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.
Another great read on the working of the interwar Gold Exchange Standard is H.L. Johnson's "Gold, France and the Great Depression". Johnson basically shows how two 'big players' in the world gold markets, the Bank of France and the Fed, by undervaluing their currencies and sterilizing gold inflows, contributed to a sharp increase in the demand for monetary gold.
ReplyDeleteI used White's (1999) Gold stock/flow diagram to explain the mechanics of the gold market in my undergraduate thesis. One of my advisor's couldn't get over the fact that my supply curves were upward sloping. I was all like, "bro, do you even endogenous money""