What Does Gold Standard Mean?

A monetary system in which a country's government allows its currency

unit to be freely converted into fixed amounts of gold and vice versa.
The exchange rate under the gold standard monetary system is determined
by the economic difference for an ounce of gold between two currencies.
 The gold standard was mainly used from 1875 to 1914 and also during
the interwar years. 
 The use of the gold standard would mark the first use of formalized
exchange rates in history. However, the system was flawed because
countries needed to hold large gold reserves in order to keep up
with the volatile nature of supply and demand for currency.   

 After World War II, a modified version of the gold standard

monetary system, the Bretton Woods monetary system, was created
as its successor. This successor system was initially successful,
but because it also depended heavily on gold reserves, it was
abandoned in 1971 when U.S President Nixon "closed the gold
window". 
 How the Gold Standard Worked

• The gold standard was also an international

standard determining the value of a country’s
currency in terms of other countries’ currencies.
• United States fixed the price of gold at $20.67
per ounce
• Britain fixed the price at £3.17per ounce.
• the exchange rate between dollars and pounds
— $6.523 per pound.
• Because exchange rates were fixed, the gold standard caused price levels
around the world to move together. This comovement occurred mainly
through an automatic balance-of-payments adjustment process called the
price-specie-flow mechanism. Here is how the mechanism worked. Suppose
that a technological INNOVATION brought about faster real economic
growth in the United States. Because the supply of money (gold) essentially
was fixed in the short run, U.S. prices fell. Prices of U.S. exports then fell
relative to the prices of imports. This caused the British to DEMAND more
U.S. exports and Americans to demand fewer imports. A U.S. balance-of-
payments surplus was created, causing gold (specie) to flow from the United
Kingdom to the United States. The gold inflow increased the U.S. money
supply, reversing the initial fall in prices. In the United Kingdom, the gold
outflow reduced the money supply and, hence, lowered the price level. The
net result was balanced prices among countries.
• The fixed exchange rate also caused both
monetary and nonmonetary (real) shocks to
be transmitted via flows of gold and capital
between countries. Therefore, a shock in one
country affected the domestic money supply,
expenditure, price level, and real income in
another country.
• The California gold discovery in 1848 is an example of a monetary shock. The
newly produced gold increased the U.S. money supply, which then raised
domestic expenditures, nominal income, and, ultimately, the price level. The
rise in the domestic price level made U.S. exports more expensive, causing a
deficit in the U.S. BALANCE OF PAYMENTS. For America’s trading partners,
the same forces necessarily produced a balance-of-trade surplus. The U.S.
trade deficit was financed by a gold (specie) outflow to its trading partners,
reducing the monetary gold stock in the United States. In the trading
partners, the money supply increased, raising domestic expenditures,
nominal incomes, and, ultimately, the price level. Depending on the relative
share of the U.S. monetary gold stock in the world total, world prices and
income rose. Although the initial effect of the gold discovery was to increase
real output (because wages and prices did not immediately increase),
eventually the full effect was on the price level alone.
• For the gold standard to work fully, central banks, where they existed, were supposed
to play by the “rules of the game.” In other words, they were supposed to raise their
discount rates—the interest rate at which the central bank lends money to member
banks—to speed a gold inflow, and to lower their discount rates to facilitate a gold
outflow. Thus, if a country was running a balance-of-payments deficit, the rules of the
game required it to allow a gold outflow until the ratio of its price level to that of its
principal trading partners was restored to the par exchange rate.
• The exemplar of central bank behavior was the Bank of England, which played by the
rules over much of the period between 1870 and 1914. Whenever Great Britain faced
a balance-of-payments deficit and the Bank of England saw its gold reserves declining,
it raised its “bank rate” (discount rate). By causing other INTEREST RATES in the United
Kingdom to rise as well, the rise in the bank rate was supposed to cause the holdings
of inventories and other INVESTMENT expenditures to decrease. These reductions
would then cause a reduction in overall domestic spending and a fall in the price level.
At the same time, the rise in the bank rate would stem any short-term capital outflow
and attract short-term funds from abroad.
• Most other countries on the gold standard—notably
France and Belgium—did not follow the rules of the
game. They never allowed interest rates to rise enough
to decrease the domestic price level. Also, many
countries frequently broke the rules by “sterilization”—
shielding the domestic money supply from external
disequilibrium by buying or selling domestic securities. If,
for example, France’s central bank wished to prevent an
inflow of gold from increasing the nation’s money supply,
it would sell securities for gold, thus reducing the
amount of gold circulating.