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

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.

How the Gold Standard works A gold standard implies that we have “fixed” exchange rates between currencies. $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £10.29 mill. 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 only £8 mill. of F&C is exported, selling for $38.88 mill. in the U.S..

How the Gold Standard works $20.67 = 1 oz. 1 oz. = £4.25 1 oz. = £4.25 $50 mill. $4.86 = £1 £8 mill. 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

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

Confounding the Gold Standard 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. 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!

Stress on the Gold Standard WWI - Combatant countries go off gold standard to spending. Gold rushes into the U.S. as countries buy war material. Post-WWI, gold stocks insufficient for existing price levels. Worldwide deflation (i.e., depression) is required. Victors can ease burden by acquiring gold stocks. Burden on losers is unsustainable. Eventually, U.S. lends gold to Germany.

Stress on the Gold Standard The Gold Exchange Standard: U.S. & U.K. hold gold Other countries hold gold, $, £ U.K. recession restores gold value by 1925. France devalues currency; gold inflows. 1927 - France redeems pounds; more gold inflows. Fed lowers i; gold flows from U.S.; burden on U.K. lessened. 1927 - 9% of world’s gold; 1929 - 17%; 1931 - 22% Gold inflows sterilized and MS in France was constant.

Stress on the Gold Standard U.S. monetary policy is erratic: 1927 - lowers i (3.5%) and gold flows out. 1928 - raises i to stop gold outflows. By Sept. 1929, i up to 6%; gold inflows 1929/1930. After crash, i lowered; down to 1.5% in April 1931. Gold outflows 1931; raised i to 3.5%. March 1932 Fed begins OMO which stops deflation. OMO stop in July 1932. Devaluation concerns drive gold outflow Jan-Mar 1933.

The Gold Standard - Collapse 1933 – FDR abolishes gold std. 1971 – Nixon abolishes international gold payments. We now live in an era of “flexible” exchange rates and there is no restraint on monetary policy.

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