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Title: Monetary Standards
An Essay written for the Oxford Encyclopedia of Economic History
A monetary standard refers to the set of monetary arrangements and institutions governing the supply of money. It differs from the term “monetary regime” defined as a set of monetary arrangements and institutions accompanied by a set of expectations─expectations by the public with respect to policymaker actions and expectations by policymakers about the public's reaction to their actions.
We distinguish two aspects of monetary standards/regimes: domestic and international. The domestic aspect refers to the institutional arrangements and policy actions of monetary authorities. The international aspect relates to monetary arrangements between nations. Two basic types of monetary arrangements prevail: fixed and flexible exchange rates, along with a number of intermediate variants including adjustable pegs and managed floats.
Two types of monetary standards/regimes have been present in history,
- those based on convertibility of all forms of money into currency, generally specie, and
- those based on fiat.
The Theory of Specie Standards as Domestic Standard
The specie standards that were adopted as far back as ancient times are types of commodity money standards. Commodity standards have generally been based on silver, gold or bimetallism (gold and silver coins circulating at a fixed ratio of their weights). However, other commodities such as bronze, copper or Cowrie shells have also been used. Proposals for reform such as basing the monetary standard on a basket of commodities including the precious metals such as Alfred Marshall’s (1926) symetallism (a combination of gold and silver bullion bars in fixed proportions) and Robert Hall’s (1982) ANCAP (a resource unit with fixed weights consisting of: aluminum, copper, plywood and ammonium nitrate).
Under a specie standard such as the gold standard, the monetary authority defines the weight of gold coins, or else fixes the price of an ounce of gold in terms of national currency. By being willing to buy and sell gold freely at the mint price, the authority maintains the fixed price. Ownership or use of gold is unrestricted.
Under the gold standard the money supply consists partially or entirely of the monetary gold stock. A gold standard served as a natural constraint on monetary growth because new production is limited (by increasing costs) relative to the existing stock.
Specie standards provided a self-regulating mechanism that ensured long-run monetary and price level stability. The commodity theory of money most clearly analyzed by Irving Fisher (1922/1965) explained why this was so. The price level of the world, treated as a closed system, was determined by the interaction of the money market and the commodity or bullion market. The real price (or purchasing power) of gold was determined by the commodity market, given the fixed nominal price of gold set by the monetary authorities. The price level was determined by the demand for and the supply of monetary gold. The demand for monetary gold was in turn derived from the demand for money; the supply of the monetary gold stock was a residual defined as the difference between the total world gold stock and the non-monetary demand. Changes in the monetary gold stock reflected gold production and shifts between monetary and non-monetary uses of gold.
Under the self-equilibrating gold standard, shocks to the demand for or supply of monetary gold would change the price level. Demand and supply changes would be reversed as changes in the price level affected the real price of gold, which offset changes in gold production and led to shifts between monetary and non-monetary uses of gold. This mechanism produced mean reversion in the price level and a tendency toward long-run price stability. In the shorter run, shocks to the gold market created price level instability. The empirical evidence suggests that the mechanism worked roughly according to the theory. However the simple picture is complicated by a number of important considerations: technical progress in mining; the exhaustion of high quality ores; and depletion of gold as a durable exhaustible resource [Cagan (1965), Bordo (1981), Rockoff (1984)]. With depletion, in the absence of offsetting technical changes a gold standard must inevitably result in long-run deflation (Bordo and Ellson 1985).
The Theory of Specie Standards as International Standards
The international specie standard evolved from domestic standards with the common fixing of the specie price by different nations. The classical gold standard, which prevailed from 1880 to 1914 was the pinnacle of this evolution. Unlike later arrangements, the classical gold standard was not the result of an international agreement but was driven largely by market forces.
Under the classical gold standard fixed exchange rate system, the world’s monetary gold stock was distributed according to the member nations’ demand for money and use of substitutes for gold. Disturbances to the balance pf payments were automatically equilibrated by the Humean price-specie flow mechanism. Under that mechanism, arbitrage in gold kept nations’ price levels in line. Gold would flow from countries with balance of payments deficits (caused, for example, by higher price levels) to those with surpluses (caused by lower price levels), in turn keeping their domestic money supplies and price levels in line.
Some authors stressed the operation of the law of one price and commodity arbitrage in traded goods prices, others the adjustment of the terms of trade, still others the adjustment of traded relative to non-traded goods prices [Bordo (1984)]. Debate continues on the details of the adjustment mechanism; however, there is consensus that it worked smoothly for the core countries of the world although not necessarily for the periphery which suffered frequent terms of trade shocks and financial crises [Ford (1962), DeCecco (1974), Fishlow (1985)]. It also facilitated a massive transfer of long-term capital from Europe to the new world in the four decades before World War I on a scale relative to income, which has yet to be replicated.
Although in theory exchange rates were supposed to be perfectly rigid, in practice the rate of exchange was bounded by upper and lower limits -- the gold points – within which the exchange rate floated. The gold points were determined by transactions costs, risk and other costs of shipping gold. Recent research indicates that although in the classical period exchange rates frequently departed from par, violations of the gold points were rare [Officer (1996)], as were devaluations [Eichengreen (1985)]. Adjustment to balance of payments disturbances was greatly facilitated by short-term capital flows. Capital would quickly flow between countries to iron out interest differentials. By the end of the nineteenth century the world capital market was so efficient that capital flows largely replaced gold flows in effecting adjustment.
Central banks also played an important role in the international gold standard. By varying their discount rates and using other tools of monetary policy they were supposed to follow “the rules of the game” and speed up adjustment to balance of payments disequilibria. In fact many central banks violated the rules [Bloomfield (1959), Dutton (1984), Pippenger (1984), Giovannini (1986), Jeanne (1995), Davutyan and Parke (1995)] by not raising their discount rates or by using “gold devices” which artificially altered the price of gold in the face of a payments deficit [Sayers (1957)]. But the violations were never sufficient to threaten convertibility [Schwartz (1984)]. They were in fact tolerated because market participants viewed them as temporary attempts by central banks to smooth interest rates and economic activity while keeping within the overriding constraint of convertibility [Goodfriend (1988)]. An alternative interpretation is that violations of the rules of the game represented the operation of an effective target zone bordered by the gold points. Because of the credibility of the commitment to gold convertibility, monetary authorities could alter their discount rates to affect domestic objectives by exploiting the mean reversion properties of exchange rates within the zone [Svensson (1994), Bordo and MacDonald (1997)].
An alternative to the view that the gold standard was managed by central banks in a symmetrical fashion is that it was managed by the Bank of England [Scammell (1965)]. By manipulating its Bank rate, it could attract whatever gold it needed; furthermore, other central banks adjusted their discount rates to hers. They did so because London was the center for the world’s principal gold, commodities, and capital markets, outstanding sterling-denominated assets were huge, and sterling served as an international reserve currency (as a substitute for gold). There is considerable evidence supporting this view [Lindert (1969), Giovannini (1986), Eichengreen (1987)]. There is also evidence which suggests that two other European core countries, France and Germany had some control over discount rates within their respective economic spheres [Tullio and Wolters (1996)].
The Specie Standard as a Rule
One of the most important features of the specie standard was that it embodied a monetary rule or commitment mechanism that constrained the actions of the monetary authorities. To the classical economists it was preferable for monetary authorities to follow rules rather than subjecting monetary policy to the discretion of well-meaning officials. Today a rule serves to bind policy actions over time. This view of policy rules, in contrast to the earlier tradition that stressed both impersonality and automaticity, stems form the recent literature on the time inconsistency of optimal government policy.
In terms of the modern perspectives of Kydland and Prescott (1977) and Barro and Gordon (1983), the rule served as a commitment mechanism to prevent governments from setting policies sequentially in a time inconsistent manner. According to this approach, adherence to the fixed price of gold was the commitment that prevented governments from creating surprise fiduciary money issues in order to capture seigniorage revenue, or form defaulting on outstanding debt [Bordo and Kydland (1996)]. On this basis, adherence to the specie standard rule before 1914 enabled many countries to avoid the problems of high inflation and stagflation that troubled the late twentieth century.
The specie standard rule in the century before World War I can also be interpreted as a contingent rule, or a rule with escape clauses [Grossman and Van Huyck (1988)], Bordo and Kydland (1996)]. The monetary authority maintained the standard - kept the price of the currency in terms of specie fixed – except in the event of a well understood emergency such as a major war. In wartime it might suspend specie convertibility and issue paper money to finance its expenditures, and it could sell debt issues in terms of the nominal value of its undepreciated paper. The rule was contingent in the sense that the public understood that the suspension would last only for the duration of the wartime emergency plus some period of adjustment, and that afterwards the government would adopt the deflationary policies necessary to resume payments at the original parity.
Observing such a rule would allow the government to smooth its revenue from different sources of finance: taxation, borrowing, and seignorage [Lucas and Stokey (1983), Mankiw (1987)]. That is, in wartime present taxes on labor effort would reduce output when it was needed most, but relying on future taxes or borrowing would be optimal. At the same time positive collection costs might also make it optimal to use the inflation tax as a substitute for conventional taxes [Bordo and Vegh (2002)]. A temporary suspension of convertibility would then allow the government to use the optimal mix of the three sources of finance.
The basic specie standard rule is a domestic rule, enforced by the reputation of the specie standard itself i.e., by the historical evolution of specie as money. An alternative commitment mechanism was to guarantee gold convertibility in the constitution as was the case in Sweden before 1914 [Jounung (1984)].
Although the specie standard rule originally evolved as a domestic commitment mechanism, its enduring fame is as an international rule, namely maintenance of specie convertibility to the established par. Maintenance of a fixed price of gold by its adherents in turn ensured fixed exchange rates. The fixed price of domestic currency in terms of specie served as a nominal anchor under the international monetary system.
According to the game theoretic literature, for an international monetary arrangement to be effective both between countries and within them, a time –consistency credible commitment mechanism is required [Canzoneri and Henderson (1991)]. Adherence to specie convertibility rule provided such a mechanism.
In addition to the reputation of the domestic specie standard and constitutional provisions which ensured a domestic commitment, adherence to international specie standard rule may have been enforced by other mechanisms [see Bordo and Kydland (1996)]. These include: the operation of the rules of the game; the hegemonic power of England; central bank cooperation; and improved access to the international capital markets.
Indeed the key enforcement mechanism of the specie standard rule for peripheral countries was access to capital obtainable from the core countries. Adherence to the gold standard was a signal of good behavior, like the “ good housekeeping seal of approval”; it explains why countries that adhered to gold convertibility paid lower interest rates on loans contracted in London than others with less consistent performance [Bordo and Rockoff (1996)].
Fiat Money Standards (... ...)
The History of Monetary Standards From Specie Standards to Fiat Money
Bimetallism and the Gold Standard (... ...)
The interwar Gold Exchange Standard (... ....)
Bretton Woods (... ...)
The Managed Float and the Fiat Standard
As a reaction to the flaws of Bretton Woods, the world turned to generalized floating exchange rates in March 1973. Though the early years of the floating exchange rates were often characterized as a dirty float, whereby monetary authorities extensively intervened to affect both the levels and volatility of exchange rates, by the 1990s it evolved into a system where exchange market intervention occurred primarily with the intention of smoothing fluctuations.
The advent of generalized floating in 1973 allowed each country more flexibility to conduct independent monetary policy. In the 1970s inflation accelerated as advanced countries attempted to use monetary policy to maintain full employment. However, monetary policy could be used to target the level of unemployment only at the expense of accelerating inflation [Friedman (1968), Phelps (1968)]. In addition the USA and other countries used expansionary monetary policy to accommodate oil price shocks in 1973 and 1979. The high inflation rates that ensued led to a determined effort by monetary authorities in the USA and UK and other countries to disinflate.
The 1980s witnessed renewed emphasis by central banks on low inflation as their primary (if not sole) objective. Although no formal monetary rule has been established, a number of countries have granted their central banks independence from the fiscal authority and have also instituted mandates for low inflation or price stability.
In some respects for the US and other major countries there appears to be a return to a rule like the convertibility principle and the fixed nominal anchor of a specie standard.
The European Monetary Union
Within the context of the worldwide shift towards a floating exchange rate regime, the majority of European countries have opted for a monetary union. The EMU has many attributes of the classical gold standard including perfectly fixed exchange rates (one national currency) and the free mobility of goods, capital and labor. It differs significantly however in that it is based on a fiat standard. The Euro is issued and controlled by the European Central Bank. The actions of the independent ECB are constrained by a mandate for low inflation which its founders hoped would serve as the type of credible nominal anchor that gave long-run price stability to the classical gold standard.
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