The Gold Standard
Isaac Newton
David Hume
Lecture 12 – Thursday, 19 October 2011
J A Morrison
1
Lec 12: The Gold Standard
I. Intro: Why bother with Gold?
II. The Gold Standard as an Ideal
Type
III.Breaking the “Rules of the
Game”
IV.Brief History of the International
Gold Standard
V. Conclusion
3
Lec 12: The Gold Standard
I. Intro: Why bother with Gold?
II. The Gold Standard as an Ideal
Type
III.Breaking the “Rules of the
Game”
IV.Brief History of the International
Gold Standard
V. Conclusion
4
Historical Significance
• Provides insight into most of monetary
history
• Integral to First Era of Globalization
• Enduring legacies in contemporary system
– International Monetary Fund
– Distribution of worldwide gold supply
5
Intellectual Significance
• Robust alternative to current system of
floating ERs
• Lessons from First Era of Globalization
• Parallels with current crises
– China’s “dirty float”
– Constraints and opportunities generated by
currency union (e.g. Euro)
6
Lec 12: The Gold Standard
I. Intro: Why bother with Gold?
II. The Gold Standard as an Ideal
Type
• Breaking the “Rules of the
Game”
• Brief History of the International
Gold Standard
• Conclusion
7
II. THE GOLD STANDARD AS AN IDEAL
TYPE
1. The Gold Standard Rules
2. Purchasing Power Parity
3. The Automaticity of the Gold Standard
Remember our understanding
of an exchange rate: the
valuation between the domestic
currency and foreign
currency/currencies.
9
In theory, the gold standard
(GS) was an exchange rate
regime that related the member
countries’ currencies through
their valuations to gold.
10
Gold as an Intermediary
$
£
¥
€
Example: £1 = 1 oz gold = $4.86
11
II. THE GOLD STANDARD AS AN IDEAL
TYPE
1. The Gold Standard Rules
2. Purchasing Power Parity
• The Automaticity of the Gold Standard
The gold standard ideal was
that all currencies would be
freely convertible through gold.
This would secure purchasing
power parity (PPP).
And PPP would ensure
complete market integration.
19
Purchasing Power Parity (PPP)
• Purchasing power (PP): command over
goods and services
– $919.50 = 1 oz gold
– £639.43 = 1 oz gold
• PPP: money enjoys the same purchasing
power in every market even after making
necessary conversions
– Implied PPP (based on gold prices): $1 =
£0.695
• PPP can be calculated using any “basket”
of goods & services
20
PPP versus Market Rates
• Implied PPP (from gold prices): $1 =
£0.695
• If I can trade $1 for £0.695, I should be
able to buy gold at the same “price” in GB
and in the US
• BUT Market Exchange Rate: $1 = £0.691
 Why the difference? Why doesn’t
arbitrage eliminate the difference?
21
Let’s go through an example…
22
$499
£429
23
But the market ER is $1 = £0.63
So, $499 = £314
Yet...iPads cost £429 in London!
That’s over £100 more!
Why don’t the Brits just buy their
iPads here?
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25
Well, some do buy them here!
But, for many, the costs are
greater than just buying it in
London.
26
Valuation
• Valuation: the relationship between market
price and underlying “value”
• Different ways to calculate valuation
– Stock: price-to-earnings-to-growth (PEG) ratio
– Currency: PP versus ER
• Over and Under
– Overvalued: currency purchases less than ER
implies (PP < ER)
– Undervalued: currency purchases more than
ER implies (PP > ER)
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II. THE GOLD STANDARD AS AN IDEAL
TYPE
1. The Gold Standard Rules
2. Purchasing Power Parity
3. The Automaticity of the Gold Standard
The GS was meant to
automatically ensure both the
quantity of money in the world
and the distribution of money
around the world.
29
GS Regulation of Quantity
• Official/Mint Price: price of gold in terms of local
currency
• Free Conversion: monetary authority should…
– Purchase gold with currency at the official price
– Sell gold for currency at the official price
• Automatic Quantity Adjustment
– Overvalued currency  sell currency for gold 
decrease in currency and increase of gold
– Undervalued currency  sell gold for currency 
increase in currency and decrease in gold
• Sustained increases in gold price  mining
30
By regulating the quantity of
currency automatically,
adherence to the GS would
theoretically ensure domestic
price stability.
After all, if the official ER did not
match the PPP, currency/gold
would be converted.
31
What about the distribution of
gold? Who gets how much
gold?
32
GS Regulation of Distribution
• David Hume’s Price-Specie-Flow Model
• Assume: costless int’l transport &
conversion
Excess
Gold in US
Rise in US
Prices
US Prices Fall;
BoT Equilibrates
US Imports
Increase; Exports
Decrease
US Exports
Gold
33
Despite these advantages,
policymakers have frequently
found it in their interest to bend
the “rules of the gold standard
game”…
34
Lec 12: The Gold Standard
I. Intro: Why bother with Gold?
II. The Gold Standard as an Ideal
Type
III.Breaking the “Rules of the
Game”
• Brief History of the International
Gold Standard
• Conclusion
35
As a formal matter, being on the
GS required two things:
(1) maintain exchange rate
stability (“gold parity”);
(2) maintain convertibility
between domestic currency
gold...
12
(1) Maintain Exchange Rate
Stability (“gold parity”)
--> the monetary authority commits
to doing everything in its power to
ensure that the market ER with gold
remains at the predetermined,
official “parity.”
12
(2) Maintain Convertibility
between Domestic Currency &
Gold.
--> No restrictions on the
purchase/sale of domestic
currency/gold. No restrictions on the
import/export of gold or currency.
But remember the balance of
payments constraint.
States only have a few ways to
reconcile imbalances of
payments...
Remember this slide?
Lecture 6: Balance of Payments (Slide #38)
38
Following the gold standard
rules precludes two…
41
Reconciling the BoP under the
Gold Standard
1. Adjustment of Reserves
2. Adjustment of Internal Prices &
Incomes
3. Exchange Rate (ER) Adjustment
4. Exchange Controls
1. Capital Controls: Limit convertibility
2. Commercial Policy
15
Bracketing option 1 (adjusting
reserves), states face a difficult choice
between:
(2) allow price-specie-flow to dictate
changes in domestic macroeconomic
conditions;
(4.2) use commercial policy (tariffs,
subsidies, &c.)
40
These are the “golden fetters”
that have put policymakers in a
“golden straightjacket.”
41
But why can’t they just
adjust reserves?
42
Remember the asymmetric
positions of deficit and surplus
countries:
Surplus countries can accumulate
reserves ad infinitum.
While deficit countries will
eventually exhaust their reserves.
42
IV. BREAKING THE RULES OF THE
GAME
1. Deficit Countries
2. Surplus Countries
Deficit countries have frequently
violated the two formal “rules of
the gold standard game.”
44
Exchange Rate Adjustment
• Specie: Change quantity of precious
metal in coins
• Backed currency: Adjustment of official
exchange rate
• Fixed fiat currency: Shift in “target”
market rate
45
Limitations on Convertibility
• Restrictions on market exchange, foreign
investment, and import/export of currency
(e.g. China today)
• Government imposed costs on
conversion
– Fees to convert currency via monetary
authority
– Restrictions on conversion (e.g. delay at the
mint)
46
– Tax on capital movement (e.g. Tobin tax)
IV. BREAKING THE RULES OF THE
GAME
1. Deficit Countries
2. Surplus Countries
Sterilized Intervention
• Intervention: government maintains
stable market ER by selling domestic
currency in exchange for foreign currency
– Foreign currency is then held in reserve
• Sterilization: government counters
inflation by buying excess domestic
currency with government debt (open
market operations)
• Sterilized Intervention: intervention +
sterilization
49
The result is that the exchange rate
remains stable, domestic prices and
incomes remain stable, and the
government simply amasses foreign
reserves.
This saves the surplus country from
having to adjust today.
It also provides reserves for a “rainy
day” in the future.
50
Surplus Countries under the
The sky is the limit! Gold Standard
Inflation countered by
sterilization
1. Adjustment of Reserves
2. Adjustment of Internal Prices &
Incomes
3. Exchange Rate (ER) Adjustment
Maintained through
intervention
4. Exchange Controls
1. Capital Controls: Limit convertibility
2. Commercial Policy
51
But it also shifts the burden
of adjustment entirely onto
the shoulders of the deficit
country.
And it creates competition for
reserves.
52
This is what the US and
France did in the 1920s.
And this is largely what China
is doing today.
53
Lec 12: The Gold Standard
I. Intro: Why bother with Gold?
II. The Gold Standard as an Ideal
Type
III.Breaking the “Rules of the
Game”
IV.Brief History of the International
Gold Standard
• Conclusion
54
Here are a few of the highlights
of the emergence and ascent of
the international GS.
55
56
Britain Adopts the “Silver
Standard”
• 1696: Locke convinces Parliament to
adopt silver standard
– permanently fixed
– Fully convertible units into specified amounts
of metal
• Locke combated bimetallism
– “Silver is the instrument and measure of
Commerce in all the Civilized and Trading
parts of the world.” (374)
– Let gold float vis-à-vis silver; no official
exchange rate between gold & silver
57
From Silver to Gold
• 1717: Newton overvalues gold vis-à-vis silver
– Gresham’s Law: overvalued gold drives out
undervalued silver
– Britain is on de facto gold standard
• 1819-1821: Ricardo convinces Britain to adopt
de jure gold standard
– Exchange rate stability: return to pre-war parity!
– Convertibility: no limits on convertibility
 Throughout, Britain maintained a robust commitment
to a metallic standard. All that changed was the
metal.
58
59
The US: Hamilton versus Jefferson
• Hamilton’s Reports
– Report on a National Bank (1790)
– Report on the Mint (1791)
– Report on Manufactures (1791)
• Hamilton: Banks & Paper Money
– Stimulate domestic industry
– Reduce dependence on foreign trade & capital
– Court financial interest  political stability
• Jefferson: Specie & International Integration
– Market integration  efficiency & peace
– Suspicion of financial interest: banks & corruption
– Insulation  Southern dependence on North
60
US Monetary Policy
• 1791: First Bank of the United States
– Triggered Constitutional debate on Art 1, Sec
8: “Necessary & Proper” Clause
– Bank issues extensive token/paper currency,
heavily leveraged
• 1792: US Mint Act
– Bimetallism
– Hamilton says, “What the hell: we’ll have
some specie too!”
61
My Assessment
• Hamilton was lazy
– Did not bother with important technical details
– Just copied Britain
• But he had political savvy
– Won public debate by citing British example
– Got backing of powerful financial elites
– Had Washington’s ear
• Jefferson was a philosopher
– Better understanding of technical details
– But too abstract and reactionary for public
– Did not build a coalition in time
62
Maggie and Me at the First Bank of the United
States in Philadelphia
63
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France
• Nominally bimetallic
• But traditionally a silver country
• 1840s: gold discoveries 
overvalued gold  de facto gold
standard
65
66
Setting the Standard
• 1867: Paris conference to officially
appoint gold as int’l standard
• Conference wasn’t legally successful, but
inspired trend
• 1870s
– Germany moves toward gold
– France attempts to undercut Germany by
attracting gold  bimetallic block busts
• 1879: US goes to gold; Japan follows
• Network Effect: value of being on common
standard increases as membership
67
Lec 12: The Gold Standard
I. Intro: Why bother with Gold?
II. The Gold Standard as an Ideal
Type
III.Breaking the “Rules of the
Game”
IV.Brief History of the International
Gold Standard
V. Conclusion
68
The gold standard certainly
seems dated.
None of us had been born when
the international gold standard
system collapsed in the 1970s.
But there are good reasons to
understand it…
69
Importance of Gold
• Era of fiat currency (1971-present) is vast
exception to rule; commodity currency has
been norm
• Will the new era endure?
– Nth Currency is a national currency
– Can governments be trusted with fiat
currency?
• Key insights useful to new era
– Emergence of capital controls in China
– Challenges in EU: integration versus
domestic policy autonomy
70
Essentials of Gold Standard
“Era”
• Few countries fully adhered to the “rules
of the gold standard game”
– Deficit countries violated formal rules:
convertibility and ER stability
– Surplus countries violated informal rules:
amassed reserves
• Level of adherence correlated with:
– Closeness to London
– Relative size of economy
 How might we explain this correlation?
71
Next time, we’ll discuss the
decline and fall of the gold
standard.
This will allow us to examine the
political dimensions of
exchange rate regimes in a rich
context.
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Mercantilism - James Ashley Morrison