Gold Standards & Bretton Woods

(VIPUL)

Gold Standard System This is the oldest system and was in operation till the First World War.

This system is based on value of gold and relates to the amount of gold

held by the monetary authority.

There are three known kinds of gold standard that have been adopted

since the early 1700s-

1. The gold specie

2. The gold exchange

3. The gold bullion standards

(1)Gold Specie Standard (C G)

In this system the actual gold coins or coins

with fixed content of gold were used in

circulation.

In this gold standard, the unit of currency is

linked to the gold coins. Gold coins were used

along with silver coins or coins of other metals.

There was a fixed conversion ratio such as

5 silver coins = 1gold coins

cont….

As per this system:

(i) The government has to confirm that gold is the

currency and can be used to trade goods &

services.

(ii) Value of gold coins is just the same as value of

gold in it.

(iii) Gold in any form has to be convertible/

exchangeable to coins & vice versa.

cont…….

(iv)Gold should be freely exported or imported.

(v) The supply of gold determined the liquidity and

consequently its value.

Eg. US dollars was minted as gold & silver coins

till 1862 and continued along with paper notes

till 1933.

2. Gold Bullion Standard

In Gold Bullion Standard, monetary authorities

hold stock of gold.

Currency in circulation is a paper currency note

[ or silver coins or low value metal coins]

On these paper notes there is a written promise

of monetary authorities that if you demand, on

submission of this note, they would give you

specified quantity of gold. This means currency is

pegged with gold. This is called as fiat money.

Mechanisms Of Exchange Of Two Currencies It is obvious that exchange mechanism in either of

these systems is very simple.

It was basically gold that was getting exchanged, either actually or through promises.

Hence in bullion standard, if one currency is worth X grams of gold and other Y grams.

The mechanisms for calculating exchanges rates under bullion standard was called mint par of exchange.

1 ounce of Gold = $20

1 ounce of Gold = Rs. 420

Exchange Rate = $ 20=Rs.420

3. Gold Exchange Standard

In Gold Exchange Standard System, currency is

exchangeable for another currency at a specified

ratio, as promised by monetary authority. Another

currency with which it is pegged is called as a

reserve currency.

Most used currency were US Dollars & British

Pounds.

Advantages of Gold Standard System

Monetary Discipline – monetary authority could issue currency only if it has

sufficient quantity of gold.

In-built anti- inflationary system – since amount of money is restricted by

quantity of gold, excess money was an uncommon feature and it limited the

inflation rates.

Exchange rate are stable- since the exchange rates were simply the ratios

of gold quantity represented by each currency, it remained stable.

Changes in exchange rate were more predictable – The government

would change its gold parity with discussions .

Essential Elements For the success of Gold Standard System

They should never change the ratio (parity) of conversion of paper money to gold.

They should be able to convert unlimited amount of paper currency to gold at anytime whatsoever.

There should not be any restrictions on transfer of gold from one country to another. It should be free flow in all respects.

They should issue notes exactly proportionate to the quantity of gold they have in reserve.

Demerits Of Gold Standard

Rigid Monetary Discipline on policy makers and monetary authorities.

Inflation to some extent is a good sign of a growing economy. It achieves growth of production and targets full employment. Since gold standard is anti-inflationary, it compromises on these goals.

• Political cost – Such economic compromises cause huge political costs.

It is not possible to maintain gold parity in critical times like natural calamities.

Free trade of gold with all the countries all the time is not possible.

Free convertibility of gold is a very high & unpredictable liability

on the authorities.

Bretton Wood System

Introduction

The Bretton Woods system was one of the most

memorable conference in the history of money .

Because of many events, including the breakdown of

Gold Standard Systems, world monetary system

was not really a system at all.

After the second world war policy makers from UK

& US along with allies initiated the process of

reviving world monetary system.

In 1944, representatives from around 44 countries

met at Bretton Woods, a town in new Hampeshire

State of the US.

Bretton Woods System

Total more than 44 currenices

Gold Reserve Currency

Real Gold in

stock of

Monetary

Authority

US Dollar

All other currencies

French Franks

1 US $ = 119.1FFr

Italian Lire

1 US $ = 575 lire

Switzerland

1 US $ = 43.77 S Franc

Finland

1US $ =320 Markka

Structure Of Bretton Wood Structure The USA undertook to convert the US Dollar freely

into gold at a fixed parity of $35 per ounce.

Other countries (member countries of IMF) agreed to maintain their currencies at specific parities (ratio) with US Dollar.

1% variation in this parity (+ or -) was allowed. If variation was more, than authorities shall take the necessary measures to restore it.

This was supposed to be done by buying and selling dollars.

Eg. If market are buying dollars heavily, then authorities should sell dollars to maintain the parity.

Cont……..

In order to follow this parity – maintaining obligations, if

required, member country may borrow from IMF in the

form of Special Drawing Rights.

If there was a genuine problem in maintaining parity to a

particular member country, then it can change its parity

itself by 10% (+/-) without consulting IMF. If it desires to

exceed 10% limit, it has to inform IMF. Because of this

feature, this system is referred as Adjustable Peg

System.

Triffin’s Paradox

According to him, US Dollars to serve as an

international currency (strong currency) will require

huge surplus of US Dollars to rest of the world,

resulting in large Balance of Payments deficit in the

USA.

Such deficit would weaken US Dollar.

Hence there was a contradiction within the system

& so is called as Triffin’s Paradox

Tiffin’s Paradox

In order to maintain the Bretton Woods system the US had to:

(i) Run a balance of payments current account deficits to provide

liquidity for the conversion of gold into dollars. With more US

Dollars in the system the citizens began to speculate, that US Dollar

was overvalued.

(ii) Run a balance of payments current account surplus to maintain

confidence in US Dollar. This was known as Triffin’s dilemma

Collapse/Failure of Bretton Woods System

US inflation was rising in the late 1960s as the US Central bank kept on printing

more and more dollars to finance the growing budget deficit, the Vietnam war and

the social spending.

To maintain the fixed exchange rate, non-reserve(non US) central banks had to

purchase dollars. During 1960 and 70s, there was a rising stock of dollar

reserves.

Dollar overhang occurred when the amount of US dollars held by non-reserve

(non US) central banks exceeded the total stock of gold in the US treasury.

US could run out of its gold stock if all non-US banks continued to exchange

their dollars for gold.

Because all the countries expected the Dollars to fall in value at some future date,

they started to convert these dollars to gold.

The only option available to US was devaluation of the dollar with respect to

gold i.e US could raise the price of gold to $40 or $50 per ounce or more. But this

would not have been enough, the devaluation would have to be extremely large to

prevent the depletion of US gold reserve.

Bretton Woods system collapsed in 1971.