The Gold Standard

The Gold Standard Lecture 12 – Thursday, 19 October 2011J A Morrison Isaac Newton David Hume 1

Lec 12: The Gold Standard • Intro: Why bother with Gold? • The Gold Standard as an Ideal Type • Breaking the “Rules of the Game” • Brief History of the International Gold Standard • Conclusion 3

Historical Significance • Provides insight into most of monetary history • Integral to First Era of Globalization • Enduring legacies in contemporary system • International Monetary Fund • Distribution of worldwide gold supply 5

Intellectual Significance • Robust alternative to current system of floating ERs • Lessons from First Era of Globalization • Parallels with current crises • China’s “dirty float” • Constraints and opportunities generated by currency union (e.g. Euro) 6

II. THE GOLD STANDARD AS AN IDEAL TYPE • The Gold Standard Rules • Purchasing Power Parity • The Automaticity of the Gold Standard

Remember our understanding of an exchange rate: the valuation between the domestic currency and foreign currency/currencies. 9

In theory, the gold standard (GS) was an exchange rate regime that related the member countries’ currencies through their valuations to gold. 10

Gold as an Intermediary $ £ ¥ € Example: £1 = 1 oz gold = $4.86 11

The gold standard ideal was that all currencies would be freely convertible through gold. This would secure purchasing power parity (PPP).And PPP would ensure complete market integration. 19

Purchasing Power Parity (PPP) • Purchasing power (PP): command over goods and services • $919.50 = 1 oz gold • £639.43 = 1 oz gold • PPP: money enjoys the same purchasing power in every market even after making necessary conversions • Implied PPP (based on gold prices): $1 = £0.695 • PPP can be calculated using any “basket” of goods & services • The Economist uses the Big Mac! 20

PPP versus Market Rates • Implied PPP (from gold prices): $1 = £0.695 • If I can trade $1 for £0.695, I should be able to buy gold at the same “price” in GB and in the US • BUT Market Exchange Rate: $1 = £0.691  Why the difference? Why doesn’t arbitrage eliminate the difference? 21

Let’s go through an example… 22

$499 £429 23

But the market ER is $1 = £0.63So, $499 = £314Yet...iPads cost £429 in London!That’s over £100 more!Why don’t the Brits just buy their iPads here? 24

Well, some do buy them here! But, for many, the costs are greater than just buying it in London. 26

Valuation • Valuation: the relationship between market price and underlying “value” • Different ways to calculate valuation • Stock: price-to-earnings-to-growth (PEG) ratio • Currency: PP versus ER • Over and Under • Overvalued: currency purchases less than ER implies (PP < ER) • Undervalued: currency purchases more than ER implies (PP > ER) 27

The GS was meant to automatically ensure both the quantity of money in the world and the distribution of money around the world. 29

GS Regulation of Quantity • Official/Mint Price: price of gold in terms of local currency • Free Conversion: monetary authority should… • Purchase gold with currency at the official price • Sell gold for currency at the official price • Automatic Quantity Adjustment • Overvalued currency  sell currency for gold  decrease in currency and increase of gold • Undervalued currency  sell gold for currency  increase in currency and decrease in gold • Sustained increases in gold price  mining 30

By regulating the quantity of currency automatically, adherence to the GS would theoretically ensure domestic price stability.After all, if the official ER did not match the PPP, currency/gold would be converted. 31

What about the distribution of gold? Who gets how much gold? 32

Rise in US Prices Excess Gold in US US Imports Increase; Exports Decrease US Prices Fall; BoT Equilibrates US Exports Gold GS Regulation of Distribution • David Hume’s Price-Specie-Flow Model • Assume: costless int’l transport & conversion 33

Despite these advantages, policymakers have frequently found it in their interest to bend the “rules of the gold standard game”… 34

As a formal matter, being on the GS required two things:(1) maintain exchange rate stability (“gold parity”);(2) maintain convertibility between domestic currency gold... 12

(1) Maintain Exchange Rate Stability (“gold parity”) --> the monetary authority commits to doing everything in its power to ensure that the market ER with gold remains at the predetermined, official “parity.” 12

(2) Maintain Convertibility between Domestic Currency & Gold. --> No restrictions on the purchase/sale of domestic currency/gold. No restrictions on the import/export of gold or currency.

But remember the balance of payments constraint.States only have a few ways to reconcile imbalances of payments...

Remember this slide? Lecture 6: Balance of Payments (Slide #38) 38

Following the gold standard rules precludes two… 41

Reconciling the BoP under the Gold Standard • Adjustment of Reserves • Adjustment of Internal Prices & Incomes • Exchange Rate (ER) Adjustment • Exchange Controls • Capital Controls: Limit convertibility • Commercial Policy 15

Bracketing option 1 (adjusting reserves), states face a difficult choice between:(2) allow price-specie-flow to dictate changes in domestic macroeconomic conditions; (4.2) use commercial policy (tariffs, subsidies, &c.) 40

These are the “golden fetters” that have put policymakers in a “golden straightjacket.” 41

But why can’t they just adjust reserves? 42

Remember the asymmetric positions of deficit and surplus countries:Surplus countries can accumulate reserves ad infinitum. While deficit countries will eventually exhaust their reserves. 42

IV. BREAKING THE RULES OF THE GAME • Deficit Countries • Surplus Countries

Deficit countries have frequently violated the two formal “rules of the gold standard game.” 44

Exchange Rate Adjustment • Specie: Change quantity of precious metal in coins • Backed currency: Adjustment of official exchange rate • Fixed fiat currency: Shift in “target” market rate 45

Limitations on Convertibility • Restrictions on market exchange, foreign investment, and import/export of currency (e.g. China today) • Government imposed costs on conversion • Fees to convert currency via monetary authority • Restrictions on conversion (e.g. delay at the mint) • Tax on capital movement (e.g. Tobin tax) 46

IV. BREAKING THE RULES OF THE GAME • Deficit Countries • Surplus Countries

Sterilized Intervention • Intervention: government maintains stable market ER by selling domestic currency in exchange for foreign currency • Foreign currency is then held in reserve • Sterilization: government counters inflation by buying excess domestic currency with government debt (open market operations) • Sterilized Intervention: intervention + sterilization 49

The result is that the exchange rate remains stable, domestic prices and incomes remain stable, and the government simply amasses foreign reserves.This saves the surplus country from having to adjust today.It also provides reserves for a “rainy day” in the future. 50

The sky is the limit! Inflation countered by sterilization Maintained through intervention Surplus Countries under the Gold Standard • Adjustment of Reserves • Adjustment of Internal Prices & Incomes • Exchange Rate (ER) Adjustment • Exchange Controls • Capital Controls: Limit convertibility • Commercial Policy 51

But it also shifts the burden of adjustment entirely onto the shoulders of the deficit country.And it creates competition for reserves. 52

This is what the US and France did in the 1920s.And this is largely what China is doing today. 53

The Gold Standard