What is the Gold Standard?
The gold standard refers to an economy where paper money and coins are equal to a set amount of gold and can be exchanged for that amount at any time.
A gold standard is a monetary system where the value of money is directly linked to gold. That is, a dollar — or other unit of currency — can be redeemed for set amount of gold. No country currently uses a gold standard. Paper (or fiat) currencies, on the other hand, are promissory notes issued by governments, backed by their full faith and credit the United States and many other countries used the gold standard early in the 20th Century, but most have since moved to a fiat system where the value of money is not based on gold or any other physical item.
Let’s pretend the United States returned to the gold standard. The U.S. government would have to decide how much each dollar was worth in terms of gold. For example, it could decree that $1 would be redeemable for 1/500th of an ounce of gold. Individuals, and countries holding stores of U.S. currency, would then have the right to convert their paper currency into gold at any time.
The gold standard for countries is like individuals storing actual gold bars in the bank instead of cash…
The gold may make you feel more secure — What if the U.S. government goes bankrupt tomorrow!? — but it’s going to make day-to-day business much more difficult. And your bank account’s value, like a country’s economic fortunes, will be arbitrarily tied to the value of an arbitrary commodity.
A fiat monetary system means that the money of a country has value because the government says it does. There is no tangible value behind the money, no intrinsic value. You cannot exchange fiat money for a set amount of a commodity (like gold or silver). The perceived strength of the government that issues the money drives the global view of that specific fiat money —Trust is the backer of the value instead of a commodity.
A fiat monetary system allows the government to print more money without buying a commodity to back the new money. However, if the government prints too much fiat money, inflation generally rises, and the value of the cash usually falls. Fiat money can affect credit as well, as other countries must take amounts based on trust rather than a commodity. For example, in the 1990s, Russian money — the Ruble — became so undervalued due to the government printing too much money too quickly that people abandoned the Ruble in favor of the U.S. Dollar, cigarettes, and vodka in everyday transactions.
Money is anything that can be used to trade for goods or services — a medium of exchange. Shells were once used as money. Using paper money and stamped coins allow the currency to have a uniform value and become more comfortable to use.
A commodity monetary system, like the gold standard, uses money as a stand-in for a physical item considered valuable. Gold coins are not required, only that coins have set rates for conversion into gold.
Fiat financial systems use money as a trade standard without any physical representation to control the money value. In other words, fiat money is a standardized item of convenience.
In addition to a gold standard, American money has previously been backed by a bimetallic (gold and silver) standard and a silver standard. Although the official standard was bimetallic, from the years 1792 until 1834, the American monetary system was an unofficial silver standard. U.S. Dollars at the time were set in value so that each ounce of gold was worth 15 times more dollars than each ounce of silver.
Precious metals and jewels have held value throughout centuries. However, modern gold standards began to become normalized when countries first moved to bimetallic (gold and silver) standards for ease of international trade. Then, price competition between metals and mistakes in valuation began to cause countries to move to gold alone. England adopted a gold standard in 1819. The U.S. followed in 1900 with the passage of the Gold Standard Act following the gold/silver ratio troubles of the late 1700s/early 1800s. Other major countries also moved to a formal gold standard in the late 1800s. The years 1880 to 1914 are often called the classical gold standard because of the number of countries moving to the standard.
World War I interrupted the way the gold standard worked in practice, as combating countries engaged in financial warfare as well as physical warfare. Afterward, from 1925 to 1931, the world saw the gold standard return as the Gold Exchange Standard (Reconstructed Gold Standard). That agreement saw most countries agreeing to hold gold reserves, U.S. Dollars, or British Pounds as their monetary reserves. The U.S. and U.K. were to act as gates of sorts, holding only gold reserves in an attempt to restabilize world economies. However, France's work to reestablish the Franc eventually undermined the arrangement.
The United States stopped using the gold standard because of the global financial crisis in the early 1930s and the Great Depression. As the Great Depression began, there were international runs on the U.S. Dollar in 1931 and 1932 that added to the financial pressures already ripping apart the U.S. economy. President Roosevelt closed the banks from March 6 to March 13, 1933, calling it a bank holiday due to another run on the gold reserves of the New York Federal Reserve.
During that time, emergency measures were put in place to recoup gold reserves, including requiring banks to exchange their gold for U.S. notes and private citizens to do the same. These events were the unofficial end of the gold standard in the United States. The process of moving to a modified fiat standard continued until the 1970s. However, the lack of a commodity system is still a sore point for many, and new bills are introduced occasionally in an attempt to move the U.S. back to a gold standard.
If the U.S. returned to a gold standard, there would be a period of transition. First, the U.S. would have to determine how much gold each unit of money would be worth in comparison. The U.S. would then have to purchase (or mine) enough gold to back all of the money currently in circulation. When the U.S. left the gold standard, old notes were called in and exchanged for the new fiat money. This process would have to happen again if we returned to a gold standard. The physical commodity backing and exchange are minor concerns compared to economic and monetary policy concerns.
The exchange rate with other countries would likely change based on the price of gold and how much each unit of money was worth in gold weight. The Federal Reserve (the central bank of the U.S.) wouldn't be able to use a monetary policy of directly injecting new cash to stimulate the economy or control interest rates without obtaining gold to back the new funds.
Likewise, a response to a national emergency or war couldn't be funded by just printing more money; gold would have to be obtained to back it. As the U.S. would mine gold, the supply increases, and the value might decrease, creating inflation due to supply increases. People might turn in money for gold when gold prices rose and reduce the money supply.
No major country is currently using a gold standard. However, many countries do keep gold reserves. Some states keep significant reserves, although it is not enough to completely back their economies. The United States still holds a sizeable gold reserve, as do Switzerland, Germany, and Australia. China actively mines more gold to increase its gold reserves as well.
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