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It is a monetary system where a country's currency or paper money has a value directly linked to gold.
This link that the currency had to gold was cut on August 15, 1971, when U.S. President Nixon took the United States off the Gold standard, causing people all over the world to lose faith in paper money.
It was not until 1976 when the link between Gold and currency was restored in Europe since they were being manipulated.
It is estimated that 95% of the money today is not backed by gold or any material.
It is simply a piece of paper with some ink on it or just digits in an electronic account.
History of the Gold Standard
In the 19th century, many European countries followed a bi-metallic standard, typically with gold and silver standards.
Countries would fix their exchange rates relative to other countries using a gold standard as well as fix prices of goods in terms of the currency.
In the 20th century, these countries transitioned from a bimetallic standard to a monometallic gold standard, most notable being Britain. They were soon followed by Canada in 1853.
The United States used a silver standard without any backing of gold until the civil war where the U.S. introduced legal tenders that could be used to redeem government securities for gold or silver coin at face value.
This made paper money equivalent to what was considered a dollar's worth of Gold.
In 1944, the Bretton Woods Agreement was signed, which set rules for commercial and financial relations among major states.
This agreement established the values of all currencies in terms of gold but allowed governments to peg their currency's value to a currency of another country at rates that could be changed periodically.
The agreement also induced countries to convert large holdings of gold into U.S. dollars, while the U.S. government promised to buy and sell gold at $35 per ounce.
Over time, these pegged parities were revised downward in response to pressures on international exchange markets, which reflected the accumulation of vast debts owed by the United States (after its involvement in World War I ) and Germany (with its reparations payments).
Britain attempted to prop up the system by taking over most of the world's gold reserves with the intention of dishing it out gradually as loans to other countries.
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Aspects of the Gold Standard
The ideal goal of the gold standard is to ensure price stability by keeping international exchange rates stable in terms of ounces of gold.
Since gold itself has few uses, what determines its value is its relationship with currency.
This relationship helps to avoid inflation (a sharp decrease in the value of money) and deflation (the reverse).
Under this system, if your country consistently experiences an increase in prices, then there would be a call for your government to print more money.
On the other hand, when prices start to go down, demand for currency will also go down because fewer transactions are taking place, leading to deflation.
If there were no link between paper currency and gold, these problems would become much worse since countries wouldn't be able to control the production of their own currency.
The gold standard works for small and open economies that do not wish to trade in their currencies.
However, it also attempts to set exchange rates relative to a basket of currencies by gold instead of allowing them to adjust their value relative to the shifts and pressures on an individual basis (which may well become impractical).
The problem is that the price system becomes very rigid as one country pegs its currency's value with another even though there are differences in productivity between countries.
This would lead the way for huge capital flows, which could destabilize national economies.
Countries such as France wanted a return to bi-metallic standards where they could print more money if they, but this was opposed by Britain, who wanted the gold standard.
Rules of the Gold Standard
When it was on the gold standard, countries had to follow some rules.
The first rule was that they could only print new money if there were enough gold reserves.
Countries that did not have enough gold reserves would be forced to reduce their money supply by claiming some of the cash in circulation, which would help them save up some more gold.
This would decrease people's purchasing power and so decrease inflation.
However, this method ran the risk of deflation, where prices overall go down because people are saving up instead of spending, which can cause economic depressions.
The second rule is that the money supply must closely match total output (GDP) within an acceptable range.
If output went up, then the money supply should increase with it or vice versa.
For example, in the Great Depression in 1929, there was a decrease in both output and money supply which led to deflation.
The last rule is that if foreign capital flows are too significant, then countries must maintain their exchange rates with other currencies by buying or selling gold.
For example, during the 1930s, when America left the gold standard, France devalued its currency at first to keep its gold reserves high instead of keeping the value of the franc pegged with America's dollar.
However, this failed because France still lost a vast amount of gold reserves.
When countries borrow, they have to pay back interest on the loan. This can be done if their economy grows faster than the interest rate or there is a decrease in the capital borrowed. In reality, countries often borrow without creating enough money so that it exceeds the number of gold reserves by a great deal at low-interest rates, which allows these countries to pay interest on their loans. This is because gold standards give bigger powers to lenders than borrowers. Since all countries obey the same rules, they cannot print money as normal capitalists do.
Pros of the Gold Standard
The gold standard creates a good incentive for countries to become more productive.
If there is a decrease in productivity, then it becomes harder to print money, and so economies will slow down if they don't increase their production.
Countries can make agreements with each other about how much they should produce depending on what effect this would have on people's purchasing power.
The gold standard can be used to help control inflation.
For example, during the early 19th-century, inflation was practically zero while there was a pretty good growth rate in productivity.
Gold standards are more stable because they are only affected by events that are big enough to disrupt total output.
This means that countries do not have to fear an economic crisis as much as before.
Countries can set the rules of the game and keep very good track of any changes in their gold reserves.
They can even print more money as long as there is enough gold to back it up.
Gold standards make trade between countries easier without worrying about changing currency values and fees for exchanging currencies all the time, which makes transactions less expensive.
Countries can hoard gold which allows them to use it as a powerful tool for international deals.
Cons of the Gold Standard
The gold standard is not very flexible and can be biased to creditors.
If a country borrows too much, it may have to cut back, which will slow down its economy and cause deflation.
Countries cannot print money when in debt because they would need to add interest rates to this.
This means that countries like America which has a high debt but also prints money, would not benefit from the gold standard.
Countries cannot set a certain exchange rate between gold and their currency which can be very useful when it comes to emergencies.
If a country needs more money, it has to borrow from other countries or reduce its spending, which will cause economic problems for them in the future.
Countries also have to pay fees if they need to change currencies while trading overseas.
What is the gold standard? It's a great way to hold value in the money your country and citizens held.
Nowadays in the US, our dollar is backed by the shallow words of our politicians.
A gem of a hedge against inflation in a sea of non-valuable dollars is worth taking advantage of.