through to the outbreak of World War I. The apparent virtues of the gold standard lay in (1) its ability to eliminate exchange rate risk, thereby facilitating trade and international investment and (2) its ability as a self-equilibriating mechanism to eliminate balance of payments problems.
The operation of the gold standard required the monetary authorities of each nation to adhere to certain basic principles. First, the money supply of each country (in the form of bank notes and bank deposits) was directly linked to the gold reserves held by the monetary authorities. Second, the monetary authorities would always be willing to exchange a specified weight of gold for any amount of its currency presented to it at a pre-defined fixed rate. Throughout the 19th century, countries such as Great Britain, France, Germany, and the United States all linked their currencies to gold in this manner. The outcome of this was a fixed and stable rate of exchange between the respective currencies. To take one example, the price of one ounce of gold in Britain and the United States was set at £3 17s. 10.56? and $20.67, respectively. With both currencies permanently equivalent to a definite weight of gold, the price of one unit of sterling expressed in terms of dollars was therefore fixed at £1 = $4,866.
The gold standard not only served as a stimulus to trade and investment by removing the risk of loss from exchange rate fluctuations, but also provided an automatic mechanism for maintaining a nation’s balance of payments in equilibrium. We can illustrate this idea by means of a simple example. Let us assume that there are two countries, X and Y, and that country X is experiencing a prolonged balance of payments deficit. How would this problem be resolved?
Given that the gold standard represented a fixed exchange rate system, a downward movement in the exchange value of country Xs currency such as deliberate monetary authority devaluation would almost certainly be ruled out. If devaluation were pursued, it could undermine confidence in country Xs currency if it was expected that X would resort to such measures were she to get into future balance of payments difficulties. An alternative method to resolve this excess of imports over exports would be to settle such debts in terms of international gold movements. Based on the above-mentioned relationship between the nation’s money supply and her gold reserves, the shipment of gold from country X to country ^ would lead to the contraction of the money supply in X and the expansion of the money supply in Y.
The contraction of the domestic money supply in X would, in turn, lead to reductions in the money cost of production (deflation) that would act to reduce demand for imports and stimulate exports. In contrast, the expansion of the domestic money supply in Y would lead to an increase in the money costs of production (inflation) that would reduce exports and stimulate the demand for imports. Thus, under the gold standard, international gold movements appear to be a perfect, self-equilibriating mechanism that brings about changes in expenditure and prices sufficient to eliminate a balance of payments deficit. Yet there are numerous situations that could act to undermine its success. In the above example, the monetary authorities in country X could speed up the adjustment process, and so facilitate speedy gold movements, by lowering their discount rate relative to that in country Y.
However, historical research has suggested that few central banks throughout the 19th century actually adhered to the “rules of the game” and did not always vary their discount rates in the prescribed manner. We should also note that there is no guarantee that the necessary relationship between money supply and price level movements would function properly so as to eliminate the trade deficit.
For example, the necessary fall in the money cost of production in country X would not take place if labor within the country refused to accept reductions in wage rates.
The gold standard was dealt a severe blow by the economic chaos of World War I, and finally collapsed during the Great Depression of the early 1930s. After World War II, the gold standard was replaced by the Bretton Woods fixed exchange rate system, which lasted from 1947 until 1972. This was essentially a special form of the gold standard, referred to as a gold exchange standard, in which the exchange rates of other currencies were fixed, via the U.S. dollar, against gold.