When people travel to foreign countries, they must change their money into foreign
currencies. The same is true when goods are imported. For example, when Americans import
Toyotas, Volkswagens, champagne, or coffee, the dollars paid for these goods must be
exchanged for yen, Deutsche marks, francs, or pesos. In April 1983 a United States dollar was
valued in the foreign exchange markets at 238 Japanese yen, 2.4 West German Deutsche
marks, 7.3 French francs, 151 Mexican pesos, and 0.65 British pound. The other way around, a
British pound could be exchanged for $1.58, the peso for less than a cent, the franc for 13
cents, the Deutsche mark for 41 cents, and the yen for less than half a cent.
A foreign exchange rate is a kind of price—the price of one country's currency in terms of
another's. Like all prices, exchange rates rise and fall. If Americans buy more from Japan than
the Japanese buy from the United States, the value of the yen tends to rise in terms of the
dollar. If over the years one country's economy grows faster than another's so that its citizens
become relatively more productive, its currency will rise in terms of the other. A United States
citizen had to exchange five dollars for a British pound in 1936 and only $1.58 in April 1983.
The difference reflected the more rapid economic growth of the United States.
Balance of Payments
Just as a business keeps a balance sheet of its income and expenditures, so most countries
keep track of their currency flows through a balance of payments account. The United States
account shows the payments made to foreigners for goods and services purchased by
Americans. It also shows the payments made by foreigners for American items.
The balance of payments has two main parts: the current account and the capital account.
The current account covers all payments made for goods and services purchased during the
period covered plus transfers of money. The bulk of these are for imports and exports of
merchandise. The difference between the values of imports and exports of merchandise is
called the balance of trade. A negative balance of trade means that the country is importing
more goods than it exports. But often a negative balance of trade will be more than offset by
net receipts from investments abroad, sales of services, and other “invisibles.” This makes it
possible to have a positive balance of payments despite a negative balance of trade. For
example, if an American company sells insurance to foreigners, or transports foreign goods,
the payments will be counted as exports of services. In the first quarter of 1982, the United
States balance of trade was a negative 5.9 billion dollars, but net receipts from services plus
income from investments amounted to more than 9 billion dollars. Even after subtracting gifts
and transfers of money to foreigners, there was a positive balance on the current account of
about 1.1 billion dollars.
The other main part of the balance of payments is the capital account. This is a record of
investments and loans that flow from one country to another. If a United States company buys
a factory in France, dollars must be converted into francs. This is called an export of capital,
but it is treated in the balance of payments as a negative item. On the other hand, if a French
investor buys United States bonds, francs will be exchanged for dollars—a positive item in the
balance of payments. In the first quarter of 1982, the United States balance on the capital
account was a negative 6.1 billion dollars.
The Gold Standard
Before World War I the currencies of most countries were based on gold. That is, even though
they used paper money and silver coins, the governments of these countries stood ready to
exchange their currency for gold at specified rates. When a country's imports exceeded its
exports, it paid for the extra imports with shipments of gold. When its imports were less than
its exports, it received gold from other countries. Gold flowing into a country increased the
money supply and caused prices to rise, while gold flowing out of a country had the opposite
effect. These changes in prices tended to restore the balance of trade, since a country with
rising prices found it more difficult to sell goods abroad while a country with falling prices had
an advantage in international competition.
The Bretton Woods System
The international gold standard was abandoned during World War I. Efforts were made to
revive it after the war but without much success. Toward the end of World War II, a new
international monetary system was established at the Bretton Woods, N.H., conference in
1944. The system was based on fixed exchange rates as under the gold standard but differed in
that countries faced with a trade deficit could borrow from the International Monetary Fund
(IMF) instead of relying on their gold reserves. The IMF held reserves of gold and currencies
and lent them to these countries.
The Bretton Woods system worked fairly well in the late 1940s and the 1950s. During those
years the United States dollar was strong. The United States Treasury had most of the world's
gold and was prepared to pay foreigners 35 dollars per ounce for additional gold. Dollars
became a sort of international currency because they were readily accepted in payment for
goods and services throughout the world. The era of the dollar ended, however, in the 1970s.
The economies of other countries had grown stronger, while inflation had made the dollar less
desirable abroad. In August 1971, because of balance of payments difficulties, the United
States stopped exchanging dollars for gold. This was the end of the fixed exchange rate
After 1973 a flexible system developed. Countries allowed their exchange rates to fluctuate in
response to changing conditions. The Swiss franc rose against the dollar—from 21 cents in 1972
to 60 cents in 1979—and declined to 49 cents in 1982. Over the same period the British pound
fell against the dollar—from $2.50 to $1.75. In the 1970s the dollar fell against strong
currencies such as the Swiss, the Japanese, and the West German.
Exchange rates, however, are not completely free to float; governments try to prevent them
from fluctuating widely because wide fluctuations discourage international trade. For
example, if the dollar depreciates by more than 10 percent in a short period, the United States
government is likely to draw upon its reserves and buy dollars in the foreign exchange market
to raise their price. Governments can increase their reserves by drawing upon the International
Monetary Fund and by borrowing from other governments.
The gold standard was a commitment by participating countries to fix the prices
of their domestic currencies in terms of a specified amount of gold. National
money and other forms of money (bank deposits and notes) were freely
converted into gold at the fixed price. England adopted a de facto gold standard
in 1717 after the master of the mint, Sir Isaac Newton, overvalued the guinea in
terms of silver, and formally adopted the gold standard in 1819. The United
States, though formally on a bimetallic (gold and silver) standard, switched to
gold de facto in 1834 and de jure in 1900 when Congress passed the Gold
Standard Act. In 1834, the United States fixed the price of gold at $20.67 per
ounce, where it remained until 1933. Other major countries joined the gold
standard in the 1870s. The period from 1880 to 1914 is known as the classical
gold standard. During that time, the majority of countries adhered (in varying
degrees) to gold. It was also a period of unprecedented ECONOMIC GROWTH with
relatively FREE TRADE in goods, labor, and capital.
The gold standard broke down during World War I, as major belligerents
resorted to inflationary finance, and was briefly reinstated from 1925 to 1931 as
the Gold Exchange Standard. Under this standard, countries could hold gold or
dollars or pounds as reserves, except for the United States and the United
Kingdom, which held reserves only in gold. This version broke down in 1931
following Britain’s departure from gold in the face of massive gold and capital
outflows. In 1933, President Franklin D. Roosevelt nationalized gold owned by
private citizens and abrogated contracts in which payment was specified in gold.
Between 1946 and 1971, countries operated under the Bretton Woods system.
Under this further modification of the gold standard, most countries settled their
international balances in U.S. dollars, but the U.S. government promised to
redeem other central banks’ holdings of dollars for gold at a fixed rate of thirty-
five dollars per ounce. Persistent U.S. balance-of-payments deficits steadily
reduced U.S. gold reserves, however, reducing confidence in the ability of the
United States to redeem its currency in gold. Finally, on August 15, 1971,
President Richard M. Nixon announced that the United States would no longer
redeem currency for gold. This was the final step in abandoning the gold
Widespread dissatisfaction with high INFLATION in the late 1970s and early
1980s brought renewed interest in the gold standard. Although that interest is
not strong today, it seems to strengthen every time inflation moves much above
5 percent. This makes sense: whatever other problems there were with the gold
standard, persistent inflation was not one of them. Between 1880 and 1914, the
period when the United States was on the “classical gold standard,” inflation
averaged only 0.1 percent per year.
How the Gold Standard Worked
The gold standard was a domestic standard regulating the quantity and growth
rate of a country’s MONEY SUPPLY. Because new production of gold would add
only a small fraction to the accumulated stock, and because the authorities
guaranteed free convertibility of gold into nongold money, the gold standard
ensured that the money supply, and hence the price level, would not vary much.
But periodic surges in the world’s gold stock, such as the gold discoveries in
Australia and California around 1850, caused price levels to be very unstable in
the short run.
The gold standard was also an international standard determining the value of a
country’s currency in terms of other countries’ currencies. Because adherents to
the standard maintained a fixed price for gold, rates of exchange between
currencies tied to gold were necessarily fixed. For example, the United States
fixed the price of gold at $20.67 per ounce, and Britain fixed the price at £3 17s.
10½ per ounce. Therefore, the exchange rate between dollars and pounds—the
“par exchange rate”—necessarily equaled $4.867 per pound.
Because exchange rates were fixed, the gold standard caused price levels
around the world to move together. This comovement occurred mainly through
an automatic balance-of-payments adjustment process called the price-specie-
flow mechanism. Here is how the mechanism worked. Suppose that a
technological INNOVATION brought about faster real economic growth in the
United States. Because the supply of money (gold) essentially was fixed in the
short run, U.S. prices fell. Prices of U.S. exports then fell relative to the prices of
imports. This caused the British to DEMAND more U.S. exports and Americans to
demand fewer imports. A U.S. balance-of-payments surplus was created,
causing gold (specie) to flow from the United Kingdom to the United States. The
gold inflow increased the U.S. money supply, reversing the initial fall in prices.
In the United Kingdom, the gold outflow reduced the money supply and, hence,
lowered the price level. The net result was balanced prices among countries.
The fixed exchange rate also caused both monetary andnonmonetary (real)
shocks to be transmitted via flows of gold and capital between countries.
Therefore, a shock in one country affected the domestic money supply,
expenditure, price level, and real income in another country.
The California gold discovery in 1848 is an example of a monetary shock. The
newly produced gold increased the U.S. money supply, which then raised
domestic expenditures, nominal income, and, ultimately, the price level. The rise
in the domestic price level made U.S. exports more expensive, causing a deficit
in the U.S. BALANCE OF PAYMENTS. For America’s trading partners, the same
forces necessarily produced a balance-of-trade surplus. The U.S. trade deficit
was financed by a gold (specie) outflow to its trading partners, reducing the
monetary gold stock in the United States. In the trading partners, the money
supply increased, raising domestic expenditures, nominal incomes, and,
ultimately, the price level. Depending on the relative share of the U.S. monetary
gold stock in the world total, world prices and income rose. Although the initial
effect of the gold discovery was to increase real output (because wages and
prices did not immediately increase), eventually the full effect was on the price
For the gold standard to work fully, central banks, where they existed, were
supposed to play by the “rules of the game.” In other words, they were
supposed to raise their discount rates—the interest rate at which the central
bank lends money to member banks—to speed a gold inflow, and to lower their
discount rates to facilitate a gold outflow. Thus, if a country was running a
balance-of-payments deficit, the rules of the game required it to allow a gold
outflow until the ratio of its price level to that of its principal trading partners
was restored to the par exchange rate.
The exemplar of central bank behavior was the Bank of England, which played
by the rules over much of the period between 1870 and 1914. Whenever Great
Britain faced a balance-of-payments deficit and the Bank of England saw its gold
reserves declining, it raised its “bank rate” (discount rate). By causing
other INTEREST RATES in the United Kingdom to rise as well, the rise in the bank
rate was supposed to cause the holdings of inventories and
other INVESTMENT expenditures to decrease. These reductions would then cause
a reduction in overall domestic spending and a fall in the price level. At the same
time, the rise in the bank rate would stem any short-term capital outflow and
attract short-term funds from abroad.
Most other countries on the gold standard—notably France and Belgium—did not
follow the rules of the game. They never allowed interest rates to rise enough to
decrease the domestic price level. Also, many countries frequently broke the
rules by “sterilization”—shielding the domestic money supply from external
disequilibrium by buying or selling domestic securities. If, for example, France’s
central bank wished to prevent an inflow of gold from increasing the nation’s
money supply, it would sell securities for gold, thus reducing the amount of gold
Yet the central bankers’ breaches of the rules must be put into perspective.
Although exchange rates in principal countries frequently deviated from par,
governments rarely debased their currencies or otherwise manipulated the gold
standard to support domestic economic activity. Suspension of convertibility in
England (1797-1821, 1914-1925) and the United States (1862-1879) did occur
in wartime emergencies. But, as promised, convertibility at the original parity
was resumed after the emergency passed. These resumptions fortified the
credibility of the gold standard rule.
Performance of the Gold Standard
As mentioned, the great virtue of the gold standard was that it assured long-
term price stability. Compare the aforementioned average annual inflation rate
of 0.1 percent between 1880 and 1914 with the average of 4.1 percent between
1946 and 2003. (The reason for excluding the period from 1914 to 1946 is that
it was neither a period of the classical gold standard nor a period during which
governments understood how to manage MONETARY POLICY.)
But because economies under the gold standard were so vulnerable to real and
monetary shocks, prices were highly unstable in the short run. A measure of
short-term price instability is the coefficient of variation—the ratio of the
standard deviation of annual percentage changes in the price level to the
average annual percentage change. The higher the coefficient of variation, the
greater the short-term instability. For the United States between 1879 and
1913, the coefficient was 17.0, which is quite high. Between 1946 and 1990 it
was only 0.88. In the most volatile decade of the gold standard, 1894-1904, the
mean inflation rate was 0.36 and the standard deviation was 2.1, which gives a
coefficient of variation of 5.8; in the most volatile decade of the more recent
period, 1946-1956, the mean inflation rate was 4.0, the standard deviation was
5.7, and the coefficient of variation was 1.42.
Moreover, because the gold standard gives government very little discretion to
use monetary policy, economies on the gold standard are less able to avoid or
offset either monetary or real shocks. Real output, therefore, is more variable
under the gold standard. The coefficient of variation for real output was 3.5
between 1879 and 1913, and only 0.4 between 1946 and 2003. Not
coincidentally, since the government could not have discretion over monetary
policy, UNEMPLOYMENT was higher during the gold standard years. It averaged
6.8 percent in the United States between 1879 and 1913, and 5.9 percent
between 1946 and 2003.
Finally, any consideration of the pros and cons of the gold standard must include
a large negative: the resource cost of producing gold. MILTON
FRIEDMAN estimated the cost of maintaining a full gold coin standard for the
United States in 1960 to be more than 2.5 percent of GNP. In 2005, this cost
would have been about $300 billion.
Although the last vestiges of the gold standard disappeared in 1971, its appeal is
still strong. Those who oppose giving discretionary powers to the central bank
are attracted by the simplicity of its basic rule. Others view it as an effective
anchor for the world price level. Still others look back longingly to the fixity of
exchange rates. Despite its appeal, however, many of the conditions that made
the gold standard so successful vanished in 1914. In particular, the importance
that governments attach to full employment means that they are unlikely to
make maintaining the gold standard link and its corollary, long-run price
stability, the primary goal of economic policy.
The Bretton Woods system
It was clear during the Second World War that a new international system would be
needed to replace the Gold Standard after the war ended. The design for it was
drawn up at the Bretton Woods Conference in the US in 1944. US political and
economic dominance necessitated the dollar being at the centre of the system. After
the chaos of the inter-war period there was a desire for stability, with fixed exchange
rates seen as essential for trade, but also for more flexibility than the traditional Gold
Standard had provided. The system drawn up fixed the dollar to gold at the existing
parity of US$35 per ounce, while all other currencies had fixed, but adjustable,
exchange rates to the dollar. Unlike the classical Gold Standard, capital controls
were permitted to enable governments to stimulate their economies without suffering
from financial market penalties.
During the Bretton Woods era the world economy grew rapidly. Keynesian economic
policies enabled governments to dampen economic fluctuations, and recessions
were generally minor. However strains started to show in the 1960s. Persistent,
albeit low-level, global inflation made the price of gold too low in real terms. A
chronic US trade deficit drained US gold reserves, but there was considerable
resistance to the idea of devaluing the dollar against gold; in any event this would
have required agreement among surplus countries to raise their exchange rates
against the dollar to bring about the needed adjustment. Meanwhile, the pace of
economic growth meant that the level of international reserves generally became
inadequate; the invention of the ‘Special Drawing Right’ (SDR)
failed to solve this
problem. While capital controls still remained, they were considerably weaker by the
end of the 1960s than in the early 1950s, raising prospects of capital flight from, or
speculation against, currencies that were perceived as weak.
In 1961 the London Gold Pool was formed. Eight nations pooled their gold reserves
to defend the US$35 per ounce peg and prevent the price of gold moving upwards.
This worked for a while, but strains started to emerge. In March 1968, a two-tier gold
market was introduced with a freely floating private market, and official transactions
at the fixed parity. The two-tier system was inherently fragile. The problem of the US
deficit remained and intensified. With speculation against the dollar intensifying,
other central banks became increasingly reluctant to accept dollars in settlement; the
situation became untenable. Finally in August 1971, President Nixon announced that
the US would end on-demand convertibility of the dollar into gold for the central
banks of other nations. The Bretton Woods system collapsed and gold traded freely
on the world’s markets.
The Bretton Woods System
Nations attempted to revive the gold standard following World War I, but it collapsed entirely
during the Great Depression of the 1930s. Some economists said adherence to the gold
standard had prevented monetary authorities from expanding the money supply rapidly enough to
revive economic activity. In any event, representatives of most of the world's leading nations met
at Bretton Woods, New Hampshire, in 1944 to create a new international monetary system.
Because the United States at the time accounted for over half of the world's manufacturing
capacity and held most of the world's gold, the leaders decided to tie world currencies to the
dollar, which, in turn, they agreed should be convertible into gold at $35 per ounce.
Under the Bretton Woods system, central banks of countries other than the United States were given the
task of maintaining fixed exchange ratesbetween their currencies and the dollar. They did this by
intervening in foreign exchange markets. If a country's currency was too high relative to the
dollar, its central bank would sell its currency in exchange for dollars, driving down the value of its
currency. Conversely, if the value of a country's money was too low, the country would buy its
own currency, thereby driving up the price.
The Bretton Woods system lasted until 1971. By that time, inflation in the United States and a growing
American trade deficit were undermining the value of the dollar. Americans urged Germany and Japan,
both of which had favorable payments balances, to appreciate their currencies. But those nations
were reluctant to take that step, since raising the value of their currencies would increases prices
for their goods and hurt their exports. Finally, the United States abandoned the fixed value of the
dollar and allowed it to "float" -- that is, to fluctuate against other currencies. The dollar promptly
fell. World leaders sought to revive the Bretton Woods system with the so-called Smithsonian
Agreement in 1971, but the effort failed. By 1973, the United States and other nations agreed to
allow exchange rates to float.
Economists call the resulting system a "managed float regime," meaning that even thoughexchange
rates for most currencies float, central banks still intervene to prevent sharp changes. As in 1971,
countries with large trade surpluses often sell their own currencies in an effort to prevent them
from appreciating (and thereby hurting exports). By the same token, countries with
large deficits often buy their own currencies in order to prevent depreciation , which raises domestic
prices. But there are limits to what can be accomplished through intervention, especially for
countries with large trade deficits. Eventually, a country that intervenes to support its currency
may deplete its international reserves, making it unable to continue buttressing the currency and
potentially leaving it unable to meet its international obligations.