GOLD,MONETARY POLICY, AND INFLATION

• MUSTAFA ERGAZİLİ 108592• SÖZALP KAHVALTICI

108697• ANGE AKONO 109345

GOLD,MONETARY POLICY, AND INFLATION

INTRODUCTION GOLD STANDARD MONEY AND PRICES in US ESTABLISHMENT OF FEDERAL RESERVE POSTDEVALUATION MONETARY POLICY INFLATION CONCLUSION

DEFINITION OF 'GOLD STANDARD'

Gold Standard : Monetary system in which a country's government allows its currency unit to be freely converted into fixed amounts of gold and vice versa. The exchange rate under the gold standard monetary system is determined by the economic difference for an ounce of gold between two currencies. The gold standard was mainly used from 1875 to 1914 and also during the interwar years.

GOLD STANDARD (CONT.)

On September 20, 1931, the British government announced that England was going off the gold standard. It would no longer exchange gold for an account at the Bank of England or for British currency, the pound sterling.The government said this is a temporary action but it was the mark of the beginning of the end of gold standard.

GOLD STANDARD (CONT.)

Most of the government officials were thinking that quitting from gold would be very harmful for the government and for the economy but despite the dire predictions of government officials, shareholders viewed casting off the gold standard as good for the economy and even better for stocks.

GOLD STANDARD (CONT.)

The stock market gave a ringing endorsement to the actions that shocked conservative world financiers. In fact, September 1931 marked the low point of the British stock market, while the United States and other countries that stayed on the gold standard continued to sink into depression.As a result of this depression a year and half later US joined Britain in giving up gold standard and finally every nation started to use paper money standard.

MONEY AND PRICES

Why is the quantity of money so closely connected to the pricelevel?

FEDERAL RESERVE

The Federal Reserve System was created on December 23, 1913,largely in response to a series of financial panics.

The U.S. Congress established three key objectives for monetary policy in the Federal Reserve Act: Maximum employment, stable prices, and moderate long-term interest rates

THE FALL OF GOLD STANDARD

To prevent a steep loss of gold, Great Britain took the first step and abandoned the gold standard on September 20, 1931, suspending the payment of gold for sterling.18 months later, on April 19, 1933,the US also suspended the gold standard as the Depressionand financial crisis worsened.

THE FALL OF GOLD STANDARD

The financial markets loved the government’s new-found flexibility,and the reaction of the U.S. stock market to gold’s overthrow was even more enthusiastic than that in Great Britain. Stocks soared over 9 percent on April 19 and almost 6 percent the next day.

POSTDEVALUATION MONETARY POLICY

As the part of the Bretton Woods agreement, U.S. government promised to exchange all dolars for gold held by foreign central banks at the fixed rate of $35 per ounce.

In the postwar period, inflation increases and the dollar bought less and less, gold seemed more attractive to foreigners. U.S. gold reserves began to decrease.

As the gold reserves decreased Congress removed the gold-backing requirement for U.S. currency in 1968.

Government admitted that domestic monetary policy would not be the subject to the discipline of gold.

On August 15,1971 President Nixon announced the « New Economic Policy » which was;

1. Freezing wages and prices and closing the «gold window» that was enabling foreigners to exchange U.S. currency for gold. The link of gold to money was permanently broken.

POSTGOLD MONETARY POLICY With the dismantling of the gold standard, there was no

longer any constraint on monetary expansion, either in U.S. or in foreign countries.

In 1975 U.S. Congress obliged the central bank to announce monetary growth targets. Three years later Congress passed the Humphrey-Hawkins Act.

But unfortunately the FED largely ignored the money targets it set in 1970s because surge of inflation in 1979 brought increased pressure on the Federal Reserves to change its policy.

In 1979 Paul Volcker announced radical change in the implementation of monetary policy. No longer Federal Reserve set interest rate to guide the policy. Instead it would exercise to control the money supply.

THE FEDERAL RESERVE AND MONEY CREATION

When the Fed wants to increase the money supply it buys a government bond in the open market. What is unique about Fed is that when it buys government bonds it pays for them by crediting the reserve account of the bank of the customer from whom the Fed bought the bond and thereby creating the money.

If the Fed wants to reduce the money supply, it sells government bonds from its portfolio.

Open Market Sale

HOW THE FED’S ACTIONS AFFECT INTEREST RATES Federal Funds Market and Federal Funds Rate

If the Fed buys securities, then the supply of reserves is increased and the interest rate on federal funds goes down because banks then have ample reserves to lend. If the Fed sells securities the supply of reserves is reduced and the federal funds rate goes up because banks scramble for the remaining supply.

Interest rates are an extremely important influence on stock prices because interest rates discount the future cash flows from stocks. Therefore bonds compete with stocks in investment portfolios.