Gold Standard: Definition, How It Works, and Example

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.