Tradeoff: Exchange Rates and Inflation Under the Gold Standard

The effects of central bank policy operated through multiple channels under the international gold standard. The most obvious is the domestic inflation rate. As the central bank expands the monetary base, prices tend to rise. As it contracts the base, prices tend to fall. A full account of the consequences of independent central bank policy must be broader than a measure of monetary expansion and movements of domestic prices – whether one is referring to movements of relative prices or price the price level. Central bank policy also influences exchange rates, and therefore, international trade.

Without fixed exchange rates, a unilateral inflation that lowered a central bank’s reserve ratio tends to also reduce the value of the respective national currency relative to other currencies. Under the gold standard, prices of currency were not allowed to fluctuate, so the prices of goods denominated in a particular currency reflected the adjustments. In other words, an ounce of gold became less valuable in a country that expanded its money stock faster than other gold standard nations. Gold thus flowed to nations whose rate of monetary expansion had not exceeded the general rate of monetary expansion of gold standard countries. In these nations, prices for both bonds [at least in the short run] and goods were lower than in the state that engaged in the out-of-sync expansion.                

Monetary policy under the old gold regime necessitated a tradeoff between domestic inflation and the balancing of exchange rates. Of concern here is a central bank’s response to gold inflows and outflows. If a central bank receives gold and allows its reserve ratio to rise, it engages in a passive sterilization. This perpetuates a discrepancy between prices in the countries receiving gold and losing gold. Likewise, if a central bank expands as gold flows into the country, it will tend to stabilize exchange rates by allowing prices to rise. The two options are mutually exclusive.

               

The merit of the international gold standard was, as Hayek phrased it, that it approximated an “international currency system (2)” where all countries essentially used the same money. This merit depended on the stability of exchange rates. If distortions in exchange rates persisted, the benefits of an international money was lost. It is for this reason that stabilization of exchange rates under the gold standard was the most appropriate policy.

Food for Thought: Although Hayek defended the merit of an international standard, he suggests that the best policy would be for a central bank to keep reserves “large enough to allow them to vary by the full amount by which the total circulation [of money] of the country might possibly change.” In other words, the central bank should offset changes in M1 by shifting reserve ratios. By doing this, however, the central banks would be distorting exchange rates. Hayek wanted to have his cake and eat it too. Either the standard is international, which under a “gold nucleus standard” [not 100% backed by gold] meant that central bank policy was to keep the reserve ratio constant, or domestic money expansion could be neutralized by changes in the reserve ratio. You can’t have both.