How the gold standard works

Related: Why is gold so valuable

What is a gold standard? A gold standard is a monetary system where gold is used to measure the value of goods, services or investments in an economy. Printed money is used as legal tender where it has an equivalent value of gold upon demand. This system ensures that issued notes by a government is backed by the intrinsic value of gold. This gold standard was introduced in 1816 by Great Britain to ensure ease of trade by using bank notes that represents a particular weight of gold. It soon became universal for countries to use the gold standard in their monetary system. Under the gold standard, prices of goods and services slowly deflated as the industrial revolution gave way for more efficient tools and thus boosting output.

The value of money is higher under the gold standard because the resulting surplus of income from lower prices turned into interest producing savings into banks, the banks then lend the savings to finance projects that benefits the economy such as a new business venture for a car company. Another factor is that once the savings was used to finance a major venture, few is left for real money to be used therefore, credit for capital is harder to acquire until a sufficient amount of gold is mined to back new currency issues. While this system prevents an economy from acquiring too much debt than it can handle, the mere fact of a new project that cant be fully financed because savings needed to finance it ran out can restrict an economy to expand or grow at a faster pace. This system requires the economy to spend time in order to expand noting that the opportunity cost for waiting to start the venture forgoes the benefits of possible revenues. Under the gold standard, money can also be created or inflated to accommodate the necessary capital to finance consumption or investment. However, once the public realise that there are far fewer gold than there are paper currency, inflation can happen. But during times when people panic and make runs to the bank to pull out their savings, a bank may not have enough gold to pay. As a result an economic depression may occur, because inadequate gold to finance expansion causes a credit crunch and a massive sell off occurs triggering one huge selloff after another.

Now, how did the gold standard fail? During periods of very high demand such as World War 1, countries involved needed an unlimited supply of ammunitions and war equipment in order to win. A victory is unattainable if the gold needed to finance the seemingly limitless demand for war equipment is in short supply. This war scenario is equivalent to an expanding economy where people's desire for goods and services are boundless, but without a boundless supply of capital this cannot be attained and would always lead to a contraction. Countries involved in the war abandoned the gold standard, at least temporarily to accomodate the limitless demand that gold cannot keep up with.

But since World War 1 happened during the industrial revolution noting that efficiency for producing goods was exponentially increased, prices of goods should continue to decline, then why did the gold standard unable to deliver the required demand? The answer may lie in the technological capacity to produce the required ammunition. The seemingly unlimited demand for war equipment reveals a quota or limit to the quantity of items that a single equipment can produce per a designated amount of time. Meaning, if 20 machines can only make 10,000 bullets a day and bullets are consumed in the front lines at a rate of 50,000 per day, extra machines and man power are needed to accomodate that demand. This would mean that extra workers and equipment are needed to produce 50,000 bullets. If the daily cost to manufacture 10,000 bullets is $100,000, then producing 50,000 bullets requires the manufacturer to buy 80 more machines and hire more workers causing the daily production cost to increase to $500,000. It is now obvious that the marginal cost to produce extra bullets to meet the demand would require additional capital and thus more gold. This enormous demand coupled with the boundaries of technology would definitely stagnate production if extra capital is not obtained. Gold restricts this mega expansion and the gold standard was suspended for a fiat currency system.

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