Question

During World War 1 (WW1 -1914-1919) people witnessed inflation and lost confidence in the gold standard system. How did inflation make people lose their confidence in the gold standard system?

Answer 1

The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.

The first U.S. paper money was issued in 1861, by Treasury Secretary Salmon Chase. The 1900 Gold Standard Act determined that gold was the only metal used to redeem paper money. This fixed the gold premium at $20.67 an ounce. Eurpoean nations decided to standardize trades on the booming world trade market, and by the 1870s they introduced the gold standard.

It ensured that the government would exchange every sum of paper money for its gold worth, which meant that transactions would no longer have to be made of hard gold bullion or coins, because paper currency was now ensured to be priced at something actual.

In 1913, Congress created the Federal Reserve to stabilize gold and currency values in the United States. When World War I broke out, the United States and European countries suspended the gold standard so they could print enough money to pay for their military involvement.

When the central bank sets the dollar price of gold instead of the price of services we buy, fluctuations in the dollar price of services override fluctuations in the gold market price. Since rates are tied to the amount of money in the economy that is tied to the gold supply, inflation depends on the rate that gold is extracted.

When used at home and abroad, the gold standard is an exchange-rate policy in which international transactions must be settled in gold. Gold digging out of one hole in the ground (a mine) to place it in another hole in the ground (a vault) is wasting resources.

Both inflation and economic growth were quite volatile under the gold standard.The standard deviation of inflation during the 53 years of the gold standard is nearly twice what it has been since the collapse of the Bretton Woods system in 1973.

The standard for gold is procyclical. Inflation usually increases as the economy booms. In the absence of a central bank to drive up the nominal interest rate, the real interest rate rises, giving development another impetus. Conversely, counter-cyclical monetary policy – whether or not centered on a Taylor rule – will turn towards the boom.

Under a gold standard, the size of the liabilities of the central bank – currency plus reserves – is determined by the gold in its vault. Imagine that people come to expect a devaluation of the currency as a result of an prolonged decline. Therefore, they are afraid the central bank will lift the price of gold for the currency.In such a situation, investors would find it natural to take their dollars to the central bank to exchange them for gold. The fears that fuel such a run can be self-fulfilling: if the central bank starts to drain gold reserves, it can easily be pressured to increase the dollar price, or to fully abandon redemption.Therefore, gold standard has significant exchange rate implications.

Under a gold standard, inflation, growth and the financial system are all less stable. There are more recessions, larger swings in consumer prices and more banking crises. When things go wrong in one part of the world, the distress will be transmitted more quickly and completely to others.