Gold Standard

 MEANING

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.

FEATURES:-

(i) The monetary unit is defined in terms of certain weight and fineness of gold.

(ii) All gold coins are held as standard coins and considered unlimited legal tender.

(iii) All other types of money (paper money or token money) are freely convertible into gold or equivalent of gold.

(iv) There is unlimited coinage of gold at no cost.

(v) There is free and unlimited melting of gold.

(vi) Import and export of gold is freely allowed.

(vii) The monetary authority is under permanent obligation to buy and sell gold at the fixed price without limit.

FORMS

Historically there have been different forms of gold standard. They are :-

1. Gold Coin Standard:- Gold coin standard or gold currency standard or gold species standard is the oldest form of gold standard. It is also known as orthodox gold standard or traditional gold standard. This standard was prevalent in the U.K., France, Germany and the U.S.A. before the World War I.

Gold coin standard is also regarded as full gold standard because under this standard full- bodies standard coins made of gold were circulated. Other forms of money are redeemable into gold. According to Crowther – “A currency system in which gold coins either form the whole circulation or else circulate equally with notes is known as the full-gold standard.”

 2. Gold Bullion Standard:- After World War I, Gold standard was revived in some countries of Europe not on gold currency basis but on gold bullion basis. It was adopted by Great Britain in 1925. Gold bullion standard is a modified version of gold coin standard in which there was no gold coinage and the currency is convertible into gold bullion (i.e., gold bars).

3. Gold Exchange Standard:- Gold exchange standard refers to a system in which there is neither a gold currency in circulation not gold reserves held for external purposes. Under this system, the domestic currency of a country (which is composed of token coins and paper notes) is not converted into gold for meeting internal needs, but is converted into the currency of some foreign payments.

The external value of the domestic currency unit is determined in terms of the foreign currency. Thus, under gold exchange standard, the domestic currency has no direct link with gold; it is linked at a fixed exchange rate with the currency of another country which is convertible into gold. In addition to gold reserves, the monetary authority of the country maintains sufficient amount of foreign exchange reserves for making international payments.

Gold exchange standard is a cheaper form of gold standard particularly suitable for the underdeveloped or gold-scarce countries. It was first adopted by Holland in 1877 and then by Austria, Hungary, Russia and India during the last decade of the 19th century. India abandoned this standard in 1926 on the recommendations Of the Hilton Young Commission.

4. Gold Reserve Standard:- After the breakdown of gold standard, a new monetary system called gold reserve standard, was developed in 1936 mainly to ensure stability in exchange rates. In 1936, Great Britain, the U.S.A. and France entered into a Tripartite Monetary Agreement according to which free flow of gold or foreign currency was allowed to stabilize exchange rates and promote foreign trade without affecting the internal value of the domestic currency.

For this purpose, Exchange Equalization Funds were created. The gold reserve standard functioned successfully for three years and came to an end with the outbreak of World War II.

 5. Gold Parity Standard:- In essence, gold parity standard is the modern version of the gold standard. It came into force with the establishment of the International Monetary Fund (IMF) in 1946. Under this standard, every member country has to define the par value of its currency in terms of gold in order to determine the exchange rate. The gold parity standard aims at maintaining stable exchange rates without interfering into the domestic monetary system of the member countries.

RULES 

For the smooth and automatic working of gold standard, certain conditions are to be fulfilled. These conditions are called ‘the rules of the gold standard game’. According to Crowther. “The gold standard is a jealous God. It will work provided it is given exclusive devotion.”

1. Free Movements of Gold:- There should be no restriction on the movement of gold among the gold standard countries. They can freely import and export gold.

2. Elastic Money Supply:- The Government of the gold standard countries must expand currency and credit when gold is coming in and contract currency and credit when gold is going out. This requires that whatever non-gold money (paper money or coins or demand deposits) may be in circulation, gold reserves in some fixed proportion must be kept. For example, if the gold reserve ratio is 50%, then for a reduction of $ 1 gold reserve, there must be a reduction of $ 2 of credit money.

3. Flexible Price System:- Price-cost system of gold standard countries should be flexible so that when money supply increases (or decreases) as a result of gold inflow (or gold outflow), the prices, wages, interest rates, etc., rise (or fall).

4. Free Movement of Goods:- There should also be free movement of goods and services among the gold standard countries. Under gold standard, differences in prices between countries are expressed through excess of exports or imports of one country over the other and the excess of exports or imports are adjusted through inflow or outflow of gold. Thus, restrictions on import or export of goods disturb the automatic working of the gold standard.

5. No Speculative Capital Movements:- There should not be large movements of capital between countries. Small short-term capital movements are necessary to fill the gap in the international payments and, thereby, to correct the disequilibrium in the balance of payments.

For example, the monetary authority of a country, with adverse balance of payments, can raise interest rates, and thus, attract capital from other countries and, in turn, correct its adverse balance of payments position. But large panic movements of capital as a result of political, social and economic disturbances are dangerous for the smooth working of the gold standard.

6. No International Indebtedness:- Gold standard countries should make efforts to avoid international indebtedness. When external debt increases, the country should increase exports to pay back the interest and the principal.

7. Proper Distribution of Gold:- An important requirement for the successful working of the gold standard is the availability of sufficient gold reserves and their proper distribution among the participating countries.

FUNCTIONS

The Gold standard performs two important functions:

1. To Regulate the Volume of Currency:- Internally, gold standard forms the basis of the currency and acts as a regulator of the volume of currency in the country. This function is called the domestic aspect of the gold standard since it is concerned with stabilising the internal value of the currency. Under gold standard, currency notes are exchangeable on demand for gold of equivalent value.

Thus, note issue is fully backed by gold reserves and the growth of fiduciary note issue (without gold backing) is checked. Moreover, since the amount of cash in the country is limited by the gold reserve held by the central bank and there must be a cash basis for credit creation, the capacity of the banks to create credit is also limited by the gold reserve. Thus under gold standard, total currency of the country is regulated by its gold reserves.

2. To Maintain the Stability of Exchange Rate:- Externally, gold standard aims at regulating and stabilising the exchange rate between the gold standard countries. This function is called the international aspect of the gold standard because it is concerned with stabilising the external value of the currency. Under gold standard, every member country fixes the value of its currency in terms of certain weight of gold given purity.

Moreover, there is an undertaking given by each country’s monetary authority to purchase or sell gold in unlimited quantity at the officially fixed price. Under these conditions, a stable relation exists between the money units of different gold standard countries and free movement of gold helps in maintaining the stability of exchange rates.

DOWNFALL

Before World War I, gold standard worked efficiently and remained widely accepted. It succeeded in ensuring exchange stability among the countries. But with the starting of the war in 1914, gold standard was abandoned everywhere.

Mainly because of two reasons:

(a) To avoid adverse balance of payments and

(b) To prevent gold exports falling into the hands of the enemy.

After the war in 1918, efforts were made to revive gold standard and, by 1925, it was widely established again. But, the great depression of 1929-33 ultimately led to the breakdown of the gold standard which disappeared completely from the world by 1937. The gold standard failed because the rules of the gold standard game were not observed.

Following were the main reasons of the decline of the gold standard:

1. Violation of Rules of Gold Standard:-The successful working of the gold standard requires the observance of the basic rules of the gold standard:

(a) There should be free movement of gold between countries;

(b) There should be automatic expansion or contraction of currency and credit with the inflow and outflow of gold;

(c) The governments in different countries should help facilitate the gold movements by keeping their internal price system flexible in their respective economies.

After World War I, the governments of gold standard countries did not want their people to experience the inflationary and deflationary tendencies which would result by following the gold standard.

2. Restrictions on Free Trade:-The successful working of gold standard requires free and uninterrupted trade of goods between the countries. But during interwar period, most of the gold standard countries abandoned the free trade policy under the impact of narrow nationalism and adopted restrictive policies regarding imports. This resulted in the reduction in international trade and thus the breakdown of the gold standard.

3. Inelastic Internal Price System:-The gold standard aimed at exchange stability at the expense of the internal price stability. But during the inter-war period, the monetary authorities sought to maintain both exchange stability as well as price stability. This was impossible because exchange stability is generally accompanied by internal price fluctuations.

4. Unbalanced Distribution of Gold:- A necessary condition for the success of gold standard is the availability of adequate gold stocks and their proper distribution among the member countries. But in the inter­war period, countries like the U.S.A. and France accumulated too much gold, while countries of Eastern Europe and Germany had very low stocks of gold. This shortage of gold reserves led to the abandonment of the gold standard.

5. External Indebtedness:- Smooth working of gold standard requires that gold should be used for trade purposes and not for the movement of capital. But during the inter-war period, excessive international indebtedness led to the decline of gold standard.

6. Excessive Use of Gold Exchange Standard:- The excessive use of gold exchange standard was also responsible for the break-down of gold standard. Many small countries which were on gold exchange standard kept their reserves in London and New York. But, rumors of war and abnormal conditions forced the depositing countries to withdraw their gold reserves. This led to the abandonment of the gold standard.

7. Absence of International Monetary Centre:- Movement of gold involves cost. Before 1914, such movement was not heeded because London was working as the international monetary centre and the countries having deposit accounts in the London banks adjusted their adverse balance of payments through book entries.

But during inter-war period, London was fast losing its position as an international financial centre. In the absence of such a centre, every country had to keep large stocks of gold with them and large movements of gold had to take place. This was not proper and easily manageable. Thus, gold standard failed due to the absence of inter-national financial centre after World War I.

8. Lack of Co-Operation:- Economic co-operation among the participating countries is a necessary condition for the success of gold standard. But after World War I, there was complete absence of such co­operation among the gold standard countries, which led to the downfall of the gold standard.

9. Political Instability:- Political instability among the European countries also was responsible for the failure of gold standard. There were rumors of war, revolutions, political agitations, fear of transfer of funds to other countries. All these factors threatened the safe working of the gold standard and ultimately led to its abandonment.

Thus, both endogenous as well as exogenous factors were responsible for the breakdown of the gold standard: