In their paper, “Price-Level Determination Under the Gold Standard,” Daniel Sanches of the Philadelphia Fed and Jesús Fernández-Villaverde of the University of Pennsylvania, the National Bureau of Economic Research, and the Centre for Economic Policy Research investigate the international monetary system under the gold standard as used by most advanced economies at the turn of the last century — particularly its effects on macroeconomic stability and well-being. They also contrast their findings on the gold standard with their findings on fiat money. (Under the gold standard, there is no government control of the quantity of money in an economy, while a system based on fiat money requires central bank intervention to regulate the money supply.)

The “classical” gold standard was used by most advanced economies from the early 1870s to the early 1930s.1 Under this commodity money system, each unit of currency, including the U.S. dollar, was exchangeable for a fixed amount of gold set by international agreement. This classical gold standard was replaced, following a transition period starting in the Depression era and lasting until 1973, by the fiat money system we know today.2 Under a fiat money system, the money supply is not tied to precious metals and is controlled by individual central banks in countries worldwide.3

Even though the gold standard is in the world’s rearview mirror, the authors argue that it continues to be “an important benchmark for analyzing the international monetary system.”4 They focus their study on the role of the gold standard in generating price stability, its efficiency as a monetary arrangement, and how well economies handle external trade shocks under the gold standard. (External trade shocks can occur for many reasons, including a change in an international trade policy by a major trading partner or a financial crisis in a major gold standard country.)

The authors use a monetary model of a small open economy (that is, an economy engaging in international trade but too small to influence world prices) to study the short- and long-run stability of money, prices, and output under the gold standard.5 Their model determines the money supply in the home country by examining gold flows associated with domestic and international trade.6 To gain further insights into how the gold standard affects macroeconomic indicators in larger regions, the authors revise their model to feature two large open economies rather than one small open economy. Then, the authors investigate policy options designed to make the gold standard a more efficient international monetary system — that is, one that best promotes price stability and maximum employment and output. (When policy is undertaken within a gold standard framework, they note, it is considered a “hybrid monetary system,” as countries adopt both the gold standard and some policy interventions characteristic of a fiat money system.) Finally, they use their models to consider the implications of a pure fiat money system, which entails the demonetization of gold and an active role for monetary authorities.

Under the gold standard, the authors find, external shocks do affect money, prices, and output in the short run. These negative economic developments can harm consumers and businesses. This short-run instability, they argue, is a “fundamental flaw of commodity money systems,” but these impacts are brief: The gold standard promotes long-term price stability “as the quantity of money and prices only temporarily deviate from their steady-state [that is, equilibrium] levels.”

When extending their analysis to the two large economies, they find preliminary evidence of the gold standard’s stabilizing effect on prices. They also extend their analysis to evaluate policy interventions — specifically, government subsidies to promote gold holdings7 — and find that these policies may enhance the long-run efficiency of the gold standard.

For the gold standard to succeed, the authors stress, international coordination is essential — particularly to ensure that each national currency is valued in terms of a specific amount of gold. This international coordination, they add, can be politically challenging. In particular, a country may be tempted to stray from internationally set currency agreements tied to gold when doing so would benefit its domestic economy and prove popular with its citizens.

Their model also shows that a fiat money system, like the one in which we operate today, can achieve economic efficiency without the gold standard. However, an efficient fiat money system requires “an optimal monetary policy.”

  1. The views expressed here are solely those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  2. Some countries kept the gold standard for many more years, but they often operated using a hybrid approach involving government intervention in their currency markets.
  3. Part of this transition period, from 1945 to 1971, is known as the Bretton Woods era, when all currencies were pegged to the U.S. dollar and the dollar was tied to gold.
  4. The classical gold standard, by design, also entails an international trading system based on fixed exchange rates. Abandonment of the gold standard eventually gave rise to varied exchange rate regimes.
  5. Important studies covering the properties of the gold standard include Milton Friedman and Anna Jacobson Schwartz’s A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963) and Barry Eichengreen’s Globalizing Capital: A History of the International Monetary System, 3rd ed. (Princeton, NJ: Princeton University Press, 2019).
  6. They use a model with random matching and bargaining that characterizes the price-specie flow mechanism developed by David Hume in “Of the Balance of Trade” in Essays Moral, Political, Literary (Indianapolis: Liberty Fund, [1752] 1977).
  7. The authors assume that only trade changes the size of the money supply. However, adding domestic mining of gold into their model framework, they note, would be an interesting extension for future work.
  8. For more on this topic, see Ricardo Lagos and Randall Wright, “Dynamics, Cycles, and Sunspot Equilibria in ‘Genuinely Dynamic, Fundamentally Disaggregative’ Models of Money,” Journal of Economic Theory, 109:2 (2003), pp. 156–171.