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THE CLASSICA

GOLD STANDARSYSTEM

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The gold standardmonetary system in whicstandard economic uni

account is based on a quantity of gold.

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A commitment b

participating countries tfix the prices of the

domestic currencies terms of a specifieamount of gold.

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Why GOLD?GOLD has the desirable properties

that early writers in economics haveIt is durable, easily standardized. Eimportant, changes in its stock are least in the short run, by high

production, making it costly for govemanipulate. Because of these attributes, it emerged as one of thforms of money.

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CLASSICAL GOLD STANDA1875-

1914

During this period in most major cou Gold alone was assured of unr

coinage

There was two-way convertibility gold and national currencies at a stab

Gold could be freely exported or imp

The exchange rate between two cocurrencies would be determined brelative gold contents.

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For example, if the dollar is peggto gold at U.S.$30 = 1 ounce of go

and the British pound is peggedgold at 6 = 1 ounce of gold, it mbe the case that the exchange ratedetermined by the relative g

contents:$30 = 6

$5 = 1

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Highly stable exchange rates underthe classical gold standard providedan environment that was conducive

to international trade andinvestment.

Misalignment of exchange rates andinternational imbalances of paymentwere automatically corrected by the

price-specie-flow mechanism.

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The price-level adjustment mechaunder the gold standard is know

as the

price-specieautomatic adjustment mechanism

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Price specie flow mechanism is adjustment of prices as gold (spe

flows into or out of a country, causinadjustment in the flow of goods.

An inflow of gold tends to inflaprices.

An outflow of gold tends to deprices.

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Thus, price specie flow mecha

of the gold standard could recurrent account surpluses deficits, achieving a measu

external balance for all countrie

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There are shortcomings:

The supply of newly minted gold is so res

that the growth of world trade and investmcan be hampered for the lack of sufficientmonetary reserves.

Even if the world returned to a gold stand

any national government could abandon tstandard.

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The policy of not allowinga change in reservesto change supply of money

is known asSTERILIZATION or NEUTRALIZATION P

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The gold standard broke

down at the outset of WorldWar I, as countries resortedto inflationary policies to

finance the war and, later,the reconstruction efforts.

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The EN