What is the Automatic Functioning of the International Gold Standard?

Prior to World War I, the chief characteristic of gold standard was its automatic functioning. That is to say, the equilibrium in the balance of payments position of the gold standard countries was automatically adjusted through gold movements under the International Gold Standard set up.

Thus, so far as the balance of payments was concerned, the international gold standard was a self- correcting mechanism and no international organisation or agreements were necessary for its successful operation.

This self-adjusting automatic process of gold standard can be explained by the theory of gold movements. According to this theory, a country with a relatively low cost-price structure loses gold.

To put it in another way, a country with a deficit balance of payments loses gold, i.e., gold flows out of the country, whereas, a country with a surplus balance of payments receives gold, i.e., there will be an inflow of gold into the country.

It has been argued that an influx of gold will have the following repercussions:

1. When there is deficit in the balance of payments, the induced outflow of gold leads to a contraction of currency and credit in the country. For, the exporters of gold will purchase gold from the central bank.

Thus, the gold reserve of the central bank falls and to that extent it will have to reduce the issue of notes and currency in circulation. So also commercial banks find reduction in their demand deposits if withdrawals were made by these gold exporters for purchasing gold from the central bank. To that extent commercial banks’ cash reserves are depleted and they are forced to contract credit accordingly.

2. Contraction in money supply (currency plus credit) will lead to a decrease in prices.

3. The fall in prices in the country will encourage foreigners’ demand for its goods and services so that, its exports will increase. Simultaneously, its imports will decline because people will find foreign goods relatively costlier.

4. The increase in exports and decrease in imports of the country would increase the supply of and decrease the demand for foreign currency.

5. Ultimately the deficit in the balance of payments will be wiped out and the country may become a surplus country. That is to say, a formerly gold-losing country will now become a gold- receiving country.

Thus, the efflux of gold automatically creates conditions for the removal of the deficit in the balance of payments of a gold-losing country, the deficit which was the cause of the out-flow of gold.

Similarly, a reverse process will follow in the gold receiving country with an inflow of gold as described under:

1. The inflow of gold which is caused by the surplus balance of payments, in effect, leads to an expansion of credit and currency in the country. For, when exporters in the surplus country receive gold from the debtor country, they will get local currency in exchange from the central bank. Thus, the central bank’s gold reserve position is strengthened and its capacity to issue more currency increases. Simultaneously, when these people deposit their money with the commercial banks, the latter’s cash reserves grow and so does their credit creation capacity.

2. The expansion of credit and currency will lead to a rise in prices in the country.

3. With the rise in prices the country’s exports will decline while its imports will increase.

4. When exports decline and imports increase in the country, its demand for foreign currency increases, while the supply of foreign currency in the country declines.

5. Ultimately, the country’s surplus balance of payments may turn reverse so that, a formerly gold-receiving country will now become a gold-losing country.

Thus, the inflow of gold automatically creates conditions of the removal of the surplus in the balance of payments of gold receiving country, the surplus which was the cause of the gold inflow.

Now, suppose country A is a gold-losing country due to its deficit balance of payments, and country B is a gold receiving country on account of its surplus balance of payments.

Then, there will be an outflow of gold from country A, with an inflow of gold in country B. The outflow from country A will generate a deflationary process and correspondingly an inflow will generate an inflationary process in country B, and they will be instrumental in resorting equilibrium in the balance of payments position of these two countries.

Thus, the gold movements (inflow and outflow) act like a catalytic force, so that, there cannot be a persistent and sustained one-sided movement of gold. This process of adjustment through gold movements works in an automatic fashion allowing no scope for any sort of interference.

This process of the automatic working has been summarised in the

However, there is one important fact to be noted about this adjustment process. The adjustment effected through changes in the relative prices and incomes in the two countries is the consequence of the changes in the level of activity in the countries concerned. This automatic process of adjustment is reinforced by the central banks of the gold standard countries, through changes in the bank rate.

The gold-losing country’s central bank raises the bank rate. Rise in bank rate causes credit contraction. Credit contraction leads to a fall in prices which will cause further decline in investment, employment and income in the economy. But with falling prices, exports will rise whereas, imports will decline. Moreover, the rise in the bank rate will attract foreign investment funds in the country which will arrest the movement of gold out of the country.

On the other hand, the bank rate will be lowered by the gold-receiving country. A fall in the bank rate will lead to an expansion of credit. Thus, prices will rise so that, exports will decline, whereas imports will rise.

A rise in prices will have the consequence of increasing investment, employment and income in the gold-receiving country. But with the fall in interest rates, capital fund will tend to fly away from the country, thereby arresting the movement of inflow of gold into the country.

All these tendencies will quicken the pace of adjustment. However, the emergence of income deflation and unemployment in the gold-losing country and that of inflation in the gold- receiving country follow as a corollary to the adjustment brought about through the gold movements.

Thus, the entire process of adjustment under the gold standard is somewhat painful. At full employment level in the country, the inflow of gold and the corresponding credit expansion will produce an inflationary spiral in the gold-receiving country. But the pains of the gold-losing country are much more severe. In it the gold outflow and the resulting credit contraction will lead to deflation.

It has thus, been stressed that the gold standard mechanism has an ‘inherent bias towards deflation.’ Because, even when gold begins to flow back to the gold-losing country, the central bank finds it very difficult to stimulate credit expansion and overcome deflation. Prof. J. H. Williams gives the following two important reasons for the deflationary bias of the gold standard mechanism: (1) The unequal importance of the balance of payments in different countries’ national income, as some countries may have substantial foreign trade and income from abroad relative to their domestic economy while the other countries have no significant international economic transactions, so least contribution of income from abroad. (2) The unequal size of trading countries, leading to imbalances in trade (usually small or less developed countries having deficit balance of payments have to resort to deflation for correcting their disequilibrium under gold standard). And we know that though, inflation is unjust, deflation is worse because it is inexpedient.

In short, the basic features of gold standard mechanism are the contraction and resulting repercussions which it causes in the economy of the gold-losing country, and the expansion and its repercussions in the economy of the gold-receiving country.

These reciprocal contraction and expansion processes constitute an automatic tendency towards integration of the monetary and credit policies of the two countries which leads to the restoration of international payments equilibrium.