The Gold Standard - Online Tutor, Practice Problems & Exam Prep

The Gold Standard was a monetary system where currency value was directly linked to gold reserves. Countries with more gold had stronger currencies, allowing for fixed exchange rates. For example, if a US dollar was backed by one-third of an ounce of gold, the exchange rate would be $3 for 1 British pound, which was backed by 1 ounce of gold. However, the Gold Standard was abandoned during the Great Depression due to its limitations on monetary policy and control over the money supply, leading to prolonged economic hardships for countries that adhered to it.

The Gold Standard

So before we had our current exchange rate system where the exchange rate fluctuates based on the supply and demand of those currencies, we followed what was called the Gold Standard. Let's go ahead and see what the Gold Standard was. So the gold standard was a system of setting exchange rates based on, what do you think? The amount of gold, right? The amount of gold that a country had. So it was basically thought that the more gold a country had, the more value their currency was worth. So gold coins and paper money were all backed by gold. It was backed by the gold that the country had in its reserves. So the idea was that you could take that gold coin that you had or paper money and you could turn it into the government and you would actually get gold. You would get actual gold for your money. Okay? So you could turn in your money and get actual gold. This is not something you can do anymore, with your paper money. You can go buy gold on the market but you can't just go to a bank and get gold for your money, okay?

So the first country to adopt the gold standard was the United Kingdom. The United Kingdom started the gold standard back in 1816, but few countries followed. As the United Kingdom became more and more of the center of international trade, more countries started to adopt their gold standard. And by 1913, most countries in Europe and the Western Hemisphere had adopted this gold standard. Okay? So most countries had it, basically prior to World War I.

So as an example, just to understand how this gold standard works. Suppose that each US dollar is backed by one-third of an ounce of gold. So that means there's enough gold in the reserves to pay out a third of an ounce for each dollar. And each British pound is backed by 1 ounce of gold. So they have more gold in their reserves to back each of their pounds that they sell for 1 ounce of gold. So if you went to a British bank with a pound, they would give you an ounce of gold. If you went to a US bank with a dollar, they'd give you a third of an ounce. So what would be the exchange rate between US dollars and British pounds? Well, if one-third of an ounce for $1, right? If you get one-third of an ounce of gold for $1 and 1 ounce of gold for each pound, well, that means to get 1 ounce of gold, right? If we multiply this by 3 to get to 1 ounce of gold, let me do that in a different color. Well, it basically means that we need $3 for 1 ounce of gold, right? Obviously, $3 for 1 ounce of gold. So $3 is equal to 1 pound. That would be the exchange rate in this case. So for every $3 you have, you can get 1 Great British pound based on these, this gold standard, right? The amount of gold that each country has.

So the gold standard was used for a little while there, but then the gold standard was abandoned by many countries during the Great Depression. So during the Great Depression in the 1930s, many countries left the gold standard. And the reason was, is that the gold standard gave you a lack of control over the money supply, right? You weren't able to just increase the money supply and do basically, the monetary policy that we learned about in this course. You can't just go ahead and do monetary policy, increase the money supply to lower interest rates, right? You can't do any of those things because each dollar was backed by the gold, right? You needed to have gold to print more money. So by printing more money, the currency would lose its value without more gold to back it up. And it's not so easy to find gold, right? If you know an easy way to go find more gold, you know, go ahead and send me a text message and we'll work out a little deal there. And we'll go ahead and start our own new gold standard together. Okay? So that was a major drawback is no control over the money supply. And what we learned was that the longer a country took to abandon the gold standard, the harder the depression hit them. So the longer a country stayed attached to this gold standard, the depression lasted longer for those countries. And for that reason, no real attempt has been made to reinstate the gold standard, okay? So it was basically abandoned during the Great Depression and it's never been brought back. Okay? So the Gold Standard money was backed by gold and you basically did not have control over your money supply. It was more or less fixed. Alright, let's pause here and let's move on to the next video.

Here’s what students ask on this topic:

What was the Gold Standard and how did it work?

The Gold Standard was a monetary system where the value of a country's currency was directly linked to its gold reserves. Under this system, countries agreed to convert paper money into a fixed amount of gold. For example, if a US dollar was backed by one-third of an ounce of gold, you could exchange $3 for 1 ounce of gold. This system allowed for fixed exchange rates between currencies. The more gold a country had, the stronger its currency. However, the Gold Standard limited a country's ability to control its money supply and conduct monetary policy, which led to its abandonment during the Great Depression.

Why was the Gold Standard abandoned during the Great Depression?

The Gold Standard was abandoned during the Great Depression because it severely limited countries' ability to control their money supply and implement effective monetary policy. Under the Gold Standard, the amount of money a country could issue was directly tied to its gold reserves. This restriction made it difficult to increase the money supply to stimulate the economy, lower interest rates, or combat deflation. As a result, countries that adhered to the Gold Standard experienced prolonged economic hardships. The inability to adjust the money supply to meet economic needs led many countries to abandon the Gold Standard in favor of more flexible monetary systems.

What were the main drawbacks of the Gold Standard?

The main drawbacks of the Gold Standard included a lack of control over the money supply and limited flexibility in monetary policy. Since currency value was tied to gold reserves, countries could not easily increase their money supply to stimulate economic growth or combat deflation. This rigidity made it difficult to respond to economic crises, such as the Great Depression. Additionally, finding and acquiring more gold to back additional currency was challenging. These limitations led to prolonged economic hardships for countries that adhered to the Gold Standard, ultimately resulting in its abandonment.

How did the Gold Standard affect exchange rates between countries?

Under the Gold Standard, exchange rates between countries were fixed based on the amount of gold backing their currencies. For example, if a US dollar was backed by one-third of an ounce of gold and a British pound was backed by 1 ounce of gold, the exchange rate would be $3 for 1 British pound. This fixed exchange rate system provided stability in international trade and investment. However, it also limited countries' ability to adjust their exchange rates in response to economic conditions, contributing to economic rigidity and difficulties during periods of economic stress, such as the Great Depression.

Which country was the first to adopt the Gold Standard and when?

The United Kingdom was the first country to adopt the Gold Standard, doing so in 1816. As the UK became a central hub for international trade, other countries began to follow suit. By 1913, most countries in Europe and the Western Hemisphere had adopted the Gold Standard. This widespread adoption facilitated international trade by providing a stable and predictable exchange rate system. However, the limitations of the Gold Standard, particularly during economic crises like the Great Depression, eventually led to its abandonment by most countries.