Classical Gold Standard

Definition
The gold standard based on a commitment by participating countries to fix
the prices of their domestic currencies in terms of a specified amount of gold.
National money and other forms of money (bank deposits and notes) were
freely converted into gold at the fixed price. The process was first used by
England in 1717 after the master of the mint, Sir Isaac Newton, overvalued
the guinea, a former British gold coin, in terms of silver, and England formally
adopted the gold standard in 1819. The United States used a bimetallic (gold
and silver) standard. They switched to gold standard in 1834 and the process
was legalized in 1900 by Gold Standard Act passed in Congress. In 1834, the
United States fixed the price of gold at $20.67 per ounce, where it remained
until 1933. Other major countries joined the gold standard in the 1870s. The
period from 1880 to 1914 is known as the classical gold standard. During
that time, the majority of countries adhered (in varying degrees) to gold. It
was also a period of unprecedented economic growth with relatively free
trade in goods, labor, and capital.
How it worked

The gold standard made price levels around the world to move together as
exchange
rates
among
the
participating countries were fixed.
This
co-movement
occurred
mainly through an automatic
balance-of-payments adjustment
process called the price-specieflow mechanism. An example
might help to understand total
process.
Suppose
that
a
technological innovation brought
about faster real economic growth
in the United States. Because the
supply of money (gold) essentially
was fixed in the short run, U.S.
prices fell. Prices of U.S. exports then fell relative to the prices of imports.
This caused the British to demand more U.S. exports and Americans to
demand fewer imports. A U.S. balance-of-payments surplus was created,
causing gold (specie) to flow from the United Kingdom to the United States.
The gold inflow increased the U.S. money supply, reversing the initial fall in
prices. In the United Kingdom, the gold outflow reduced the money supply
and, hence, lowered the price level. The net result was balanced prices
among countries.

Advantages
1. Simplicity:
Gold standard is considered to be a very simple monetary standard. It avoids
the complicacies of other standards and can be easily understood by the
general public.
2. Public Confidence:
Gold standard promotes public confidence because (a) gold is universely
desired because of its intrinsic value, (b) all kinds of no-gold money (paper
money, token coins, etc.) are convertible into gold, and (c) total volume of
currency in the country is directly related to the volume of gold and there is
no danger of over-issue currency.
3. Automatic Working:

Under gold standard, the monetary system functions automatically and

requires no interference of the government. Given the relationship between
gold and quantity of money, changes in gold reserves automatically lead to
corresponding changes in the supply of money. Thus, the disequilibrium
conditions of adverse or favorable balance of payment on the international
level or of inflation or deflation on the domestic level are automatically
corrected.
4. Price Stability:
Gold standard ensures internal price stability. Under this monetary system,
gold forms the currency base and the prices of gold do not fluctuate much
because of the stability in the monetary gold stock of the world and also
because the annual production of gold is only a small fraction of world's total
existing stock of monetary gold. Thus, the price system which is founded on
relatively stable gold base will be more or less stable than under any other
monetary standard.
5. Exchange Stability:
Gold standard ensures stability in the rate of exchange between countries.
Stability of exchange rate is necessary for the development of international
trade and the smooth flow of capital movements among countries.
Fluctuations in the exchange rate adversely affect the foreign trade.
Disadvantages
1. The fixed exchange rate caused both monetary and nonmonetary
(real) shocks to be transmitted via flows of gold and capital between
countries. Therefore, a shock in one country affected the domestic
money supply, expenditure, price level, and real income in another
country.
2. Because economies under the gold standard were so vulnerable to
real and monetary shocks, prices were highly unstable in the short
run.
3. There is a limited supply of gold. If nations can only print as much
currency as they can back with gold, there could be a shortage of
money. History shows that money shortages lead to hording. This
stifles economies as people buy and sell less.
4. The gold standard the ability of governments to make economic
policy. A common practice during tough economic times is to increase
the money supply to stimulate the economy. This would not be
possible under the gold standard since currency supply is limited by
the gold supply. Currency can only be increased as more gold is
mined or purchased.

Reasons for its Failure

1. For the gold standard to work fully, central banks, where they existed,
were supposed to play by the rules of the game. In other words, they
were supposed to raise their discount ratesthe interest rate at which
the central bank lends money to member banksto speed a gold
inflow, and to lower their discount rates to facilitate a gold outflow.
Thus, if a country was running a balance-of-payments deficit, the rules
of the game required it to allow a gold outflow until the ratio of its price
level to that of its principal trading partners was restored to the par
exchange rate.
Most other countries on the gold standardnotably France and
Belgiumdid not follow the rules of the game. They never allowed
interest rates to rise enough to decrease the domestic price level. Also,
many countries frequently broke the rules by sterilizationshielding
the domestic money supply from external disequilibrium by buying or
selling domestic securities.
2. The gold standard broke down during the 1930s as countries engaged
in competitive devaluations. The gold standard worked fairly well from
the 1870s until the start of World War I. During the war the
government financed military expenses by printing money resulting in
inflation, and price levels were high everywhere by the end of the war.
Then, in an effort to encourage exports and domestic employment,
countries started regularly devaluing their currencies. People lost
confidence in the system and started to demand gold for their currency
putting pressure on countries' gold reserves, and forcing them to
suspend gold convertibility and by World War II, the gold standard was
over.

Bibliography
Bordo, Michael D. The Classical Gold StandardSome Lessons for Today. Federal Reserve
Bank of St. Louis Review 63, no. 5 (1981): 2-17.
Bordo, Michael D. Financial Crises, Banking Crises, Stock Market Crashes, and the Money
Supply: Some International Evidence, 1870-1933. In Forrest Capie and Geoffrey E. Wood, eds.,
Financial Crises and the World Banking System. London: Macmillan, 1986.
Bordo, Michael D., and A. J. Schwartz, eds. A Retrospective on the Classical Gold Standard,
1821-1931. Chicago: University of Chicago Press, 1984. Especially The Gold Standard and the
Bank of England in the Crisis of 1847, by R. Dornbusch and J. Frenkel.
Bordo, Michael D., and A. J. Schwartz, eds. Transmission of Real and Monetary Disturbances
Under Fixed and Floating Rates. Cato Journal 8, no. 2 (1988): 451-472.
Ford, A. The Gold Standard, 1880-1914: Britain and Argentina. Oxford: Clarendon Press, 1962.
Officer, L. The Efficiency of the Dollar-Sterling Gold Standard, 1890-1908. Journal of
Political Economy 94 (1986): 1038-1073.