Back to Basics, Pt. 1: 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.

When defining money, we can use many different criteria such as the medium of account(MoA), the medium of exchange(MoE), or liquid assets. I believe MoA is the most useful definition because we will significantly set aside the distractions that MoE can create and focus more quickly on important issues. Indeed, silver itself is an MoA, and I will use this term from now on.

The value of the MoA(let’s call this “money” hereinafter) is equal to 1/PS. The price level is determined only in the silver market. The modeling of the price level is a microeconomic issue in the long run, whereas the effects of changes in the price level concern the macroeconomy.

In our classic model, when a new silver discovery is made that shifts the silver supply to the right, the value of the silver will decrease and the price level will rise inversely with this. We don’t have a money quantity theory yet; we’ll see this later with the fiat money system(although it should be noted that the theory was ironically invented during the period of the commodity money system).

Ultimately, most countries have passed the gold standard. In the US, the dollar was defined as 1/20.67 ounces of gold until 1933. Governments do not usually operate gold mines, so monetary policy in this system is just one tool and only this tool can affect changes in gold demand. This can be done differently, such as changing the amount of gold associated with the paper dollar using discount credits, changing reserve requirements, or Open Market Operations. Less demand for gold is expansionary and vice versa. Small countries obviously have little influence on the value of gold set in global markets.

If we are under a gold standard, we can speak of a kind of “zero lower bound problem” for gold reserves, which Keynes incorrectly called a liquidity trap. For this reason, tightening the money is easier to do than easing, because the easy money is constrained by the idea that the central bank’s demand for gold cannot fall below zero.

Most people think that this is why the US left the gold standard in 1933. But the US did not really abandon the gold standard in 1933, it just suspended it temporarily. It is difficult to say with certainty what the real problem is: perhaps the FDR could not inflate the Fed as much as it wanted, thus raising the price of gold, putting an end to it. However, the dollar was fixed again in gold in 1934, and this continued until 1968.

It took 34 years for gold to be completely obsolete, and there was a huge increase in the price level during this period. This degree of inflation can be attributed to three factors(the first two are related to FDR’s decisions, and the third is pure coincidence):

  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.

Regardless, in the mid-1960s US policy was so expansionary that the gold standard had to be abandoned. Finally, in 1968, foreigners(other than governments) trading in gold was stopped and the free market price of gold rose above $35. The gold standard took its place in history.

Why did this whole process take 34 years? When we look at it today, we cannot fully grasp how deep the idea of the gold standard was in people’s minds in 1933. Even Keynes was vehemently opposed to a pure fiat currency regime(instead of that, he proposed an adjustable gold currency). Post-WWI hyperinflation was not forgotten, and if you talk about the virtues of fiat money in 1933, any “expert” would show you Weimar Germany. 

In 1968, however, the post-war Keynesian model was dominant, and money and everything connected to it was almost completely pushed to the background – this would continue until the 1970s showed people its 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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