Gold Standard: Definition, How It Works,

and Example
Reviewed by
MICHAEL J BOYLE
Fact checked by
YARILET PEREZ

What Is the Gold Standard?

The gold standard is a fixed monetary regime under which the government's
currency is fixed and may be freely converted into gold. It can also refer to a
freely competitive monetary system in which gold or bank receipts for gold act
as the principal medium of exchange; or to a standard of international trade,
wherein some or all countries fix their exchange rate based on the relative
gold parity values between individual currencies.

KEY TAKEAWAYS

 The gold standard is a monetary system backed by the value of

physical gold.
 Gold coins, as well as paper notes backed by or which can be
redeemed for gold, are used as currency under this system.
 The gold standard was popular throughout human civilization, often part
of a bi-metallic system that also utilized silver.
 Most of the world's economies have abandoned the gold standard
since the 1930s and now have free-floating fiat currency regimes.

How the Gold Standard Works

The gold standard is a monetary system where a country's currency or paper
money has a value directly linked to gold. With the gold standard, countries
agreed to convert paper money into a fixed amount of gold.

A country that uses the gold standard sets a fixed price for gold and buys and
sells gold at that price. That fixed price is used to determine the value of the
currency. For example, if the U.S. sets the price of gold at $500 an ounce, the
value of the dollar would be 1/500th of an ounce of gold.
The gold standard developed a nebulous definition over time but is generally
used to describe any commodity-based monetary regime that does not rely
on un-backed fiat money, or money that is only valuable because the
government forces people to use it. Beyond that, however, there are major
differences.

Some gold standards only rely on the actual circulation of physical gold coins
and bars, or bullion, but others allow other commodities or paper currencies.
Recent historical systems only granted the ability to convert the national
currency into gold, thereby limiting the inflationary and deflationary ability of
banks or governments.

Why Gold?
Most commodity-money advocates choose gold as a medium of
exchange because of its intrinsic properties. Gold has non-monetary uses,
especially in jewelry, electronics, and dentistry, so it should always retain a
minimum level of real demand.

It is perfectly and evenly divisible without losing value, unlike diamonds, and
does not spoil over time. It is impossible to counterfeit perfectly and has a
fixed stock—there is only so much gold on Earth, and inflation is limited to the
speed of mining.

Advantages and Disadvantages of the Gold Standard

There are many advantages to using the gold standard, including price
stability. This is a long-term advantage that makes it harder for governments
to inflate prices by expanding the money supply.

Inflation is rare and hyperinflation doesn't happen because the money supply
can only grow if the supply of gold reserves increases. Similarly, the gold
standard can provide fixed international rates between countries that
participate and can also reduce the uncertainty in international trade.

But it may cause an imbalance between countries that participate in the gold
standard. Gold-producing nations may be at an advantage over those that
don't produce the precious metal, thereby increasing their reserves.

The gold standard may also, according to some economists, prevent the
mitigation of economic recessions because it hinders the ability of a
government to increase its money supply—a tool many central banks have to
help boost economic growth.

History of the Gold Standard

Around 650 B.C., gold was made into coins for the first time, enhancing its
usability as a monetary unit. Before this, gold had to be weighed and checked
for purity when settling trades.1

Gold coins were not a perfect solution, since a common practice for centuries
to come was to clip these slightly irregular coins to accumulate enough gold
that could be melted down into bullion. In 1696, the Great Recoinage in
England introduced a technology that automated the production of coins and
put an end to clipping.2

The U.S. Constitution in 1789 gave Congress the sole right to coin money
and the power to regulate its value. Creating a united national currency
enabled the standardization of a monetary system that had up until
then consisted of circulating foreign coins, mostly silver.3

With silver in greater abundance relative to gold, a bimetallic standard was

adopted in 1792. While the officially adopted silver-to-gold parity ratio of 15:1
accurately reflected the market ratio at the time, after 1793 the value of silver
steadily declined, pushing gold out of circulation, according to Gresham's
law.4

The gold standard is not currently used by any government. Britain stopped
using the gold standard in 1931 and the U.S. followed suit in 1933 and
abandoned the remnants of the system in 1973.56

The so-called "classical gold standard era" began in England in 1819 and
spread to France, Germany, Switzerland, Belgium, and the United States.
Each government pegged its national currency to a fixed weight in gold. For
example, by 1834, U.S. dollars were convertible to gold at a rate of $20.67
per ounce. These parity rates were used to price international transactions.
Other countries later joined to gain access to Western trade markets.78

There were many interruptions in the gold standard, especially during

wartime, and many countries experimented with bimetallic (gold and silver)
standards. Governments frequently spent more than their gold reserves could
back, and suspensions of national gold standards were extremely common.
Moreover, governments struggled to correctly peg the relationship between
their national currencies and gold without creating distortions.

As long as governments or central banks retained monopoly privileges over

the supply of national currencies, the gold standard proved an ineffective or
inconsistent restraint on fiscal policy. The gold standard slowly eroded during
the 20th century. This began in the United States in 1933, when Franklin
Delano Roosevelt signed an executive order criminalizing the private
possession of monetary gold.9

After WWII, the Bretton Woods agreement forced Allied countries to accept
the U.S. dollar as a reserve rather than gold, and the U.S. government
pledged to keep enough gold to back its dollars. In 1971, the Nixon
administration terminated the convertibility of U.S. dollars to gold, creating a
fiat currency regime.1011

The Gold Standard vs. Fiat Money

As its name suggests, the term gold standard refers to a monetary system in
which the value of a currency is based on gold. A fiat system, by contrast, is a
monetary system in which the value of a currency is not based on any
physical commodity but is instead allowed to fluctuate dynamically against
other currencies on the foreign-exchange markets.

The term "fiat" is derived from the Latin fieri, meaning an arbitrary act or
decree. In keeping with this etymology, the value of fiat currencies is
ultimately based on the fact that they are defined as legal tender by
government decree.

In the decades prior to the First World War, international trade was conducted
on the basis of what has come to be known as the classical gold standard. In
this system, trade between nations was settled using physical gold. Nations
with trade surpluses accumulated gold as payment for their exports.
Conversely, nations with trade deficits saw their gold reserves decline, as
gold flowed out of those nations as payment for their imports.

When Did the U.S. Abandon the Gold Standard?

The U.S. officially stopped using the gold standard in 1971 under President
Nixon. At the time, inflation was growing and there was a gold run on the
horizon. Nixon's administration ended the dollar convertibility to gold, which
ended the Bretton Woods System.11

What Replaced the Gold Standard?

The gold standard in the U.S. and many other nations was replaced by fiat
money. Fiat money is the currency of a government, which is not backed by a
commodity but has value because the government has determined that it
does and that it must be accepted as a form of payment. Fiat money includes
paper bills and metal coins.

Are Any Countries Still on the Gold Standard?

Currently, no country uses the gold standard. Countries have abandoned the
gold standard for fiat money. Countries, however, do still maintain gold
reserves.

The Bottom Line

The gold standard is a fixed currency system in which a government's
currency is fixed to the value of gold. This stands in contrast to currency
systems that use fiat money; money issued by a government that is not tied
to a commodity.

The gold standard was used much throughout history, in ancient civilizations
as well as in modern nations. The United States used the gold standard but
eventually stopped in the 1970s and is now a fiat-money-based monetary
system.

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