Unit
5: Exchange Rate Systems
Part 2: The Historical
Gold Standard
One of the reasons the gold standard was so attractive in
the 18th and 19th centuries was that it promised a certain
kind of efficiency and stability in international payments.
(Contemporary advocates of returning to the gold standard
always make this argument.) The system was governed by the
price-specie-flow mechanism, which was
initially elaborated by David Hume.
Technically, the official International Gold Standard began
in 1880 and lasted until 1914, ending with the outbreak
of WWI. It worked through each nation’s fixing the
value of its currency to a certain amount of gold, the parity
price of that currency. For example, if the price of gold
in British pounds were £4/oz, and the price of gold
in dollars were $8/oz, then the implied exchange rate would
be $2 per £1, or £1/2 per $1, depending on how
you looked at it.
Importers, exporters, lenders, and borrowers know that at
any point they can buy gold with their currencies and then
trade them for other currencies, if they so choose. So,
if the exchange rate in the market ever priced pounds above
their parity value of $2 per £1 to, say, $2.10, then
holders of dollars who needed pounds would simply bypass
the currency market, covert dollars to gold at the official
rate, and then use the gold to buy pounds, effectively securing
a parity rate. Plus, if the market rate for dollars deviated
from its parity rate, arbitrage profits could be had; holders
of pounds would buy dollars on the market (and get more
dollars than the parity rate), convert the dollars into
gold (the price of which is fixed), and then with the gold
buy pounds again.
Using the example above, 4£ on the market buys $8.40,
which buys more than 1 oz of gold, which buys back more
than 4£. But the price-specie-flow mechanism in theory
prevents easy profits like this because it prevents the
exchange rate from deviating from its implied gold parity
rate. When people start buying cheap currency (dollars,
in the example above) to exchange for gold, this pushes
the dollar’s value up in the market, which closes
the profit-making opportunity and restores parity rates
in the market. Neither of the above examples takes into
account the transportation and transactions costs associated
with gold conversion, but these costs just set an upper
and lower bound on how far markets rates can deviate from
the parity rate.
Moreover, the mechanism applies
to changes in the exchange rate for any reason. For example,
if the UK ran a trade surplus with the US, demand for pounds
would go up relative to the dollars, which would make pounds
more expensive on the market. This, however, would cause
either (a) dollars to be converted to gold and shipped to
the UK so that pounds could be gotten at parity or (b) speculators
with pounds engaging in arbitrage and buying dollars on
the market. In either case, the money supply of the US is
moving to the UK, causing prices to rise in the UK and fall
in the US—which would mean, all else equal, a trade
deficit for the UK in the next period and the movement of
market rates back toward parity. In other words, Hume’s
price-specie-flow mechanism continually works towards restoring
exchange rate parity and balanced trade under a gold standard
exchange rate system.
Why then would nations choose to abandon such a system?
Well, although such a system guarantees balanced trade,
it does so at the cost of handcuffing a nation’s monetary
policy—since you can only print more money if you
mine more gold. And when push comes to shove, a nation will
typically favor control over internal objectives—such
as financing a world war—over a guarantee of balanced
trade.
VIDEO: The Ineffectiveness
of Monetary Policy under Fixed Rate Systems
