Gold Standard Logic & Inflation

Imagine that all of the world's major currencies were tied to a mass of metal that in totality barely "filled a modest two-story town house." In 1914, 59 countries had adopted the gold standard, which legally required that all paper money be freely convertible into its gold equivalent. For this market to function, all major central banks maintained gold bullion for immediate exchange.

Central banks maintained the right to issue currency (or "print money"), but in order to do so each central bank was required by law to maintain a certain quantity of physical gold in relation to the amount of paper money in circulation. The lever available to control the flow of currency in and out of the economy was the cost to borrow, or interest rate.

It was like turning the dials up or down a notch on a giant money thermostat. When gold accumulated in its vaults, it would reduce the cost of credit, encouraging consumers and businesses to borrow and thus pump more money into the system. By contrast, when gold was scarce, interest rates were raised, consumers and businesses cut back and the amount of currency in circulation contracted.

Having the amount of paper money in circulation tied to a specific quantity of gold required that governments lived within their means. Central banks could not print beyond money beyond the reserves available or manipulate the value of the currency because it was tied to the value of gold. This kept inflation low for so long as the amount of gold in the world remain fixed. 

Source: Liaquat Ahamed | Lords of Finance: The Bankers Who Broke the World | 12/29/2009 | p. 12 | Visit

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