The Gold Standard: An Exchange Rate Regime Whose Time Has Passed APPLYING THE CONCEPT If you take a dollar bill to the Federal Reserve, officials will give you a new one. Should they offer to give you gold instead? That would be returning to the time when the dollar was \"as good as gold.\" Today, advocates of a return to the gold standard claim that it would eliminate inflation. As evidence, they point to the time before World War |, when the United States was on the gold standard and inflation averaged less than 1 percent per year. What these advocates don't advertise is that, while inflation was low on average, it was highly variable, fluctuating between +3% percent and -3% percent. In fact, for much of the late 19th century, prices fell steadily. Only early in the 20th century did they rise back to a level not far above where they started in 1880. The focus on past inflation obscures the long list of reasons few economists today advocate a return to the gold standard. To begin with, the gold standard obligates the central bank to fix the price of something we don't really care about. Instead of stabilizing the prices of the goods and services we buy and consume, the central bank fixes the dollar price of gold. In place of fluctuations in the market price of gold, there are fluctuations in the dollar price of goods. Then there is the fact that, under the gold standard, the amount of money in the economy would depend on the amount of gold available. More gold equals more money. Because, in the long run, inflation is tied to money growth, this means that inflation depends on the rate at which gold is mined. Why should monetary policy be determined by the rate at which South Africa and Russia dig gold from the ground? Moreaover, any palitical disruption in those parts of the world could have dramatic monetary policy effects. The case for gold grows even less persuasive when we realize that the gold standard is an exchange rate policy, too. The promise to convert dollars into gold means that international transactions must be settled in gold. So when the value of imports does not exactly match the value of exports, gold is transferred from one country to another. Thus, a country with a current account deficitwhose imports exceed its exportshas to pay the difference by transferring gold to countries with current account surpluses. (See the appendix to this chapter for a description of balance-of- payments accounting.) With less gold, the country's central bank must contract its balance sheet, raising interest rates, reducing the quantity of money and credit in the economy, and driving domestic prices down. Under a gold standard, countries running current account deficits will be forced into deflation. Meanwhile, countries with current account surpluses can allow their gold inflows to generate inflation, but they need not. Under the gold standard, a central bank can have too little gold, but it can never have too much. Economic historians belisve that gold flows played a central rale in spreading the Great Depression of the 1930s throughout the world. After World War |, all the major countries in the world worked to reconstruct the gold standard. By the late 1920s, they had succeeded. At the time, both the United States and France were running current account surpluses, absorbing the world's geld into their vaults. But instead of allowing the gold inflows to expand the quantity of money in their financial systems, autharities in both countries tightened monetary policy in an attempt to cool off their overheated, inflation-prone economies. The result was catastrophic, because it forced countries with current account deficits and gold outflows to tighten their monetary policies even more. The resulting deflation increased the likelihood that people would default on loans, destroying the economic and financial system in the United States and elsewhere_* Economic historians place the blame squarely on the gold standard. What makes their argument truly convincing is the fact that the sooner a country left the gold standard and regained control of its monetary policy, the faster its economy recovered. From our vantage point in the 21st century, the gold standard is a historical artifact that caused great trouble. Most economic experts do not wish to see it restored. Doing so would not even be time consistent: In bad times, investors would expect governments to exit the gold standardas they eventually did in the 1930s5encouraging sel-fulfilling speculative attacks. \"In Applying the Concapt: Deflation, Mat Worth, and Infermation Costs in Chapter 11, we disouzsed how deflation inerssses the adverse selaction problems canssd by information aspmmetrizs. Thiz iz ons of the mechanizms peopls today balisve mads the Great Depeeczion of the 1830 so deep. 3. Some claim that adoption of a gold standard would contribute to price stability. Was price stability a feature of the U.S. gold standard that prevailed prior to World War I (see ( Applying the Concept on page 535)? Based on a plot of the general price level (FRED code: M04051USM324NNBR). discuss U.S. price developments from 1880 to 1914. (LO4)