1. Education
Send to a Friend via Email
You can opt-out at any time. Please refer to our privacy policy for contact information.

Gold Standard vs. Fiat Money

What Was The Gold Standard?


The Benefits and Costs of a Gold Standard

The main benefit of a gold standard is that it insures a relatively low level of inflation. In articles such as "What is the Demand for Money?" we've seen that inflation is caused by a combination of four factors:
  1. The supply of money goes up.
  2. The supply of goods goes down.
  3. Demand for money goes down.
  4. Demand for goods goes up.
So long as the supply of gold does not change too quickly, then the supply of money will stay relatively stable. The gold standard prevents a country from printing too much money. If the supply of money rises too fast, then people will exchange money (which has become less scarce) for gold (which has not). If this goes on too long, then the treasury will eventually run out of gold. A gold standard restricts the Federal Reserve from enacting policies which significantly alter the growth of the money supply which in turn limits the inflation rate of a country. The gold standard also changes the face of the foreign exchange market. If Canada is on the gold standard and has set the price of gold at $100 an ounce, and Mexico is also on the gold standard and set the price of gold at 5000 pesos an ounce, then 1 Canadian Dollar must be worth 50 pesos. The extensive use of gold standards implies a system of fixed exchange rates. If all countries are on a gold standard, there is then only one real currency, gold, from which all others derive their value. The stability the gold standard cause in the foreign exchange market is often cited as one of the benefits of the system.

The stability caused by the gold standard is also the biggest drawback in having one. Exchange rates are not allowed to respond to changing circumstances in countries. A gold standard severely limits the stabilization policies the Federal Reserve can use. Because of these factors, countries with gold standards tend to have severe economic shocks. Economist Michael D. Bordo explains:

"Because economies under the gold standard were so vulnerable to real and monetary shocks, prices were highly unstable in the short run. A measure of short-term price instability is the coefficient of variation, which is the ratio of the standard deviation of annual percentage changes in the price level to the average annual percentage change. The higher the coefficient of variation, the greater the short-term instability. For the United States between 1879 and 1913, the coefficient was 17.0, which is quite high. Between 1946 and 1990 it was only 0.8.

Moreover, because the gold standard gives government very little discretion to use monetary policy, economies on the gold standard are less able to avoid or offset either monetary or real shocks. Real output, therefore, is more variable under the gold standard. The coefficient of variation for real output was 3.5 between 1879 and 1913, and only 1.5 between 1946 and 1990. Not coincidentally, since the government could not have discretion over monetary policy, unemployment was higher during the gold standard. It averaged 6.8 percent in the United States between 1879 and 1913 versus 5.6 percent between 1946 and 1990."

So it would appear that the major benefit to the gold standard is that it can prevent long-term inflation in a country. However, as Brad DeLong points out, "if you do not trust a central bank to keep inflation low, why should you trust it to remain on the gold standard for generations?" It does not look like the gold standard will make a return to the United States anytime in the foreseeable future.

©2014 About.com. All rights reserved.