Need the Fed? ECO 285 – Macroeconomics – Dr. D. Foster The Gold Standard: the meaning of sound money

Is Policy the Right Choice?

Advantages to the Gold Standard It promotes trade by eliminating uncertainty. It keeps governments from creating money. It insures that a nation’s currency will maintain its value over time. The Gold Standard

How the Gold Standard works $20.67 = 1 oz.1 oz. = £4.25 $4.86 = £1 American firms export goods to England … tractors. Value = $50 m. British firms export goods to U.S. … fish & chips. Value = £10.29 m. At exchange rate of $4.86 = £1, the £ earned by U.S. firms will just trade for the $ earned by the British firms. Suppose that British exports fall by 23% and that there is only £8 mill available in foreign exchange market (to buy $). £10.29 mill. $50 mill. A gold standard implies that we have “fixed” exchange rates between currencies.

Now, American exporters can’t exchange all of their £10.29 mill. for $. They can only exchange £8 mill. at the going exchange rate.... receiving $38,880,000. But, they aren’t going to lose here… They would cash the rest out in gold: £2.29 mill. = 538,823 oz. They would redeem in U.S. for dollars: 538,823 oz. = $11,120,000 Total value received = $50,000,000 $20.67 = 1 oz.1 oz. = £4.25 $4.86 = £1 £8 mill. $50 mill. How the Gold Standard works

The flow of gold from England to U.S. won’t persist over time.  gold =  MS  MS =  P inflation  gold =  MS  MS =  P deflation U.S. exports fall and British exports rise until trade flows balance. $20.67 = 1 oz.1 oz. = £4.25 $4.86 = £1 £8 mill. 538,823 ounces $50 mill. How the Gold Standard works

In England, the outflow of gold will lead to price deflation and probably a recession (or a depression). So, the Bank of England raises interest rates. This attracts foreign investment (capital inflows) which ends outflow of gold. Confounding the Gold Standard In the U.S., expanding the money supply means inflation and falling exports. The Fed can buy this gold by selling Treasury securities, so not allowing the money supply to increase. But, this will also raise U.S. interest rates which works against British policy and encourages more gold inflows!

WWI - Combatant countries go off gold standard to  spending. After, move back to gold standard. Gold stocks insufficient for existing price levels. Worldwide deflation (i.e., depression) is required. Only U.S. and U.K. go back to gold standard. U.K. depression through Great Depression adds in more stress – FDR abolishes gold std – Nixon abolishes international gold payments. The Gold Standard - Stress & Collapse We now live in an era of “flexible” exchange rates and there is no restraint on monetary policy.

Need the Fed? ECO 285 – Macroeconomics – Dr. D. Foster The Gold Standard: the meaning of sound money