One of the gold standard’s major benefits is that the adjustment of the price level and output to an external imbalance is completely automatic. All that a country must do is fix its currency in relation to gold. Once a country has stated the gold content of its currency, all it needs to be willing to do is to buy or sell its currency (gold) at that stated price. The international monetary system then can be put on autopilot, so to speak. This is not much of an exaggeration. For most of the period that the U.S. adopted the gold standard, it had no central bank. The Second Bank of the United States was closed in 1837 and the modern Federal Reserve was created in 1913. Throughout this time period, there was virtually nothing that could be called a discretionary monetary policy in the U.S. In some senses, this automatic feature of the gold standard was very comforting because there was not any question about what would happen to a country if it had a balance of payments imbalance.

A second benefit of the gold standard was that it provided an anchor and, therefore, long-run price stability for a country. For example, the average rate of inflation for the U.S. under the gold standard was 0.1 percent per annum. In the case of the U.K. prices actually declined throughout the period (deflation). Compared to the current inflationary environment, this result is almost beyond belief. However, what proponents of the gold standard tend to forget is the short run. The gold standard most assuredly does not guarantee short-run price stability. From one year to the next, prices in a gold-standard world varied substantially. In particular, the character of the price changes under the gold standard was different from our more recent experience. In the postWorld War II era, prices have varied but, on average, nearly always increase. The only remaining question is by how much? Under a gold standard, prices within a country may increase (inflation) some years and decrease (deflation) in others. The overall price level is relatively stable over a long period of time but it may vary substantially from one year to the next. In other words, deflation was just about as common as inflation. All of us are aware of the discomforts (costs) of inflation. However, the discomforts of a deflationary period are just as bad. When describing the benefit of the gold standard’s ability to ensure price stability, one has to be careful. In the long run it does have that effect, but in the short run one must realize that prices can and will fluctuate.

In summary, the gold standard has two major benefits as an international monetary system. This system also has one extremely large cost for the countries that adopt it. Under this system, the overall balance of payments position heavily influences a country’s money supply. A current account deficit can mean a contracting money supply and a contracting economy. However, a current account surplus can mean an overheated economy coupled with inflation. For example, under the gold standard the U.S. averaged a 1.4 percent increase in real per capita income per year. While GDP growth on average was healthy, the deviation from the average was relatively large. The gold standard guaranteed completely fixed exchange rates, but a large part of the system’s cost was an extremely unstable GDP growth rate.1



World War I essentially ended the international monetary system based on the gold standard. Between the end of that war and the Great Depression, governments periodically tried to revive the gold standard. These attempts invariably failed. In some sense, the period from 1914 to 1946 was similar to the current international monetary system, which is to say not much of a “system” at all. However, the governments’ desire for some form of international monetary system was still strong. This desire led to a conference in Bretton Woods, New Hampshire, in July of 1944. At this conference, forty-four countries essentially created a new international monetary system. This system usually is described as the “Bretton Woods” system.2 More precisely, this system is technically the gold-exchange standard. In this system, the U.S. dollar was tied to gold but all other currencies were tied to the dollar. In addition, the countries agreed to the creation of a new international monetary institution known as the International Monetary Fund (IMF). In this section, we consider how the Bretton Woods system functioned. Since this system and the IMF are inextricably bound together, we will also consider how the IMF played a key role in the operation of the international monetary system.

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