The Gold Standard vs. Fiat Money

The Gold Standard vs. Fiat Money An extensive essay on the gold standard on The Encyclopedia of Economics and Liberty defines it as: ...a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. National money and other forms of money (bank deposits and notes) were freely converted into gold at the fixed price. A county under the gold standard would set a price for gold, say $100 an ounce and would buy and sell gold at that price. This effectively sets a value for the currency; in our fictional example, $1 would be worth 1/100th of an ounce of gold. Other precious metals could be used to set a monetary standard; silver standards were common in the 1800s. A combination of the gold and silver standard is known as bimetallism. A Brief History of the Gold Standard If you would like to learn about the history of money in detail, there is an excellent site called A Comparative Chronology of Money which details the important places and dates in monetary history. During most of the 1800s, the United States had a bimetallic system of money;  however, it was essentially on a gold standard as very little silver was traded. A true gold standard came to fruition in 1900 with the passage of the Gold Standard Act. The gold standard effectively came to an end in 1933 when President Franklin D. Roosevelt outlawed private gold ownership. The Bretton Woods System, enacted in 1946 created a system of fixed exchange rates that allowed governments to sell their gold to the United States treasury at the price of $35/ounce: The Bretton Woods system ended on August 15, 1971, when President Richard Nixon ended trading of gold at the fixed price of $35/ounce. At that point for the first time in history, formal links between the major world currencies and real commodities were severed. The gold standard has not been used in any major economy since that time. What system of money do we use today? Almost every country, including the United States, is on a system of fiat money, which the glossary defines as money that is intrinsically useless; is used only as a medium of exchange. The value of money is set by the supply and demand for money and the supply and demand for other goods and services in the economy. The prices for those goods and services, including gold and silver, are allowed to fluctuate based on market forces.   The Benefits and Costs of a Gold Standard The main benefit of a gold standard is that it  ensures  a relatively low level of inflation. In articles such as What Is the Demand for Money? weve seen that inflation is caused by a combination of four factors: The supply of money goes up.The supply of goods goes down.Demand for money goes down.Demand for goods goes up. So long as the supply of gold does not change too quickly, then the supply of money will stay relatively stable. The gold standard prevents a country from printing too much money. If the supply of money rises too fast, then people will exchange money (which has become less scarce) for gold (which has not). If this goes on too long, then the treasury will eventually run out of gold. A gold standard restricts the  Federal Reserve  from enacting policies which significantly alter the growth of the money supply which in turn limits the  inflation rate  of a country. The gold standard also changes the face of the foreign exchange market. If Canada is on the gold standard and has set the price of gold at $100 an ounce, and Mexico is also on the gold standard and set the price of gold at 5000 pesos an ounce, then 1 Canadian Dollar must be worth 50 pesos. The extensive use of gold standards implies a system of fixed exchange rates. If all countries are on a gold standard, there is  then  only one real currency, gold, from which all others derive their value. The stability of the gold standard cause in the foreign exchange market is often cited as one of the benefits of the system. The stability caused by the gold standard is also the biggest drawback in having one.  Exchange rates  are not allowed to respond to changing circumstances in countries. A gold standard severely limits the stabilization policies the Federal Reserve can use. Because of these factors, countries with gold standards tend to have severe economic shocks. Economist  Michael D. Bordo  explains: Because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly unstable in the short run. A measure of short-term price instability is the coefficient of variation, which is the ratio of the standard deviation of annual percentage changes in the price level to the average annual percentage change. The higher the coefficient of variation, the greater the short-term instability. For the United States between 1879 and 1913, the coefficient was 17.0, which is quite high. Between 1946 and 1990 it was only 0.8. Moreover, because the gold standard gives the government little discretion to use monetary policy, economies on the gold standard are less able to avoid or offset either monetary or real shocks. Real output, therefore, is more variable under the gold standard. The coefficient of variation for real output was 3.5 between 1879 and 1913, and only 1.5 between 1946 and 1990. Not coincidentally, since the government could not have discretion over monetary policy, unemployment was higher during the gold standard. It averaged 6.8 percent in the United States between 1879 and 1913 versus 5.6 percent between 1946 and 1990. So it would appear that the major benefit to the gold standard is that it can prevent long-term inflation in a country. However, as  Brad DeLong  points out: ...if you do not trust a central bank to keep inflation low, why should you trust it to remain on the gold standard for generations? It does not look like the gold standard will make a return to the United States anytime in the foreseeable future.