[[The Gold Standard and the Development of the International Monetary Standard

Question 1

What was the Gold Standard and how did it operate?

Answer 1

Solution to allow multilateral settlements between trading countries in globalised world -> all participants could accept each other’s currencies at fixed exchange rate by pegging their currencies to a fixed amount of gold -> if two countries were on the Gold Standard, exchange rate between their currencies: fixed -> first global financial system emerged -> why its referred to as the ‘first era of financial globalisation’

Operation: each currency was worth a fixed amount of gold -> every country committed to convert its currency into gold at fixed parity -> exchange rate between two countries under the Gold Standard was essentially fixed

Question 2

What was the role of capital flows before 1914?

Question 3

What is the system of multilateral settlement?

Answer 3

Participating countries could accept each other’s currencies at a fixed exchange rate (gold)

Question 4

What were the factors that underpinned the successful operation of Gold Standard on both national and international levels?

Answer 4

1. Price-specie-flow mechanism
2. ‘Rules of the game’
   Ensured balance of payments (BOP) equilibrium
3. Multilateral settlement mechanism
4. Overseas investment
5. Key factors: (1) priority attached to convertibility, (2) role of Britain and (3) cooperation between core countries and London acting as a world banker

Question 5

What is the price-specie-flow mechanism?

Answer 5

Model developed by Scottish economist David Hume (1711–1776) to illustrate how trade imbalances can self-correct and adjust under the gold standard

Process of adjustment that prevents persistent Balance of Payment (BOP) deficit occurring

Rule that told central banks procedure if they chose to subject themselves to discipline of price-specie-flow mechanism

Example: USA has BOP deficit (imports > exports) -> pays for excess imports with gold -> stock of USA gold falls -> money = gold, USA money supply also falls -> reduces price of USA-produced goods -> more competitive domestically and abroad -> USA citizens buy domestically produced goods more -> reduces imports -> Foreigners buy more USA-produced goods -> raises USA exports -> import falls and export rises = BOP deficit disappears -> BOP returns to equilibrium

Effects
If prices & wages: perfectly flexible -> adjustment has no job losses (although real wages fall)
But, prices & wages =/ perfectly flexible -> price-specie-flow mechanism: can’t work quickly nor perfectly

Monetary variable that played part of an adjustment mechanism: money supply

Question 6

What is ‘rules of the game’?

Answer 6

Unwritten set of guidelines that central bankers were supposed to follow to speed up the adjustment process

If country is losing gold -> increase interest rate at central bank -> increase interest rate across the whole economy -> fall in investment and output -> fall in domestic product price -> increase exports and decrease imports = BOP returns to equilibrium

If country was gaining gold -> decrease interest rate at central bank -> across whole economy -> increase investment and output -> rise in domestic product price -> decrease exports and increase imports = BOP returns to equilibrium

Side-effects:
Lowers output and raises unemployment
But countries were willing to go through it to remain on the Gold Standard

Monetary variable that played part of an adjustment mechanism: interest rates

Question 7

Why does ‘rules of the game’ give national economies more pain than the price-specie-flow mechanism?

Answer 7

Because when the country is losing gold, as a ‘rule of the game’ it will increase its interest rate across the whole economy, causing reducement in output which leads to unemployment
Whereas in price-specie-flow mechanism, although the real wages do fall, the relationship between price and wages are more flexible, which will not lead to job losses as bad as applying ‘rules of the game’ by central banks

Question 8

//What is a multilateral settlement mechanism?

Answer 8

Mechanism to finance trade, with trust being a crucial factor for acceptance of a settlement mechanism

Made international trade easier

Question 9

//Why was fixed exchange rates essential for overseas investment?

Answer 9

Removed exchange rate risk faced by investors who bought overseas stocks and shares
If exchange rates fluctuated -> less overseas investment

Question 10

What were the pros of the Gold Standard?

Answer 10

1. Fixed exchange rates at a predictable rate -> stable economic environment
2. Certainty about the future exchange rate for trading and overseas investment -> encouraged trade, international lending and investment
3. Limited decision-making required to operate it (viewed as a self-adjusting system)
4. Important advantage in domestic economies in relation to government finance -> lenders guaranteed that government would honour its debts and no ‘monetary surprises’ -> lenders can lend without fear of inflation -> ‘good housekeeping seal of approval’ (Bordo and Rockoff, 1996)
5. ‘seal of approval’
   (1) important for peripheral countries e.g. Greece and Argentina had BOP problems -> forced them to leave Gold Standard -> But when they needed international loans, returned to Gold Standard -> made commitment to repaying loans more credible
   (2) out-lasted wars -> not expected that countries stay on Gold Standard in wartime because had to borrow to finance the war -> once war was over, expected that countries return to the Gold Standard ASAP
   i.e. government not expected to honour debts in wartime, but eventually government would go back to Gold Standard -> eliminate inflation -> honour commitments made before the war

Question 11

What were the cons of the Gold Standard?

Answer 11

1. Constrained US federal government -> limited money printing
2. Effects: deflationary -> national economies grew faster than gold stocks -> places downward pressure on prices of goods and service & wages -> 2 out of 3 macroeconomic policy trilemma can only be valued over independent monetary policy until vote got extended, bc workers don’t want government to reduce output and employment to ensure a fixed exchange rate

Question 12

How important was Gold Standard for sparking the first phase of globalisation?

Answer 12

Debated between those who see it offering ‘a good housekeeping seal of approval’ encouraging investment in peripheral countries and those who think investors focused more on debt burdens

Question 13

Why did the Gold Standard system work well in 1870-1914?

Answer 13

Because of the priority attached to (1) convertibility, (2) international solidarity and (3) cooperation between countries with Lodnon acting as a world banker

Question 14

//How does the Gold Standard relate to the Macroeconomics trilemma?

Answer 14

Represents 2 of the 3 solutions to the Macroeconomic trilemma -> allowing for fixed exchange rates and free flow of capital but no domestic monetary policy

Question 15

//Macroeconomic policy trilemma

Answer 15

Mundell and Fleming’s model demonstrated: country can have only 2 out of 3 of the following elements of monetary policy:
1. fixed exchange rates
2. control of capital movements
3. independent monetary policy

Question 16

Which element of monetary policy did countries give up during the classical Gold Standard era? (Based on the macroeconomic policy trilemma in Wolf 2010)

Answer 16

Gave up independent monetary policy for fixed exchange rates and free flow of capital movements

Quantity of money in each country was determined by balance of payments -> central banks expected to follow the ‘rules of the game’ to support adjustment of international balances of payments, not to support domestic macroeconomic policies (element of monetary policy given up) (Wolf, 2010)

Nutshell, rules provided that whenever:
gold flows into a country -> central bank should increase supply of national currency
gold flows out of a country -> central bank should contract its domestic assets (Nurkse, 1944, pp. 66-7)

Question 17

What was Britain’s role in the Gold Standard system?

Answer 17

Britain’s role: dominant trade player that ran steady BOP surplus (exports > imports) -> other countries should have raised interest rates and see output fall, but Britain lent them money via investing in railways, plantations or mining (recycling the surplus) -> effect: other countries had to make fewer adjustments, easier to stay on Gold Standard

Britain’s (1) large share of world trade, (2) consistent surpluses and (3) large foreign lending -> Gold Standard = sterlind standard -> countries happy to hold sterling as gold

First World War -> no longer massive BOP surplus -> no longer economic, financial and trade leader -> shift leader to USA, but didn’t play same role nor recycled its surplus like Britain in 1870-1914