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Gold Standard: Features, Functions, Working, Rules, Merits and Demerits

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In this article we will discuss about:- 1. Features of Gold Standard 2. Functions of Gold Standard 3. Automatic Working 4. Rules 5. Merits 6. Demerits 7. Breakdown.

Features of Gold Standard:

The basic features of the gold standard are:

(i) The monetary unit is defined in terms of certain weight and fineness of gold.

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(ii) All gold coins are held as standard coins and considered unlimited legal tender.

(iii) All other types of money (paper money or token money) are freely convertible into gold or equivalent of gold.

(iv) There is unlimited coinage of gold at no cost.

(v) There is free and unlimited melting of gold.

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(vi) Import and export of gold is freely allowed.

(vii) The monetary authority is under permanent obligation to buy and sell gold at the fixed price without limit.

Functions of Gold Standard:

The Gold standard performs two important functions:

1. To Regulate the Volume of Currency:

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Internally, gold standard forms the basis of the currency and acts as a regulator of the volume of currency in the country. This function is called the domestic aspect of the gold standard since it is concerned with stabilising the internal value of the currency. Under gold standard, currency notes are exchangeable on demand for gold of equivalent value.

Thus, note issue is fully backed by gold reserves and the growth of fiduciary note issue (without gold backing) is checked. Moreover, since the amount of cash in the country is limited by the gold reserve held by the central bank and there must be a cash basis for credit creation, the capacity of the banks to create credit is also limited by the gold reserve. Thus under gold standard, total currency of the country is regulated by its gold reserves.

2. To Maintain the Stability of Exchange Rate:

Externally, gold standard aims at regulating and stabilising the exchange rate between the gold standard countries. This function is called the international aspect of the gold standard because it is concerned with stabilising the external value of the currency. Under gold standard, every member country fixes the value of its currency in terms of certain weight of gold given purity.

Moreover, there is an undertaking given by each country’s monetary authority to purchase or sell gold in unlimited quantity at the officially fixed price. Under these conditions, a stable relation exists between the money units of different gold standard countries and free movement of gold helps in maintaining the stability of exchange rates.

Thus, under gold standard, a gold reserve is maintained for two purposes:

(a) As backing for note issue; and

(b) To cover a deficit in the balance of payments and thus to maintain the stability of exchange rate.

While distinguishing between the two aspects or functions of gold standard, Crowther writes- “The cardinal point in the Domestic Gold Standard is clearly the proportion of volume enforced by the law between the gold reserves and the currency. The essence of the International Gold Standard is the convertibility of the currency into gold- that is the fixed proportion of value between a unit of gold and a unit of currency.”

Automatic Working of Gold Standard:

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The most important feature of the gold standard is that it is an automatic standard. It can operate automatically without interference from the monetary authority. In other words, under international gold standard, the equilibrium in the balance of payments of the gold standard countries is automatically achieved through gold movements.

The self-adjusting mechanism of gold standard can be explained by the theory of gold movements. According to this theory, the country with relatively high cost-price structure loses gold, while the country with relatively low cost-price structure gains gold. In other words, the country with deficit balance of payments (i.e., with excess of imports over exports) will experience gold outflow and the country with surplus balance of payments (i.e., excess of exports over imports) will experience gold inflow.

Suppose two countries A and B are on gold standard. Further suppose that country A experiences a deficit balance of payments, while country B a surplus balance of payments.

The disequilibrium between these two countries will be automatically corrected through the mechanism involving the following steps:

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1. Gold Movement:

Gold will flow out of country A with adverse balance of payments and will flow in country B with favourable balance of payments.

2. Changes in Money Supply:

Given the gold reserve ratio in both the gold standard countries, the outflow of gold will lead to a contraction in the supply of money (i.e., of currency and credit) in country A. On the other hand, the inflow of gold will result in the expansion of money supply in country B.

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3. Changes in Prices and Economic Activity:

Contraction in money supply will lead to a fall in the prices and the profit margins in country A. This will, in turn, reduce investment, income, output and employment in that country. On the other hand, expansion of money supply will raise prices and profit margins and consequently investment, income, output and employment in country B.

4. Changes in Imports and Exports:

Fall in prices in country A will encourage foreigners’ demand for its products. Moreover, decrease in incomes in country A will discourage demand for goods from other countries. Thus, exports will increase and imports will decrease in country A. Similarly, rise in prices in country B will lead to an expansion of imports in that country.

5. Equilibrium in the Balance of Payments:

Expansion of exports and contraction of imports will create conditions of favourable balance of payments in country A. On the other hand, Contraction of exports and expansion of imports will lead to an adverse balance of payments in country B. As a result, gold will start flowing from country B to country A and this will ultimately remove disequilibrium in the balance of payments in both the countries.

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Thus, the movements of gold as a consequence of a disequilibrium in balance of payments will automatically create conditions for the removal of the disequilibrium and ultimately lead to an equilibrium in the balance of payments in the gold-standard countries.

Disequilibrium in balance of payments → (leading to) movements of gold (leading to) changes in money supply → (leading to) changes in prices and incomes → (leading to) changes in exports and imports → (leading to) equilibrium in the balance of payments.

Rules of Gold Standard:

For the smooth and automatic working of gold standard, certain conditions are to be fulfilled. These conditions are called ‘the rules of the gold standard game’. According to Crowther. “The gold standard is a jealous God. It will work provided it is given exclusive devotion.”

1. Free Movements of Gold:

There should be no restriction on the movement of gold among the gold standard countries. They can freely import and export gold.

2. Elastic Money Supply:

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The Government of the gold standard countries must expand currency and credit when gold is coming in and contract currency and credit when gold is going out. This requires that whatever non-gold money (paper money or coins or demand deposits) may be in circulation, gold reserves in some fixed proportion must be kept. For example, if the gold reserve ratio is 50%, then for a reduction of $ 1 gold reserve, there must be a reduction of $ 2 of credit money.

3. Flexible Price System:

Price-cost system of gold standard countries should be flexible so that when money supply increases (or decreases) as a result of gold inflow (or gold outflow), the prices, wages, interest rates, etc., rise (or fall).

4. Free Movement of Goods:

There should also be free movement of goods and services among the gold standard countries. Under gold standard, differences in prices between countries are expressed through excess of exports or imports of one country over the other and the excess of exports or imports are adjusted through inflow or outflow of gold. Thus, restrictions on import or export of goods disturb the automatic working of the gold standard.

5. No Speculative Capital Movements:

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There should not be large movements of capital between countries. Small short-term capital movements are necessary to fill the gap in the international payments and, thereby, to correct the disequilibrium in the balance of payments.

For example, the monetary authority of a country, with adverse balance of payments, can raise interest rates, and thus, attract capital from other countries and, in turn, correct its adverse balance of payments position. But large panic movements of capital as a result of political, social and economic disturbances are dangerous for the smooth working of the gold standard.

6. No International Indebtedness:

Gold standard countries should make efforts to avoid international indebtedness. When external debt increases, the country should increase exports to pay back the interest and the principal.

7. Proper Distribution of Gold:

An important requirement for the successful working of the gold standard is pie availability of sufficient gold reserves and their proper distribution among the participating countries.

Merits of Gold Standard:

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Various advantages of the gold standard are discussed as under:

1. Simplicity:

Gold standard is considered to be a very simple monetary standard. It avoids the complicacies of other standards and can be easily understood by the general public.

2. Public Confidence:

Gold standard promotes public confidence because- (a) gold is universally desired because of its intrinsic value, (b) all kinds of no-gold money, (paper money, token coins, etc.) are convertible into gold, and (c) total volume of currency in the country is directly related to the volume of gold and there is no danger of over-issue currency.

3. Automatic Working:

Under gold standard, the monetary system functions automatically and requires no interference of the government. Given the relationship between gold and quantity of money, changes in gold reserves automatically lead to corresponding changes in the supply of money. Thus, the disequilibrium conditions of adverse or favourable balance of payment on the international level or of inflation or deflation on the domestic level are automatically corrected.

4. Price Stability:

Gold standard ensures internal price stability. Under this monetary system, gold forms the currency base and the prices of gold do not fluctuate much because of the stability in the monetary gold stock of the world and also because the annual production of gold is only a small fraction of world’s total existing stock of monetary gold. Thus, the price system which is founded on relatively stable gold base will be more or less stable than under any other monetary standard.

5. Exchange Stability:

Gold standard ensures stability in the rate of exchange between countries. Stability of exchange rate is necessary for the development of international trade and the smooth flow of capital movements among countries. Fluctuations in the exchange rate adversely affect the foreign trade.

Demerits of Gold Standard:

The gold standard suffers from the following defects:

1. Not Always Simple:

Gold standard in all its forms is not simple. The gold coin standard and, to some extent, gold bullion standard may be regarded as simple to understand. But, the gold exchange standard which relates the currency unit of a country to that of the other is by no means simple to be comprehended by a common man.

2. Lack of Elasticity:

Under the gold standard, the monetary system lacks elasticity. Under this standard, money supply depends upon the gold reserves and the gold reserves cannot be easily increased. So money supply is not flexible enough to be changed to meet the changing requirements of the country.

3. Costly and Wasteful:

Gold standard is a costly standard because the medium of exchange consists of expensive metal. It is also a wasteful standard because there is a great wear and tear of the precious metal when gold coins are actually in circulation.

4. Fair-Weather Standard:

The gold standard has been regarded as a fair-weather standard because it works properly in normal or peaceful time, but during the periods of war or economic crisis, it invariably fails. During abnormal periods, those who have gold try to hoard it and those who have paper currency cry for its conversion into gold. In order to protect the falling gold reserves, the monetary authority prefers to suspend the gold standard.

5. Sacrifice of Internal Stability:

The gold standard sacrifices domestic price stability in order to ensure international exchange rate stability. In fact, under gold standard, inflation and deflation respectively are the necessary companions to a favourable and an unfavourable balance of payments.

Give the world’s total monetary gold stock, an individual country’s monetary gold stock, and consequently, the money supply and the internal price level, changes by the inflow or outflow of gold as a result of international trade. Thus the presence of external trade almost guarantees price instability under gold standard mechanism.

6. Not Automatic:

The automatic working of the gold standard requires the mutual cooperation of the participating countries. But, during the World War I, because of the lack of international cooperation, all types of countries, those receiving gold as well as those losing gold, found it necessary to abandon the gold standard to prevent disastrous inflation on the one hand and even more disastrous deflation and unemployment on the other.

7. Deflationary:

According to Mrs. Joan Robinson, gold standard generally suffers from an inherent bias towards deflation. Under this standard, the gold losing country is under the compulsion to contract money supply in proportion to the fall in gold reserves.

But the gold gaining country, on the other hand, may not increase its money supply in proportion to the increase in gold reserves. Thus, the gold standard, which necessarily produces deflation in the gold losing country, may not generate inflation in gold receiving country.

8. Economic Dependence:

Under gold standard, the problems of one country are passed on to the other countries and it is difficult for an individual country to follow independent economic policy.

9. Unsuitable for Developing Countries:

Gold standard is particularly not suitable to the developing economies which have adopted a policy of planned economic development with an objective to secure self-sufficiency.

Breakdown of Gold Standard:

Before World War I, gold standard worked efficiently and remained widely accepted. It succeeded in ensuring exchange stability among the countries. But with the starting of the war in 1914, gold standard was abandoned everywhere.

Mainly because of two reasons:

(a) To avoid adverse balance of payments and

(b) To prevent gold exports falling into the hands of the enemy.

After the war in 1918, efforts were made to revive gold standard and, by 1925, it was widely established again. But, the great depression of 1929-33 ultimately led to the breakdown of the gold standard which disappeared completely from the world by 1937. The gold standard failed because the rules of the gold standard game were not observed.

Following were the main reasons of the decline of the gold standard:

1. Violation of Rules of Gold Standard:

The successful working of the gold standard requires the observance of the basic rules of the gold standard:

(a) There should be free movement of gold between countries;

(b) There should be automatic expansion or contraction of currency and credit with the inflow and outflow of gold;

(c) The governments in different countries should help facilitate the gold movements by keeping their internal price system flexible in their respective economies.

After World War I, the governments of gold standard countries did not want their people to experience the inflationary and deflationary tendencies which would result by following the gold standard.

2. Restrictions on Free Trade:

The successful working of gold standard requires free and uninterrupted trade of goods between the countries. But during interwar period, most of the gold standard countries abandoned the free trade policy under the impact of narrow nationalism and adopted restrictive policies regarding imports. This resulted in the reduction in international trade and thus the breakdown of the gold standard.

3. Inelastic Internal Price System:

The gold standard aimed at exchange stability at the expense of the internal price stability. But during the inter-war period, the monetary authorities sought to maintain both exchange stability as well as price stability. This was impossible because exchange stability is generally accompanied by internal price fluctuations.

4. Unbalanced Distribution of Gold:

A necessary condition for the success of gold standard is the availability of adequate gold stocks and their proper distribution among the member countries. But in the inter­war period, countries like the U.S.A. and France accumulated too much gold, while countries of Eastern Europe and Germany had very low stocks of gold. This shortage of gold reserves led to the abandonment of the gold standard.

5. External Indebtedness:

Smooth working of gold standard requires that gold should be used for trade purposes and not for the movement of capital. But during the inter-war period, excessive international indebtedness led to the decline of gold standard.

There were three main reasons for the excessive movement of capital between countries:

(a) After World War I, the victor nations forced Germany to pay war reparation in gold,

(b) There was movement of large amounts of short-term capital (often called as refugee capital) from one country to another in search of security,

(c) There was plenty of borrowing by the underdeveloped countries from the advanced countries for investment purpose.

6. Excessive Use of Gold Exchange Standard:

The excessive use of gold exchange standard was also responsible for the break-down of gold standard. Many small countries which were on gold exchange standard kept their reserves in London and New York. But, rumors of war and abnormal conditions forced the depositing countries to withdraw their gold reserves. This led to the abandonment of the gold standard.

7. Absence of International Monetary Centre:

Movement of gold involves cost. Before 1914, such movement was not heeded because London was working as the international monetary centre and the countries having deposit accounts in the London banks adjusted their adverse balance of payments through book entries.

But during inter-war period, London was fast losing its position as an international financial centre. In the absence of such a centre, every country had to keep large stocks of gold with them and large movements of gold had to take place. This was not proper and easily manageable. Thus, gold standard failed due to the absence of inter-national financial centre after World War I.

8. Lack of Co-Operation:

Economic co-operation among the participating countries is a necessary condition for the success of gold standard. But after World War I, there was complete absence of such co­operation among the gold standard countries, which led to the downfall of the gold standard.

9. Political Instability:

Political instability among the European countries also was responsible for the failure of gold standard. There were rumors of war, revolutions, political agitations, fear of transfer of funds to other countries. All these factors threatened the safe working of the gold standard and ultimately led to its abandonment.

10. Great Depression:

The world-wide depression of 1929-33 probably gave the final blow to the gold standard. Falling prices and wide-spread unemployment were the fundamental features of depression which forced the countries to impose high tariffs to restrict imports and thus international trade. The great depression was also responsible for the flight of capital.

11. Rise of Economic Nationalism:

After the World War I, a wave of economic nationalism swept him European countries. With an objective to secure self-sufficiency, each country followed protectionism and thus imposed restrictions on international trade. This was a direct interference in the working of the gold standard.

Thus, both endogenous as well as exogenous factors were responsible for the breakdown of the gold standard:

(a) Some factors referred to the internal weaknesses of the gold standard;

(b) Others pointed out the failures of the monetary authorities to help the smooth working of the system; and

(c) Still others indicated the adverse external circumstances under which the gold standard had to work.

Under the conditions prevailing today, motivated by economic nationalism and dominated by selfish commercial systems, there is little hope of the revival of the gold standard in the near future.

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