The Gold Standard. Lecture 12 – Tuesday, 20 October 2009 J A Morrison. Isaac Newton. David Hume. Admin. Papers Returned Upcoming Events 7 PM, Tues, 27 Oct: Screening of Niall Ferguson’s The Ascent of Money (2009) Thurs, 29 Oct: Deadline for Second Discussion Post. The Gold Standard.
Lecture 12 – Tuesday, 20 October 2009J A Morrison
Cover this Today
Moved to Lecture 14
Well, Dewb, I thought you could use a refresher...
Remember that the balance of payments (BoP) reconciles all of a country’s financial transactions with the world.This includes trade, remittances, investment, loans, &c.
In theory, the gold standard(GS) was an exchange rate regime that related the member countries’ currencies through their valuations to gold.
Example: £1 = 1 oz gold = $4.86
In 1925, Keynes elaborated the “rules of the gold standard game.” The rules were simple: (1) maintain exchange rate stability; (2) maintain convertibility between domestic currency and predetermined amount of gold.
The gold standard, as it existed in theory, was an ideal type. It was meant to embody the complete integration of domestic and foreign financial markets. The gold standard was meant to achieve purchasing power parity…
This is just a recognition that arbitrage will occur in currency markets, as it does elsewhere.
The gold standard ideal was that all currencies would be freely convertible through gold. This would secure purchasing power parity.And PPP would ensure complete market integration.
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.
Excess Gold in US
Rise in US Prices
US Imports Increase; Exports Decrease
US Prices Fall; BoT Equilibrates
US Exports Gold
US has BoP Deficits
So, assuming no costs and perfect adherence to the “rules of the gold standard game”, everything with the gold standard should have been automatic and markets should have been completely integrated.
Remember that we’ve been assuming no conversions costs, that it is costless to move from one currency to another through gold.In the market, however, there are costs to converting currency: transport, risk & insurance, opportunity cost of time.
What are the implications of these costs? What does it matter if it costs me 10% to convert my currency into gold and have it converted abroad into foreign currency?
This means that my currency can be over/undervalued by up to 10% before it become profitable for me to convert it through gold into a foreign currency.
That means that the market exchange rate can fluctuate within a band around parity—the official exchange rate—before the price-specie-flow mechanism prompts adjustment in the quantity of currency & distribution of gold.
Gold points are the price points at which it becomes profitable to convert currency into/out of gold.The gold band is the band around parity, bound by the gold points, in which the market ER might fluctuate.
I know! It means that “fixed” ERs might still fluctuate in the market.
The existence of gold points and gold bands has an extraordinary implication: even with a “fixed” ER, the market ER might not always be stable!
This matters for foreign economic policy.At a minimum, the “gold bands” provide some flexibility to states with a fixed ER.This might be a good or bad thing depending on whether you favor monetary discipline or monetary discretion.
Some states deliberately expand the size of the gold bands to provide themselves with even more flexibility.They do this by adding politically-imposed costs to the natural market costs of converting currencies.
Throughout Britain maintained a robust commitment to a metallic standard. All that changed was the metal
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…
How might we explain this correlation?
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.
** Bonus: From Specie to Tokens & Beyond
Even in specie money systems, states violated both of the gold standard rules:(1) They routinely adjusted their exchange rates (except for England after 1696).(2) They imposed considerable costs on conversion.
Still, though, there was a decisive shift with the widespread adoption of token currenciesin place of specie.(token currency: currency backed by specie)
Even with token coins, it was possible to fulfill the spirit of the gold standard: ER stability & convertibility. But it was also easier for states to make ER adjustments and restrict convertibility.
From the standpoint of ERs, token currencies had the capacity to function like fiat currencies.States with token currencies—and currency boards today—might still implement policies that make the ER work more like a “floating” regime than a fixed regime.