What is Gold Standard?

Gold standard is a system under which gold is the standard of value. Under the system, the monetary unit of a country is defined in terms of certain weight of gold. Gold standard operated in its original form in several countries before 1914.

Salient Features of Gold Standard

1. The standard money was defined in terms of a fixed weight of gold and gold coins circulated as full legal tender.
2. All other firms of money, namely paper money and token coins were freely convertible into gold coins. The results were that the total quantity of money was dependent on the quantity of gold available in the country.
3. The currency authority was required to buy and sell gold at fixed prices.
4. There was a free import and export of gold without restrictions of any kind.

Functions

Two important functions of the gold standard were:

1. To regulate the volume of money in the country (Domestic Gold Standard)
2. To stabilize the rate of exchange (International Gold Standard).

Rules

The successful working of the gold standard depended on the observance of certain conditions known as the "Rules of the gold standard game". Two important rules are:

1. Gold should be allowed to move freely from one country to another without any restrictions
2. There must be an automatic expansion and contraction of currency and credit with the inflow and outflow of gold respectively. Only then, there would be an automatic adjustment of balance of payments between different countries. The success of the gold standard depends on the observance of the above "rules of the gold standard game".

Types of Gold Standard

There were three main forms of Gold Standard. They were:

• Gold Currency Standard
• Gold Bullion Standard
• Gold Exchange Standard

Gold Currency Standard

Gold currency standard prevailed in England and other countries before 1914. Under this system, gold coins of definite weight and fineness circulated as standard coins. Gold was not merely a measure of value, but also a medium of exchange. Sometimes, there were other forms of money like paper money and token coins and they were convertible into gold coins. There was a free coinage in gold, gold was freely bought and sold at fixed prices. And there were no restrictions on the movement of gold from one country to another. Gold currency standard was given up by most of the countries during World War I.


Gold Bullion Standard

After the war, many countries introduced gold standard in a different form known as the Gold Bullion Standard. Under this system, gold coins were not put into circulation but paper money circulated in the place of gold coins. That is, the actual currency consisted of paper money and token coins. They could not be converted into gold coins. But paper money and token coins were convertible into gold bullion (bars). Of course, only large amounts of money above certain limit was converted into gold bullion. In fact, gold bullion was sold only for making payments to foreign countries. England was on the Gold Bullion Standard from 1925-31. Some of the important advantages of this form of gold standard were: (1) There was economy in the use of gold and (2) It became a sort of managed standard similar to the inconvertible paper money type, which we have today.


Gold Exchange Standard

Under this Standard, gold coins do not circulate within the country. The local currency of a country consists of paper money and token coins. The local currency will not be converted into gold. But the currency of the country on Gold Exchange Standard will be converted into the currency of some other country which is on Gold Standard. Thus, the currency of the country on Gold Exchange Standard will be indirectly linked to gold. Many poor countries, which did not have enough gold reserves of their own were on Gold Exchange Standard for they enjoyed some of the advantages of the Gold Standard. The additional advantages of this standard were (1) It was economical, (2) There was stability of exchange and (3) The value of the currency could be stabilized in term of gold.


Merits of Gold Standard

1. If a country is on Gold Standard, its currency will be universally acceptable. It promotes international trade.
2. The volume of money in circulation in a country will be limited by the supply of gold in that country. Since the supply of money is stable, gold in that country. Since the supply of money is stable, it will create stability in the economy in general and stability of prices in particular. There is little scope for inflation or deflation.
3. The Gold Standard helps in maintain stable exchange rates among the countries, which are members of the international gold system.
4. It provides an automatic adjustment of balance of payments.
5. It is an advantage for gold producing countries.

Demerits of Gold Standard

1. Gold Standard will work well only when all the "rules of the gold standard game" are followed by the member countries. But the rules are rather rigid. It is not always easy or simple to remain on Gold Standard. The system worked well before World War I because conditions then were favorable. But when it was reintroduced after the World War, it did not work well for conditions differed then. That is why, Prof. Halm says that "It is a fair-weather craft of doubtful sea worthiness in stormy waters." It will collapse at a time of crisis.
2. It does not establish stability of prices over long periods. For in the long period, even the supply of gold is not steady.
3. Countries, which are on Gold Standard, sometimes have to sacrifice their domestic stability for stable exchange rates. Gold Standard is a jealous God.
4. Gold Standard is really not an automatic standard. The Central Bank of a country has to manage the monetary system even when it is on gold standard.
5. It involves a huge waste of gold reserves. For, under the Gold Standard in its original form, all the money in circulation in the country should be backed by gold.

Causes for the Breakdown of Gold Standard

Britain went off the Gold Standard in 1931. Other countries such as America and France followed suit within a few years. There were many causes for the breakdown of the Gold Standard.

1. The rules of the Gold Standard were not observed by many countries. For example, the U.S.A. received large amounts of gold by imports. But she "sterilized" those gold resources. Like that, many countries broke the rules of Gold Standard.
2. France under-valued her currency when she returned to Gold Standard. As a result, she got a large surplus of gold. But she did not follow the rules of the Gold Standard.
3. World War I affected the working of the Gold Standard. Many countries became debtor countries. War debts and reparations interfered with the smooth working of gold Standard.
4. The maintenance of Gold Standard became very complicated after the First World War.
5. The spirit of nationalism was also another factor that contributed to the downfall of the Gold Standard. During the inter-war period (1919-1939), each country aimed at maintaining price stability and full employment and they were not willing to sacrifice domestic interests for the sake of the Gold Standard.

The above things were some of the important factors that contributed to the downfall of the Gold Standard. Some economists feel that "the automatic Gold Standard mechanism will never return." Of course, it does not mean that gold will not play an important role in international monetary affairs. In fact, it has been given a useful role by the International Monetary Fund (I.M.F), an organization for promoting international monetary co-operation.

By HubPages

Source: HubPages

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