Why was the gold standard unstable?

In the last few decades of the international gold standard, mismanagement caused price volatility. Much of this instability occurred during World War I and the Great Depression. With the start of the First World War, the international gold standard stopped working as it had since its creation in the 1870s. Countries such as France, the United Kingdom and Germany suspended the gold standard and decided to spend gold and print money to finance the war.

Even the United States, which remained on the gold standard, banned gold exports during the war. Because exchange rates were fixed, the gold standard caused price levels around the world to move in the same way. This movement occurred mainly through an automatic balance-of-payments adjustment process called the price-species flow mechanism. This is how the mechanism worked.

Let's suppose that a technological innovation caused faster real economic growth in the United States. Since the supply of money (gold) was basically fixed in the short term, the U.S. UU. Exports then fell relative to import prices.

This caused the British to demand more U.S. Exports and Americans will demand fewer imports. A balance of payments surplus was created, causing gold (species) to flow from the United Kingdom to the United States. The inflow of gold increased in the US.

The money supply, reversing the initial fall in prices. In the United Kingdom, the outflow of gold reduced the money supply and therefore reduced the price level. The net result was an equilibrium of prices between countries. If, for example, the central bank of France wanted to prevent the inflow of gold from increasing the country's money supply, it would sell securities in exchange for gold, thus reducing the amount of gold in circulation.

For countries that operate under the gold standard, their currency could be exchanged for a specific amount of gold depending on the international value of their currency. In addition, because the gold standard gives the government very little discretion to use monetary policy, economies that follow the gold standard are less able to avoid or compensate for monetary or real shocks. The gold standard broke during World War I, when major belligerents resorted to inflationary funding, and was briefly reinstated from 1925 to 1931 as the Gold Exchange Standard. However, according to a gold standard, the availability of gold limits the possibilities of expanding central banks' liabilities.

The United States, although formally adopted a bimetallic pattern (gold and silver), switched to de facto gold in 1834 and de jure in 1900, when Congress passed the Gold Standard Act. If the price of gold in pounds changed, but the price of gold in dollars did not, the result would be a movement in the real exchange rate between the dollar and the pound. The gold standard was a global agreement that laid the foundations for a practically universal fixed exchange rate regime in which international transactions were settled in gold. However, gold reserves reduce confidence in the United States' ability to exchange its currency for gold.

As Liaquat Ahamed says in his masterful book on interwar monetary policy, The Lords of Finance, it was as if the Great Depression had been caused by the fact that there was too much gold piled up on one side of the gigantic vault located under the Federal Reserve Bank of New York (where most of the world's monetary gold was stored at the time). Disruptions in the gold market, such as private hoarding and the discovery of gold in countries outside the gold standard community, could affect a state's economic conditions. In other words, they were supposed to increase their discount rates, the interest rate at which the central bank lends money to member banks to accelerate the inflow of gold, and reduce their discount rates to facilitate the outflow of gold. Under this standard, countries could hold gold reserves or dollars or pounds, except for the United States and the United Kingdom, which only had gold reserves.

Roosevelt nationalized gold owned by private citizens and repealed contracts in which payment was specified in gold. England adopted a de facto gold standard in 1717, after the master of the mint, Sir Isaac Newton, overvalued Guinea in terms of silver and formally adopted the gold standard in 1819. .

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