For most of the 19th and 20th centuries, countries could join an international monetary system that used gold as a backstop for physical currencies. The gold standard, as the system was called, offered the prospect of stable economic growth for participating countries. However, the system didn't benefit everyone equally — particularly when a member country experienced an economic shock. In their paper, “A Model of the Gold Standard,” Jesús Fernández-Villaverde and the Philadelphia Fed’s Daniel Sanches shed light on newly discovered causes of this imbalance and explain how the imbalance contributed to the gold standard’s demise.

In modeling the effects of an economic crisis on member countries, the authors allow for swings in a crucial variable: the global supply of gold. What happens when supply is abundant? What happens when it is scarce? They show that the supply of gold has direct implications for the stability of the monetary system: “[W]e can say that the gold standard is both efficient and stable” when gold is plentiful, the authors write. When the gold supply shrinks, however, some countries fare worse than others.

The authors carefully examine the relationship between the global gold supply and the productivity level within each country in the bloc. For instance, the authors model how a productivity decline in one country affects other countries in the system. When their model simulates this asymmetric condition, the results show that “the country with the most productive domestic industries attracts a disproportionately large amount of gold in the bloc.” Their findings suggest that the least productive country concurrently loses gold, leading to a reduction in liquid assets in that country and a subsequent reduction of that country's economic output. By making these connections, their model generates evidence that a gold-based monetary system can transmit productivity shocks from one country to another. As the authors emphasize, “productivity differentials have long-lasting consequences” for countries that participate in the gold standard.

Having explored a gold standard's inefficiencies and imbalances, Fernández-Villaverde and Sanches then examine what happens when a constituent economy develops its own internal money system. When a country expands its money supply through private channels such as bank deposits and paper currency (referred to as private money or inside money), can its economy be better insulated from turbulence in other countries? To find out, they extend their model to include private banks that accept deposits and then loan a portion of those deposits to producers of socially valuable goods — a group of economic actors they label entrepreneurs.

When they calibrate their model to reflect a scarcity of gold, the authors observe that inside money has positive effects (particularly when bank deposits are transferable), and that “the rise of bank deposits as a medium of exchange eases the strains on a monetary system based exclusively on gold.” There is more aggregate liquidity, they find, and interest rates are lower. What’s more, the economy reaches an equilibrium at which welfare is improved for suppliers and consumers alike, without causing harm to any single actor (a “win-win” phenomenon described by economists as a Pareto improvement). Their findings indicate that “the welfare derived from the net consumption of … goods in the equilibrium is strictly higher than that derived from the equilibrium with illiquid bank deposits.”

However, inside money, the authors find, is also a source of instability, because inside money enables a banking crisis in one country to foment a liquidity crunch in other countries. To demonstrate this transmission, they adjust their model so that entrepreneurs face a constraint: They can pledge only a limited financial return on the ventures they fund with the money they borrow. When this rate of return declines permanently — in what the model treats as an unforeseen shock — it precipitates a banking crisis in the entrepreneur’s country. Under these circumstances, negative consequences reverberate through other countries in their model, and indeed “the overall effect on the value of liquid assets is such that aggregate liquidity falls and so does the output of goods purchased with money.”

Their results reveal a new channel by which an international gold standard can generate uneven results for countries within the system. After identifying the interconnections between positive and negative outcomes, the authors conclude that the same mechanisms originally intended to transmit economic stability can also transmit the effects of a negative economic shock. As they write, “We find that a banking crisis that occurs in a core country in the gold bloc results in a contraction of aggregate liquidity in other countries in the bloc.”

Given the circumstances and relationships portrayed in their model, the authors suggest that it’s helpful to divide member countries into two distinct groups: 1) peripheral economies, which are smaller and less developed (and therefore most at risk within the system), and 2) core, established economies that can withstand shocks relatively well. A key implication, their analysis shows, is that smaller and less productive countries would likely be better off by leaving the gold standard and thereby limiting their exposure to economic developments abroad. With that notion in mind, they describe the gold-standard landscape as one in which “the country with the most productive domestic industries attracts a disproportionately large amount of gold in the bloc,” while the least productive country loses gold. “Most importantly, if these … differences across countries are permanent, they have persistent real effects.”

In “A Model of the Gold Standard,” Fernández-Villaverde and Sanches produce practical insights into real-world monetary frameworks while documenting little-known factors that likely motivated countries to leave the gold standard. The authors do not downplay any of the other forces that contributed to the system’s eventual unwinding, but by pinpointing a previously underexamined flaw, they show that there is more to this story. “[T]he tensions highlighted by our model,” they write, “were an additional mechanism behind the demise of the gold standard … [and they have been] overlooked.”

  1. The views expressed here are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.