The Gold Standard Chapter 2, International Financial Mgmt, Eun et al 3460.02 notes by A.P. Palasvirta, PhD
Historical Monetary Standards • Bronze • Silver • Gold • U.S. Dollar Standard 3460.02 gold standard notes: a.p. palasvirta, ph.d.
The Bank of Deposit • Bank of Amsterdam (15th century) • 100% reserves of gold and silver • Depositors brought gold, silver • Were given warehousing certificates for the amount of gold, silver minus a charge • Depositors would use the warehousing certificates as money • Lower transactions costs • Easier to use 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Bank of Deposit Bank of Amsterdam Gold 100% Warehouse receipts Assets Liabilities 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Bank of Issue • Queen Elizabeth I 1563 to 1603 • Created the Bank of England • Held partial reserves of gold and silver • The rest were in treasury bills • This was not a strict gold standard, but a gold exchange standard • This bank could not refund all claims for gold with gold 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Gold Standard - Bank of England Gold 30 – 40% T-bills 60 – 70% • http://www.gata.org/node/104 Assets Liabilities 3460.02 gold standard notes: a.p. palasvirta, ph.d. currency
Objective of a monetary standard • Fix the value of the unit of account • Something immutable • Ounce of silver • Ounce of gold • Gold standard • Unit of account the troy ounce • Medium of exchange • Coinage • Gold certificates 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Gold as a unit of account • If the cost of mining gold increases • deflation • Value of gold increases • Value of other goods remain constant • Prices decrease • If the cost of mining gold decreases • Inflation • Value of gold decreases • Value of other goods remain constant • Prices increase 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Deflationary environment 1/P 1/P Supply Demand Gold 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Inflationary environment 1/P 1/P Supply Demand Demand Gold 3460.02 gold standard notes: a.p. palasvirta, ph.d.
The Act of Arbitrage • Two markets for gold • official government market • Legal unofficial private markets • Parity Price greater than market price • government’s price (parity) the high price • external markets price the low price • trader buys low sells high • buys externally • sells to government 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Arbitrage Pg S2 Private Market S1 Government Market Par Pg D2 D1 Qg 3460.02 gold standard notes: a.p. palasvirta, ph.d.
The Effects of Arbitrage • Private market gold supplies decrease • holders of gold will sell first to the government • arbitrageurs will buy up stocks and sell to the government • excess supply will dry up bringing market price to equal the parity price • Government gold supplies will increase • increases the money supply • decrease the value of money (inflation) 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Gold Standard • Countries fix parity price of gold • usd parity price = $20.67/ounce • uk parity price = 4.2474£/ounce • usd/uk£ = 4.8665$/£ • They allow arbitrage between two markets • parity price of gold at Central Bank • free market price of gold • De facto single currency the ounce of gold • many units of account • periodic falling off of the gold standard • Balance of Payments deficits settled with gold 3460.02 gold standard notes: a.p. palasvirta, ph.d.
BOT Surplus • Mechanism which mitigates BOT surplus • gold is paid to pay for excess of exports to imports • gold coming into the central bank increases money supply • inflation in the economy • your goods now more expensive in foreign markets • foreign goods less expensive to you • Price-specie flow mechanism • BOP balances settled in gold • Money adjusts • Prices adjust • International prices converge 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Gold Standard Treasury Gold T-bills gold increases due to BOT surplus cash currency Money supply increases Liabilities Assets 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Gold Standard monetary effects • Gold backs all money • prices move relative to • excess demand for gold (economic growth) • deflation • excess supply of gold (new gold finds) • inflation • Treasuries have no independent monetary policy 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Inflation/Deflation • Fixed parity price (not fixed value) • Unit of account varied with the cost of mining gold • Often the unit of account appreciated (increased in value) as gold supplies were harder to mine • With new gold discoveries, the unit of account depreciated (decreased in value) as the cost of mining gold decreased 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Gold standard & exchange rates • All currencies fixed to gold • Gold is the de facto currency • single world wide currency • all international trade is denominated in gold • No need to hedge exchange rate volatility since exchange rates are constant 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Off the Gold standard • When CBs execute a monetary policy • discipline of the gold standard is gone • after WWII governments ran inflationary policies • interest rate policies • employment policies • inflation sometimes running at 200% or more • Exchange rates fluctuate • creating uncertainty for trade 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Bimetallism up to 1875 • Colonizers (France, Spain, England, Portugal) • Gold standard • Colonies • Silver standard • Gresham’s Law • Bad money drives out good 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Interwar period • Germany reparations heavy and denominated in Deutsche Marks not gold • Germany inflated their currency in order to reduce the cost of reparations • Inflation 1 trillion% • United States had most of the gold • France, England paid for war materials bought from the U.S. in gold • Stock market crash of 1929 • Led to protectionism • Sterilization polices • Depression 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Bretton Woods 1945-72 • WWII U.S. again the supplier of arms got most of the gold in the world • 1944 end of the was the Gold Exchange Standard • The U.S. dollar became the reserve currency • Traded at par value with all currencies part of system • Balance of payments imbalances were cleared with U.S. dollars instead of gold • Cheaper to ship dollars instead of gold • Countries could earn interest on their foreign exchange reserves Special Drawing Rights (SDRs) 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Bretton woods 1945-72 • Creation of the International Monetary Fund (IMF) • International clearing house for exchange transactions with SDRs and dollars • Special Drawing Rights • Exchange reserves held at the IMF • Value weighted average of basket of major currencies • Deutsche Mark (20%), franc (12%), pound (12%), yen (16%), us dollar (42%) • The SDR as well as the U.S. dollar became the reserve currencies 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Difficulties with system • U.S. had to run a chronic BOP deficit to supply us dollars to the worlds economies • The fixed parities between currencies dependent on certain assumptions for all economies • Monetary policies aligned • Fiscal policies aligned • Revaluations necessary periodically • Monetary policies of many countries very expansionary 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Failure of system • US running inflationary monetary policy to finance Vietnamese war • US increase the dollar parity price (devalued) twice • DeGaulle demanded payment of BOP surplus with the U.S. in gold 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Current flexible exchange rate regime • January 1976 • All currencies will float with respect to each other 3460.02 gold standard notes: a.p. palasvirta, ph.d.
Current price of metals (Jun 1) • Gold = $1,212.1 • Silver = $18.411 • Platinum = $1,548.7 • Paladium = $462.7 3460.02 gold standard notes: a.p. palasvirta, ph.d.
