So the gold standard is something that often comes up when you read about the actions of central banks. If you see a story regarding interest rates or quantitative easing you will likely see a comments section filled with posts saying Oh my god! Why don’t we just go back to the gold standard and it will fix everything?!
I am going to address this in two posts because it seems like a topic that will not go away. (I know my posts have been few and far between but I will make a best effort to have this done within a week) Today’s post will set up the terminology and background while the second post will contain the main discussion of the topic.
Let’s start by asking a question. What is money? This is not a trick question, I assure you. I will leave out discussions on fractional reserve banking creating money, M1 vs M2 money and that sort of thing. We are going to stick strictly to the classic definition. Money is:
- A Medium of Exchange
- Story of Value
- A unit of account
A Medium of Exchange
Money makes exchanging goods with others easier. Without some form of money then all transactions would need to take place using the barter system. The barter system is great if person 1 grows apples and wants oranges while person 2 grows oranges but wants apples. When this occurs it is called the double coincidence of wants and it is really the only time barter systems work. Let us look at a second situation now.
Person 1 grows apples and wants oranges.
Person 2 grows oranges and wants bananas.
Person 3 grows bananas and wants apples.
In this case there is no coincidence of wants and the people cannot barter with each other directly. What happens for example is person one trades apples for bananas and then trades the bananas for oranges. He does not want the bananas and uses them as a medium of exchange. Money a universal medium of exchange and saves people the trouble of finding a chain of other producers to finally get what they wanted in the first place.
Store of Value
This one is straight forward. If I make apples and sell them but there is nothing I want to buy right away I store the value of those apples in money. Sure, money loses a bit of value from inflation but it has the advantage over other methods of storing values because it is highly liquid. It can be accessed easily, it is accepted everywhere and is easily moved around.
A Unit of Account
This means that money is used to measure the value of goods with a consistent unit. In our previous example you might be able to come up with an exchange rate between apples and orange fairly quickly but what about apples to iron ore? It is not practical to measure iron ore prices in apples so we can use money as a common indicator of value for all goods.
Bored yet? No? You will be…
Now that we know what money is, we will establish what we mean exactly when we use the term gold standard. There are variations of the gold standard but for this post I will stick to a common definition. A country is said to be on the gold standard if they only issue their national currency in a fixed ratio to the amount of physical gold they have on hand. As I am sure you have seen in various movies, the US dollar use to have text printed on it stating that it was redeemable in gold. This is no longer the case.
Rather than issuing currency based on the amount of physical gold on hand Canada uses the Bank of Canada to issue Canadian dollars(Other countries of course use their own central banks). If this post was instead a conspiracy movie about New World Order or something similar I would likely say the next line very slowly and intensely. They print the money out of thin air! I would then play dark, ominous music. This is called Fiat Currency. It is common practice in developed economies.
This is the end of the setup post. Not exactly exciting stuff I know, but if you made it this far please check back soon. We will look at the different responses an economy might have under a gold standard versus fiat currency. There might even be infographics.