a specified quantity of gold for its standard mone-
tary unit.Thus, exchange rates had fixed par values
as determined by the gold content of the national
monetary links. A modification of this system
occurred at a later date, and it became known as
the gold exchange standard. Created in 1922, the
modified system allowed countries to use both gold
and the US dollar for international settlement
because the USA stood ready to redeem dollars in
gold on demand.
In 1930, a dollar was defined as containing 23.22
grains of fine gold (with 480 grains in a troy ounce),
whereas a British pound had 113 grains. In 1971,
the gold content of the dollar was redefined from
0.888671 grams of gold to 0.73666 grams. The
price of gold, being $20.67 per fine troy ounce
in 1879, was later changed to $35 in 1933. The
increase in gold price in effect devalued the dollar.
Because each national currency had to be backed by
gold, each country’s money supply, in turn, was
determined by its gold holdings.
Because of this common denominator (i.e.,
gold), all currencies’ values were rigidly fixed.
Although the values were fixed by law, that does not
mean that these exchange rates could not fluctuate
to some small degree in accordance with the
demand and supply of a currency. The fluctuation
had to be within the limits set by the costs of inter-
est, transport, insurance, and handling of gold from
one country to another.
The gold standard functioned to maintain equi-
librium through the so-called price-specie-flow mech-
anism (or, more appropriately, the specie-flow-price
mechanism) with specie meaning gold. The mecha-
nism was intended to restore the equilibrium auto-
matically. When a country’s currency inflated too
fast, the currency lost competitiveness in the world
market. The deteriorating trade balance resulting
from imports being greater than exports led to a
decline in the confidence of the currency. As the
exchange rate approached the gold export point,
gold was withdrawn from reserves and shipped
abroad to pay for imports.With less gold at home,
the country was forced to reduce its money
supply, a reduction accompanied by a slow-down in
economic activity, high interest rates, recession,
reduced national income, and increased unemploy-
ment. The onset of hard times would pressure
inflation to be reduced.As domestic prices declined,
demand for domestic products increased, and
demand for imports declined. Price deflation thus
made domestic products attractive both at home
and abroad. The country’s balance of payments
improved, and gold started to flow into the country
once again. The price-specie-flow mechanism also
restored order in the case of trade surpluses by
working in the opposite manner.
There are several reasons why the gold standard
could not function well over the long term. Because
gold is a scarce commodity, gold volume could not
grow fast enough to allow adequate amounts of
money to be created (printed) to finance the growth
of world trade.The problem was aggravated further
by gold being taken out of reserve for art and indus-
trial consumption, not to mention the desire of
many people to own gold. The banning of gold
hoarding and public exporting of gold bullion by
President Franklin Roosevelt was not sufficient to
remedy the problem.
Another problem of the system was the unrealis-
tic expectation that countries would subordinate
their national economies to the dictates of gold as
well as to external and monetary conditions. In
other worlds, a country with high inflation and/or
trade deficit was required to reduce its money sup-
ply and consumption, resulting in recession and
unemployment.This was a strict discipline that many
nations could not force upon themselves or their
population. Instead of having sufficient courage to
use unemployment to discourage imports, import-
ing countries simply insisted on intervention
through tariffs and devaluations instead. Nations
insisted on their rights to intervene and devalue
domestic currencies in order to meet nationwide
employment objectives. Because of the rigidity of
the system,it was only a matter of time before major
countries decided to abandon the gold standard,
starting with the United Kingdom in 1931 in
the midst of a worldwide recession.With a 12 per-
cent unemployment rate at the time, the United
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