In some ways, a nominal income target emulates the operation of a gold standard. Both a gold standard and a nominal income target allow the stock of base money to adjust to demand for money. The historical gold standard serves as an ideal case study as data exists for both the supply of and demand for monetary gold. The largest increases in demand for gold occurred as a result of the decisions of Big Players – central banks – so it will be useful to observe changes in gold production and prices relative to changes in central bank holdings of gold and changes in the official gold price in different countries (Koppl 2002). In order to understand how the central bank affected the gold market as a Big Player requires that we consider the mechanism of the market for money.
Under a gold standard, production of gold responds the price of gold as determined by gold’s demand and supply. Below is a graph comparing the yearly change in the world’s total gold stock with changes in the real price of gold (U.S. Gold Commission,1982). The time required for the quantity of gold supplied to adjust to changes in demand typically took one to two years (Rockoff 1984). Not surprising, changes in the gold stock trail movements in the real price of gold. The divergence between the price of gold and the rate of increase of the gold stock during the first decade of the twentieth century was likely due to the emergence of the cyanide process at the end of the 19th century. This represented a positive shock to the supply of gold. On the demand side, changes in central bank gold reserves exercised tremendous influence over the price of gold. The data does not express this as clearly as the relationship between gold’s price and the quantity of gold supplied as the Federal Reserve did not consolidate much of the gold stock in the United States until the end of World War I. A similar problem holds after 1931 when England and other nations began to abandon the gold standard and 1933 when president Roosevelt devalued the dollar, thereby raising the world price of gold (Freidman and Schwartz 1963; McCloskey 1984). For the remainder of the decade changes in demand for gold are not fully captured by changes in gold reserve at central banks. During years where the data does not suffer from complications (1918-1931), there is a clear relationship between changes in gold reserves and changes in the real price of gold.
As noted above, the gold market was sometimes subject to distortions from price fixing. For example, France fixed the price of gold at an arbitrarily high price in 1927, after which point France began to accumulate a disproportionate share of the world’s gold (Irwin, 2012). In 1933, the United States made a similar move when the dollar was devalued so that the price for an ounce of gold rose from $20 per ounce to $35 (Friedman and Schwartz 1963). It is no surprise, then, that in the years that followed these price increases, the annual rate of increase in the world gold stock consistently rose for more than a decade. Ideally, a commodity standard would not be subject to price fixing.
In any case, there is a clear pattern. Changes in demand for gold correlate positively with a change in price. Changes in the production of gold are, subject to a 1-2 year lag, positively correlated with the price of gold. The quantity of gold supplied adjusts to meet the quantity demanded at a given price. That is to say that when gold serves as money, it is subject to Say’s principle. Say’s principle tells us that if there is a glut of goods subject to a single array of prices, then there is not enough money in the economy to clear all markets simultaneously at those prices. What is the cause of the excess supply of goods, but an excess demand for money? A higher real price of gold caused by an increase in demand for money promotes the production of more gold and the conversion of non-monetary gold into monetary gold. The market attempts to remedy the imbalance of trade, which in this case was caused by unpredictable central bank policies, by increasing the stock of base money. Prices convey that the remedy is needed.
We can see by this exposition that endogeneity of the money stock is critical for the functioning of a healthy monetary economy. Prices signal the wants and needs of consumers and scarcity of resources to producers (Hayek, 1945). Embedded in the use of a commodity as money is the market’s auto-poetic response to a shortage in money. It should come as no surprise that the supply of money has come to include a mechanism that responds to disequilibrium pricing. The development of money itself was the market’s response to the high transaction costs of barter (Menger 1976). Its quantity adjusts in response to changes in demand. Under a gold standard, this adjustment translates to a reduction of gluts in the production of goods that are not gold.