The Long Phase-Out of Gold

In this and the next few posts, I will examine how money determines the price level. It seems quite appropriate to start with the silver standard first. Let’s start by assuming that our unit of account is a pound of silver or “PS” for short.

We can define money using various criteria, including the medium of account (MoA), the medium of exchange (MoE), or liquid assets. MoA, I believe, is the most useful definition because it allows us to significantly reduce distractions caused by MoE and focus more quickly on critical issues. Indeed, silver is a MoA, and I will refer to it as such going forward.

The value of the MoA (hereafter referred to as “money”) is equal to 1/PS. Only the silver market determines the price level. In the long run, price level modeling is a microeconomic issue, whereas the macroeconomic effects of price level changes concern the macroeconomy.

When a new silver discovery reduces the supply of silver to the right, the value of silver decreases, and the price level rises inversely. We do not yet have a theory of money quantity; this will be demonstrated later with the fiat money system (although it should be noted that the theory was ironically invented during the commodity money system).

Eventually, the majority of countries shifted the gold standard. Until 1933, the dollar was defined in the United States as 1/20.67 ounces of gold. Because governments do not typically operate gold mines, monetary policy is only one tool in this system, and only this tool can affect changes in gold demand. This can be accomplished in various ways, including altering the amount of gold associated with the paper dollar via discount credits, altering reserve requirements, or conducting Open Market Operations. Reduced demand for gold stimulates the economy and vice versa. Small countries have little influence on the global market price of gold.

If we are under a gold standard, we can speak of a “zero lower bound problem” for gold reserves, which Keynes incorrectly referred to as a liquidity trap. As a result, tightening the money supply is easier than easing because easy money is constrained by the notion that the central bank’s gold demand cannot fall below zero.

The majority of people believe that this is why the United States abandoned the gold standard in 1933. However, the US did not truly abandon the gold standard in 1933; instead, it suspended it indefinitely. It is difficult to say for particular the real issue: perhaps FDR could not inflate the Fed as much as he desired, thereby raising the price of gold and effectively ending it. However, the dollar was fixed in gold again in 1934 and remained so until 1968.

It took 34 years for gold to become completely obsolete, and during this time, the price level increased dramatically. This level of inflation can be attributed to three factors (the first two are directly related to FDR’s decisions, while the third is purely coincidental):

  1. Gold is re-fixed from $1/20.67 to $1/35. Even just this increased the prices by 69%.
  2. The FDR made it illegal for Americans to accumulate gold, which reduced the global demand for gold. Next US presidents lowered the gold/currency ratio.
  3. Most of the demand for gold outside of the USA was from countries in Europe. The Great Depression and WWII exerted abnormal pressure on European economies, causing a dramatic decline in European gold demand.

Whatever the case, US policy in the mid-1960s was so expansionary that the gold standard had to be abandoned. Finally, in 1968, foreigners (other than governments) were prohibited from trading in gold, and the free market price of gold increased to more than $35. The gold standard established itself in history.

Why did it take 34 years to complete this process? When we look back on it today, we cannot fully appreciate how ingrained the gold standard concept was in people’s minds in 1933. Even Keynes opposed a regime of fiat money (instead of that, he proposed an adjustable gold currency). Post-World War II hyperinflation was not forgotten, and any “expert” in 1933 would point to Weimar Germany when discussing the virtues of fiat money.

In 1968, however, the postwar Keynesian model was dominant, and money and everything associated with it was relegated to the background – a situation that would persist until the 1970s demonstrated the currency’s importance.

In the next post, we will develop a fiat currency model. This model will also include a price level determined by supply and demand for the MoA(which is now cash), but several important nuances lead to significantly different policy outcomes.

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