by Joakim Book, American Institute for Economic Research:
A gold standard is a monetary regime where the monetary unit, the base money of the banking system — the outside money or the high-powered money — consists of a defined amount of gold. Gold standards can come in all manners and versions and with particular institutional and historical quirks that affect their operations. The key characteristic that unites them is that an economy’s underlying money is ultimately based on an amount of gold.
Using the language and the classification in the first reading session of our Harwood Graduate Colloquium, commodity monies such as a gold standard consist of objects that have alternative nonmonetary uses (for instance in production or ornament) and are absolutely scarce. That is, their scarcity is a fundamental aspect of the good itself — as opposed to fiat money, which can be expanded at the discretion of a central bank.
When money is gold, it can be increased only by extracting more gold from mines and minting it into monetary circulation. This process, expanding supply through the incentives provided by the price mechanism, subjects the supply of money to market forces rather than to discretionary policy making as is the case under our current monetary regime. That carries with it a few remarkable characteristics:
In chapter 2 of his book The Theory of Monetary Institutions, George Mason University professor and long-time private-money researcher Lawrence White lays out the ins and outs of the workings of a commodity standard. He presents the intuition behind the impersonal market forces that, under commodity standards, let the money supply expand and contract with the economy: the price incentives that lead gold miners to extract more (less) gold when the purchasing power of gold in terms of other goods is high (low) — that is, when the economy demands it.
Walking through the various scenarios of shifting supply/demand curves allows White to demonstrate (and historically illustrate) how a gold standard works in theory and how it operated in the 19th century. Its flexibility and the fact that the money supply is provided by market-tested price incentives are among its main benefits.
The second reading in this Harwood Graduate Colloquium session is a much more empirically minded article exploring how the gold standard operated in practice under what we call the classical gold standard era (1880-1913). McCloskey and Zecher’s (1985) article explains how many of the theories we have about the gold standard did not in fact apply historically.
For instance, the domestic and international price levels under a gold standard are usually believed to align through the so-called price-specie-flow (PSF) mechanism — where a price discrepancy between what gold buys in England and what it buys in America is eliminated through arbitrage. That is, speculators take gold out of England, reducing its money supply and price level, and employ it in America, which increases American money supply and price levels.
Studying actual gold flows across the Atlantic indicates a much lower amount of gold actually shipped than would be needed to play this role. And the correlations were often of the wrong sign. In 18th-century economist David Hume’s PSF model, an outflow of gold should be associated with high prices and incomes to cover a trade deficit (higher prices all else equal increase imports while reducing exports), since the same gold could buy more stuff elsewhere. Gold flows are moving inversely with prices. Empirically we rather find that prices and incomes increased in tandem with gold flowing in.
McCloskey and Zecher’s preferred mechanism for explaining this phenomenon is a money-demand argument; as incomes and/or prices rose, consumers wanted to hold more money — think of it as money holding for precautionary or transactional purposes. If that extra money could not be satisfied by the domestic monetary authorities, it could be imported, flipping the signs around; high incomes/prices increase money demand, which in turn attracts gold from abroad.
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