The Workings Of The Gold Standard

A gold standard is a monetary regime where the monetary unit, the base money of the banking system — the outside money or the high-powered money — consists of a defined amount of gold. 

Gold standards can come in all manners and versions and with particular institutional and historical quirks that affect their operations. The key characteristic that unites them is that an economy’s underlying money is ultimately based on an amount of gold. 

Using the language and the classification in the first reading session of our Harwood Graduate Colloquium, commodity monies such as a gold standard consist of objects that have alternative nonmonetary uses (for instance in production or ornament) and are absolutely scarce. That is, their scarcity is a fundamental aspect of the good itself — as opposed to fiat money, which can be expanded at the discretion of a central bank. 

When money is gold, it can be increased only by extracting more gold from mines and minting it into monetary circulation. This process, expanding supply through the incentives provided by the price mechanism, subjects the supply of money to market forces rather than to discretionary policy making as is the case under our current monetary regime. That carries with it a few remarkable characteristics:

The opportunity for price inflation is — by present standards — very limited, as the total amount of money in the economy is limited by the amount of gold. This need not be strictly so, as monetary theories going back at least to Wicksell’s pure credit economy have bank credit (and money velocity) remedying the scarcity of a commodity money. Free banking under a fractional-reserve gold standard, can, in other words, mitigate this strict supply schedule somewhat. 

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