Gold Standard

Why study the gold standard?

Gold Standard is example of super-fixed exchange
rate
Produced price stability and capital mobility
Solved Trilemma by sacrificing monetary autonomy

Yet gold standard no longer exists, and will not be

restored
Why is a system that worked well in 19th century no
longer feasible?
Understanding this gives insight to tradeoffs with
monetary systems

Gold Standard
At the source of Humes specie-flow mechanism
Gold standard is historic, but informative
Established inadvertently by Newton who set the
silver price of gold too high
Newton though supply and demand would lower the
silver price of gold
Instead, Greshams law drove silver out of Britain

Rule based system, but not organized

Rules, 1-3 key
Rules 4-6 crucial for smooth operation of system

Gold Points
If rules 1-2 hold exchange rates determined by
fixed parities
Let x be the official (mint) dollar price of an oz. of
gold and y the official (mint) sterling price of gold
Then x/y is the official exchange rate
Arbitrage keeps the spot rate (almost) equal to this amount

Let
be the cost of shipping gold to Britain, and let
St be the spot exchange rate.
Then it is profitable to ship gold if

St

x
y TUB

Arbitrage

x
Suppose that St
that is spot rate above the gold
y TUB
point
Sterlings spot price is very high, you want to sell
So you ship gold to Britain and exchange for sterling at par, and
then convert sterling to dollars at the spot rate
This makes money since

St ( y TUB ) x

The RHS is the dollar price of gold

The LHS is the dollar return on selling gold in Britain, net of the
cost of shipping
So if the spot exceeds the gold point there are arbitrage profits to be
made

Gold Points
And it is profitable to import gold if
So the spot rate is bound by these limits or gold
points
Notice that arbitrage depends on the cost of
shipping gold
As costs fell, the bounds tighten and arbitrage is
more effective

Restoration Rule
Rule 5 is the restoration rule
Means that rule 3 can be followed and gold
devices used
Temporary suspension does not lead to
speculation
Rise in interest rates is not a destabilizing signal
In modern financial crises i rises when >>0

Interest rate stabilized under the gold standard

But is this true?

Gold Points and Credibility

If gold points were credible this bounds the
interest rate
Let
Let
i.e.,

be the current short-term sterling rate

be the max value under gold points
S

x TBU
y

Then is maximum appreciation of sterling

consistent with the gold standard, and we can define
the maximum and minimum interest rate, given the
gold points (think interest parity conditions)

Interest Bounds
Thus, if the gold points are credible, the interest rate
should fluctuate within the bounds,
Amazingly, interest rates did stay within these bounds
Exceptions when fear of repudiation,
e.g., US in 1893-4, 1896

As rates rose (within the bounds) it led to stabilizing flows,

attracting capital, why?
Because no exchange risk if rule 5 is followed
=> interest rate is negative feedback mechanism
Notice the stability of prices

This is a superb feature for a monetary system

Dollar Interest Rate and Credibility Bounds

Reichsmark Interest Rate and Credibility Bounds

Franc Interest Rates and Credibility Bounds

A Model
Start with closed economy
Why use gold?
Time inconsistency problem
Ex post optimal policy not consistent with ex ante policy
Two-period tax problem: announce zero capital taxes, but in period two
capital is sunk, so optimal to tax capital
But then nobody saves in period one

Gold standard can provide commitment

Dollar price of gold given, stock fixed

Demand for gold negatively related to relative price of
gold

Stock Equilibrium

Gold Demand
Gold used for monetary and non-monetary use
Latter depends on relative price
Monetary demand depends on reserve ratio
Money demand depends on income
So,
We could easily add interest rates
GM

PL (i, y )
PG

Flow Supply
Changes in stock of gold depends on additions
(discovery) and subtractions (wastage, usage)
Let
be the non-monetary demand, and let
be the depreciation rate, then
gives wastage

So we have the flow supply diagram

Put the two together,
Suppose P falls, over time gold stock rises and
relative price of gold falls back to initial equilibrium

Flow Supply

Remember that flow demand

is negative, so when the
curves intersect the net flow
of gold is zero

Stock-flow

G 0

Open Economy Version

How to modify model for open economy?
All we do is replace the flow supply function with
export function and flow demand function with
import demand function
Net gold supply now depends on international trade
in goods and services.
i.e., on trade balance
Trade balance depends on relative prices and incomes,
PG

G TB h , y *
P

PG
f , y
P

Implies flow supply of gold changes faster

Dont need to discover gold, we can import gold

Open Economy Version

Implication
Gold standard is a price level anchor
Suppose money demand increases
This causes relative price of gold to rise (price level
falls)
Could cause recession in short run
But gold production increases and stock of gold rises
We return to old relative price of gold

What if we lost competitiveness?

Lose gold at initial relative prices => G < 0
=> P falls, so TB restored

Decline in Competitiveness
Decline in competitiveness causes gold
outflow and the price level to fall, restoring
trade balance
PG
P

PG
P

h G , y *
P

h G , y *
P
0
PG

P

PG

P 0

PG
, y
P

, y

G<0

G0

Decline in
competitiveness

Rules of the Game

Major difference between model and reality
Gold flows were not that large
Why?
Monetary policy utilized to prevent them
Anticipating gold flows and offsetting them

Keynes called this playing by the rules of the game:

The gold outflow will lead to a tightening of domestic credit and a
deflation in the price level
Anticipating this outflow the central bank tightens before the outflow
of gold occurs. Deflation and restoration of balance occurs before
gold flows out

Why play by these rules?

To avoid the loss of gold that would otherwise occur.

Example
Suppose that at current PP there is trade deficit
Over time we lose gold and price level falls, relative
price of gold rises, and we restore equilibrium
Alternatively, the Central Bank could raise
G

This increases the demand for gold and immediately raises

its relative price, without any gold flow across countries
Of course this is not the popular thing to do

Notice how 19th Century this is

A modern CB might try the opposite: sterilize the impact of
the loss of gold on the domestic economy

Benefits of Gold Standard

Gold standard produces long-run price stability
Gold standard facilitates capital flows
Good Housekeeping Hypothesis
Gold standard as a contingent rule (rule 5)
sovereign borrowing costs differed substantially from country to
country and these differences were correlated with a countrys longterm commitment to the gold standard.
Estimate that rates fell 40-50 basis points
Reverse causation?

Alternative hypothesis: British Empire

But data does not support that argument

Good Housekeeping Model

Gold standard as commitment device
Government has discretionary incentive to inflate, B
Current gain is higher employment, a one-time gain

Costs are reputational losses and higher future borrowing

costs (C)
Losses are PV of future costs:

L i Ct i
i 1

If cheating is punished sufficiently government refrains from

inflating
PV of costs of cheating (L) > current benefits of inflating (B)

If the future is valuable ( 1), refrain from cheating

Assumes collective punishments
sound money equilibrium is only attainable if the bond market
punishes countries today that left gold in the past.

Implications
Thus if two nations issue bonds with identical expected cash
flows, the bond market assigns a lower price to the nation that
abandoned gold.
Implies arbitrage opportunity which market must forego to enforce
trigger strategy equilibrium

19th century institutions such as CFB and large investment

banks may have been sufficiently patient to enforce
penalties
Corporation of Foreign Bondholders (CFB), an association of
British investors holding bonds issued by foreign governments

It helped that so much savings flowed from Britain

Good Housekeeping Model: Tests

Theory predicts that expected yields on bonds are
lower for countries that adhere
Problem, no data on expected yields
Use realized yields

Other factors affect borrowing costs

Estimate y G y M X B
i ,t
i ,t
i t
i ,t i
i ,t
Where Gi ,t 1 if country i adheres to the gold standard in year t
M
And yit Rit RUK ,t and yi Rt RUK ,t
The key hypothesis is that

Evidence supports this; predicted rates were lower where

commitment to the rule was higher

Gold Standard: Costs

If the gold standard was so good, why was it abandoned?
It ties the world money supply to the production of a
commodity.
There is no inherent reason why the growth in gold supplies will be
related to the needs of international liquidity.
When gold discoveries are rare, the world supply of gold will not
increase as fast as real income.
Between 1873 and 1896, the frequency of gold discoveries was rare
while economic growth was rapid.
That is why US prices fell 53% in this period

System requires rule 5, subordinating internal balance for

external balance
Democracy made it harder to go back to it after WW1

Bimetallism
Silver could augment gold as precious metal when gold supply
was insufficient
If mint maintains fixed exchange rate of gold for silver (e.g., 15.5 to 1
in France)
If gold is in short supply the return to mining silver rises
Under bimetallism the money supply is given by

G
PS
M P G G S
P

It is a bit weird, there are now two numeraires: dollar is x ounces of gold
and y ounces of silver fixed legal ratio as money,
If market price of silver price > official price there will be no monetary
silver, and vice versa, Greshams Law
Bimetallism gives an extra leg to stand on, but requires same rate across
countries
Debtors may want coinage of silver (at high rate) to augment M

Bimetallism
US was on bimetallic standard (16-1) till 1873
France (15.5-1) and Latin America were also
For a long time market ratio was stable
After 1873 market ratio collapses
Germany leaves Silver Standard
Crime of 1873 in US
Eventually Austria, France, Russia, India all leave silver

What seemed to work collapsed to gold standard

Notice the big increase in gold production

Wizard of OZ
Wizard of Oz is a monetary allegory
Cleveland had repealed Sherman Act, big unemployment
Bryan: "you shall not press upon the bow of labor this crown of
thorns, you shall not crucify mankind upon a cross of gold
OZ = ounces of gold
Dorothy, honest Kansan, Midwesterner who does not understand the power of
her silver shoes
Scarecrow = farmer, Tinman = worker idled (rusted) by unemployment, Cowardly
Lion = Bryan
The Wicked Witch of the East is Wall Street the advocates of tight money and
most especially Grover Cleveland.
The Wicked Witch of the West is drought at that time ruining farms in Kansas
and Nebraska
hence, destroyed by water
Toto stands for teetotaler, the prohibitionists, who agreed with the populists on
silver.

Key Characters

Search for Silver?

More Oz
Emerald City is Washington,
where people must wear green shaded glasses; thus
they are forced to see the world through the shade
of money.

The Wizard is really just a man, whose solution

a balloon vanishes like hot air
Winged Monkeys = plains Indians

Yellow Brick Road and Emerald City

Silver shoes
On the books next to last page, Glinda, Good witch of
the South, tell Dorothy,
"Your Silver Shoes will carry you over the desert.....If you had
known their power you could have gone back to your Aunt
Em the very first day you came to this country." Glinda
explains, "All you have to do is knock the heels together
three times and command the shoes to carry you wherever
you wish to go." (p.257).
William Jennings Bryan never outlined the advantages of the
silver standard any more effectively. Not understanding the
magic of the Silver Shoes, Dorothy walks the mundane
and dangerous Yellow Brick Road.

Scarecrow, Tinman, Cowardly Lion

He complains of no brain not understanding what the moneymen from
the east tell him but of course he finds that he has one by the end.
Once an independent and hard working human being, the Woodman found
that each time he swung his axe it chopped off a different part of his body.
Knowing no other trade he "worked harder than ever," for luckily in Oz
tinsmiths can repair such things. Soon the Woodman was all tin (p. 59).
In this way Eastern witchcraft dehumanized a simple laborer so that the faster and
better he worked the more quickly he became a kind of machine.
Here is a Populist view of evil Eastern influences on honest labor which could
hardly be more pointed.[16] There is one thing seriously wrong with being made
of tin; when it rains rust sets in. Tin Woodman had been standing in the same
position for a year without moving before Dorothy came along and oiled his
joints. The Tin Woodmans situation has an obvious parallel in the condition of
many Eastern workers after the depression of 1893.

This apparently is because by 1900, in his second race with McKinley, Bryan
no longer fought the bimetallism issue. Baum is thus picturing him as a
coward.

Plains Indians
"Once we were a free people, living happily in the great
forest, flying from tree to tree, eating nuts and fruit, and
doing just as we pleased without calling anybody
master." "This," he explains, "was many years ago, long
before Oz came out of the clouds to rule over this
land
Under Dorothys influence they become kind, but
cannot take her to Kansas
"We belong to this country alone, and cannot leave it"

Was Bryan Right?

Bimetallism might have worked in 1873
Greater price stability would have ensued
US on silver, UK on gold

By 1896 horse left the barn

Too many countries were off silver
Market price was 30 to 1 not 16 to 1 by then
Coordination effect

Gold discoveries could not have been easily predicted

Gibsons Paradox
The Fisher equation says nominal interest rates
should be positively correlated with inflation
But during gold standard period interest rates
were correlated with the price level

World Price Level and Consol Yield

Value of Adhering to the Rule

Value of Adhering to the Rule

Wholesale Prices in US and UK

Interest Rates and Prices under the Gold Standard

Wholesale Prices, 1790-1920

1040

750
650
550
450
350
250
150
50
1790

1800

1810

1820

1830

1840
Britain

1850

1860

France

1870
Germany

1880

1890

United
States

1900

1910

1913

1920

Wholesale Prices, 1790-1913

230
210
190
170
150
130
110
90
70
50
1790

1800

1810

1820

1830

1840
Britain

1850
France

1860

1870

Germany

1880
United
States

1890

1900

1910

1913

Value of Adhering to Gold, US

Value of Adhering to Gold, Argentina and Brazil

Japanese Risk Premium

Japanese Capital Inflows and the Gold Standard

Value of Adhering to Gold, Australia and Canada

Free Coinage
Historically US had free coinage of both silver and
gold (Hamiltons Coinage Act, 1792)
Required the government to buy all silver or gold offered to it at
prices of $1.2929... per troy ounce of pure silver and $19.3939...
per troy ounce of fine gold, that is, 15 times as much for an ounce
of gold as for an ounce of silver

15 to 1 was market price in 1792

But soon after, world price ratio rose above this
As a result, anyone who had gold and wanted to convert
it to money would do better by exchanging the gold for
silver at the market ratio and taking the silver to the mint
than by taking the gold directly to the mint.

Problem
At a 15 to 1 ratio, an obvious get-rich scheme:
Take 15 oz. of silver to the mint, get 1 oz. of gold, sell
the oz. of gold on the market for, say, 16 oz. of silver,
and repeat
with each cycle you have made 1 oz. of silver
Continue till you are millionaire

=>Mint runs out of gold

So we are effectively on a silver standard

Only silver coins circulated

That is why typically the mint commits to coinage

of only one type of specie

Gold Makes a Return

In 1834 new legislation sets price at 16 to 1
This was a Jacksonian attack on Biddles Bank
Of course in 1896, Bryan would have loved 16 to 1
But in 1834 16-1 was greater than the market price

Gold coins could replace Bank paper notes

Silver stopped being coined

Civil War puts temporary end to this

When gold standard was resumed, free coinage into
silver was not included
Omission = crime ?

Otherwise at 16 to 1 silver would have been coined

Consequences of the Crime

Omission crucial because of the expected decline in the price of silver
Had there been no decline in the silver-gold price ratio or, as it is
more usually expressed, rise in the gold-silver price ratio it would
have been irrelevant whether the fateful line was included in the act of
1873 or omitted.
In either event, the pre-Civil War situation of an effective gold standard
would have continued when and if the United States resumed specie
payments.

As it was, however, a rise in the gold-silver price ratio started well

before the United States passed the act of 1873 and was in full swing
when the United States resumed specie payments in 1879.
Gold was rising in value, but silver was no longer coined
You could not take cheap silver to the mint to buy gold

Resumption by the United States on the basis of gold was the final nail in
the coffin of silver

Rise of Gold
Gold price rose as countries left silver
This speeded up rapidly after 1870, as one European country after another shifted
from a silver or bimetallic standard to a single gold standard-a tribute to the
leadership of Britain
Germany shifted in 1871-73, after it defeated France and imposed a large war indemnity payable in
funds convertible into gold.
France, which had maintained a bimetallic standard since 1803 demonetized silver along with the
other members of the Latin Monetary Union (Italy, Belgium, and Switzerland) in 1873-74.
The Scandinavian Union (Denmark, Norway, and Sweden), the Netherlands, and Russia followed
suit in 1875-76 and Austria in 1879.
By the late 1870s, India and China were the only major countries on an effective silver standard.
And of course US increased demand for gold dramatically

The resulting increased demand for gold and increased supply of silver for
nonmonetary purposes produced a dramatic rise in the gold-silver price ratio.
From 15.4 in 1870, it jumped to 16.4 by 1873, 18.4 by 1879, and 30 by 1896,
when 16 to 1 was the Bryan battle cry.

Implications
The increased world demand for gold for monetary purposes coincided with a
slowing in the rate of increase of the world's stock of gold and a rising output
of goods and services.
These forces put downward pressure on the price level.
Issue of paper money could not offset this

The outcome was deflation from 1875 to 1896 at a rate of roughly 1.7 percent
per year in the United States and 0.8 percent per year in the United Kingdom,
which means in the gold standard world.
Led to agitation for silver purchases and coinage
Bland-Allison Act (1878) Sherman Silver Purchase Act (1890)
Agitation for free coinage of silver led to fear of leaving the gold standard
One paradoxical result of the agitation for inflation via silver was that it explains why
deflation was more severe in the United States than in the rest of the gold standard world
(1.7 percent vs. 0.8 percent).

Had there been no omission, US would have effectively been on silver, UK on

gold
Augmentation of world money supply would have meant less deflation
=> less agitation for free coinage