Exchange Rate Regimes: International Gold Standard (1875- 1914)

Though in Great Britain currency notes from the Bank of England were made fully redeemable for gold during 1821, the first full-fledged gold standard was adopted by France in 1878. Later on United States adopted it in 1879 and Russia and Japan in 1897, Switzerland, and many Scandinavian countries by 1928.

An international Gold Standard is said to exist when;

  • Gold alone is assured of unrestricted coinage
  • There is a two way convertibility between gold and national currencies at a stable ratio
  • And gold may be freely imported and exported.

In order to support unrestricted convertibility into gold, bank notes need to be backed by gold reserve of a minimum stated ratio. In addition, the domestic money stock should rise and fall as gold flows in and out of the country.

  • In a version called Gold Specie Standard, the actual currency in circulation consists of gold coins with a fixed gold content.
  • In a version called Gold Bullion Standard, the basis of money remains a fixed rate of gold but the currency in circulation consists of paper notes with the monetary authorities. i.e., the central bank of the country standing ready to convert on demand, unlimited amounts of paper currency into gold and vice versa, at a fixed conversion ratio. Thus a Pound Sterling note can be exchanged for say, X ounces of gold while a Dollar note can be converted into say, Y ounces of gold on demand.
  • Finally, under the version Gold Exchange Standard, the authorities stand ready to convert, at a fixed rate, the paper currency issued by them into paper currency of another country which is operating a gold specie or gold bullion standard. Thus if Rupees are freely convertible into Dollars and Dollars in turn into gold then Rupee can be said to be on gold exchange standard.

The exchange rate between any pair of currencies will be determined by their respective exchange rates against gold. This is called as Mint Parity Rate of Exchange. Under the true gold standard, the monetary authorities must obey the following three rule of the game:

  1. They must fix once-for-all the rate of conversion of the paper money issued by them into gold.
  2. There must be free flows of gold between countries on gold standard
  3. The money supply in the country must be tied to the amount of gold the monetary authorities have in reserve. If this amount decreases, money supply must contract and vice versa.

The gold standard regime imposes very rigid discipline on the policy makers. Often, domestic policy goals such as reducing the rate of unemployment may have to be sacrifices in order to continue operating the standard and the political cost of doing so can be quite high. For this reason, the system was rarely allowed to work in its pristine version. During the Great Depression the gold standard was finally abandoned in form and substance.

Gold standard system had many short comings. First of all, the supply of newly minted gold is so restricted that the growth of world trade and investment can be seriously tampered for the lack of sufficient monetary reserves. The world economy can face deflationary pressures.. Second, whenever the government finds it politically necessary to pursue national objectives that are inconsistent with maintaining the gold standard, it had the freedom to abandon the gold standard.

Most of the countries gave priority to stabilization of domestic economies and systematically followed a policy of Sterilization of Gold by matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit.

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