Detailed information about The Gold Standard Exchange Rate System

The Gold Standard (1876 – 1913):

A system of setting currency values whereby the participating countries commit to fix the prices of their domestic currencies in terms of a specified amount of gold. The gold standard as an international monetary system gained acceptance in Western Europe in the 1870s. The United States was something of a latecomer to the system, not officially adopting the standard until 1879.

The rules of the game under the gold standard were clear and simple. Each country set the rate at which its currency (paper or coin) could be converted to a weight of gold. The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67/ounce of gold (a rate in effect until the beginning of World War 1). The British pound was pegged at £4.2474/ounce of gold. As long as both currencies were freely convertible into gold, the dollar/pound exchange rate was:

$20.67/ounce of gold divided by £4.2474/ounce of gold = $4.8665/£

Because the government of each country on the gold standard agreed to buy or sell gold on demand to anyone at its own fixed parity rate, the value of each individual currency in terms of gold, and therefore the fixed parities between currencies, was set. Under this system it was very important for a country to maintain adequate reserves of gold to back its currency‘s value. The system also had the effect of implicitly limiting the rate at which any individual country could expand its money supply. The growth in money was limited to the rate at which additional gold could be acquired by official authorities. The gold standard worked adequately until the outbreak of World War 1 interrupted trade flows and the free movement of gold. This caused the main trading nations to suspend the operation of the gold standard.

Advantages of Gold Standard:

Several advantages are claimed for the gold standard, especially when it is adopted simultaneously by a number of countries, i.e., international gold standard.

  • It is an objective system and is not subject to the changing policies of the government or the whims of the currency authority.
  • Gold standard enables the country to maintain the purchasing power of its currency over long periods. This is so because the currency and credit structure is ultimately based on gold in possession of the currency authority.
  • Another important advantage claimed for gold standard is that it preserves and maintains the external value of the currency (rate of exchange) within narrow limits. As a matter of fact, within the gold standard system, it provides fixed exchanges, which is a great boon to traders and investors. International division of labour is greatly facilitated.
  • It gives, in fact, all the advantages of a common international currency. It establishes an international measure of value. As Marshall pointed out before the Fowler Committee (Report on Indian Currency) in 1898, the change to a gold basis is like a movement towards bringing the railway gauge on the side branches of the world‘s railway into unison with the main lines. This greatly facilitates foreign trade, because fluctuations in rates of exchange hamper international trade.
  • It is further claimed that gold standard helps to adjust the balance of payments between countries automatically. How this happens may be illustrated by a simple example. Suppose England and America are both on gold standard and only trade with each other, and that a balance of payments is due from England to America. Gold will be exported from England to America. The Bank of England will lose gold. This will contract currency in England and bring about a fall in the British price level. Price level in America will rise due to larger reserves and the expansion of currency and credit. England will become a good market to buy from and a bad market to sell in. Conversely, America will become a good market to sell in and a bad market to buy from. British exports will be encouraged and imports discouraged. American exports will be discouraged and imports encouraged. The balance of payments will tend to move in favour of Britain until equilibrium is reached. It is in this way, that movement of gold, by affecting prices and trade, keeps equilibrium among gold standard countries.

Disadvantages of Gold Standard:

  • Gold standard is costly and the cost is unnecessary. We only want a medium of exchange, why should it be made of gold? It is a luxury.-The yellow metal could tickle the fancy of savages only.
  • Even the value of gold has not been found to be absolutely stable over long periods.
  • Under the gold standard, currency cannot be expanded in response to the requirements of trade. The supply of currency depends on the supply of gold. But the supply of gold depends on the success of the mining operations, which may have nothing to do with the factors affecting the growth of trade and industry in the country.
  • Gold standard has also been charged with sacrificing internal stability to external (exchange) stability. It is the international aspect of the gold standard which has been paid more attention to.
  • Another disadvantage is that, under gold standard gold movements lead to changes in interest rates, so that investment is stimulated or checked solely in order to expand or reduce money income.
  • A country on a gold standard cannot follow an independent policy. In order to maintain the gold standard or to restore it (as in England after World War I), it may have to deflate its currency against its will. Deflation spells ruin to the economy of a country. It brings, in its wake, large-scale unemployment, closing of works and untold suffering attendant on depression.

Causes of the Break-down of the Gold Standard

The gold standard broke down in country after country soon after its rehabilitation during the post-1914-18 war decade. There were several reasons for this development:

  • Gold was very unevenly distributed among the countries in the inter-war period. While the U.S.A. and France came to possess the bulk of it, other countries did not have enough to maintain a monetary system based in gold.
  • Owing to general political unsettlement, a habit arose on the part of certain Continental countries to keep their funds for short periods in foreign central banks, especially in Great Britain. These funds were liable to be withdrawn at the earliest danger signal. Withdrawal of such funds from Britain on the part of France led to gold standard being suspended in 1931 in the former country. The Bank of England could not afford to lose its gold resources in large quantities at such a short notice.
  • International trade was not free. Some countries often imposed stringent restrictions on imports, which created serious balance of payments problems for other countries. Not having enough gold to cover the gap, they threw the gold standard overboard. This specially happened during the Great Depression of early thirties.
  • International obligation in the form of reparations and war debts arose out of World War I. Since the creditor countries refused to accept payments in the form of goods and also refused to continue lending to the debtors countries, the debts had to be cleared through gold movements. This led to concentration of 34 per cent of the world‘s gold in the U.S.A. and France, the two chief creditor countries. The gold left with the other countries was not enough to enable them to maintain gold standard successfully.
  • The gold-receiving countries did not play the game of the gold standard. They (especially the U.S.A.) did not allow this gold to have any effect on their price levels. The gold was sterilised  or made ineffective. Had prices risen in these countries, imports would have been encouraged and exports discouraged and an unfavourable balance of trade would have led to movement of gold in the reverse direction. Since this was not allowed to happen, the gold standard failed to work automatically.
  • Gold standard failed also because the economic structure of the countries concerned had become less and less elastic after the World War of 1914-18. This was due to several reasons: The enormous growth in the indebtedness of governments and local authorities resulted in a mass of interest payments fixed by contract over a long period of years. The huge expenditure in the form of payment to social services could not be easily reduced. The trade unions were now able to offer a much stronger resistance to wage cuts than before 1914. The prices of raw materials and finished goods were becoming more and more fixed by partial monopolies, cartel agreements, etc. The result was that prices no longer moved in the directions warranted by gold movements and equilibrium failed to be restored as of old.
  • Another weakness that was discovered in the gold standard in practice was that it was always liable to collapse in a crisis. It has often been called a  ‘fair weather standard’ only.
  • Another objection that was frequently urged against the system was that gold movements caused inconvenient changes in interest rates. Deflation, for instance, may be made necessary at a time of crisis to prevent suspension of the  standard. But deflation, which involves falling wages and prices, may prove a cause of serious trouble. Wage cuts are resisted by trade unions, and falling prices increase the burden of fixed payments which the government or the people may have to make. Moreover, falling prices discourage enterprise and create unemployment.

A large volume of short-term capital was moving for safely from one financial centre to another. Big flows of this hot money necessitated large gold movements, which the slender gold reserves of the countries could not maintain. Hence, gold standard was given up. Thus, it was that country after country abandoned the Gold Standard in the inter-war period (1914-1944).