What is the Mechanism of Gold Standard?

The mechanism of gold standard may be described as under:

Maintenance of Exchange Stability Gold Points:

International gold standard is basically concerned with the external value of a currency and maintaining the stability of exchange rates. The process by which gold standard maintains exchange stability is very simple. Under the international gold standard the values of the currencies of participating countries are fixed in terms of gold.

Their exchange rates, therefore, are also automatically fixed by gold parity. Thus, in a foreign exchange market if the exchange rate tends to rise much above the gold parity rate, the excess demand for foreign exchange will be met by export of gold. Similarly, if the foreign exchange rate tends to fall much below the gold parity rate, the excess supply of foreign exchange is taken off from the market by the import of gold.

In this way the demand for any currency in foreign exchange market is kept equal to the supply, so that, stability of the exchange rate is maintained. The following illustration will make the point clear.

Suppose, two countries, say India and U.K., are both on the gold standard, and that there is free import and export of gold in both countries. Now, if in India the monetary authority has fixed the value of the rupee at 1/100th ounce of pure gold and in U.K. its monetary authority has fixed the value of pound as l/5th ounce of pure gold, then the gold parity exchange rate of the two currencies would be Rs. = £ 1. f

Now, suppose that there is deficit in India’s balance of payments, and surplus in U.K.’s balance of payments. Then the demand for pound will be more than the demand for rupee, for the obvious reason that people in India with rupees will purchase more pounds for payments to their creditors in U.K. than the people in U.K. with pounds purchasing rupees for payments to their creditors in India. Thus, the value of pound tends to rise in terms of the rupee, because of the heavy demand for it.

But this change in the exchange rate cannot go far. Now, if the cost of transfer (which is made up of the cost of shipment, insurance and interest) of l/5th ounce of gold from India to U.K. is only 50 paise, the exchange rate of pound will not rise above Rs. 20.50 per pound, whatever, may be the excess demand for pounds in the foreign exchange market.

This is because anybody in India can get pounds by exporting gold to U.K. The cost of getting £1 exporting gold would be only 50 paise, and he can buy l/5th ounce of gold for Rs. 20 from the Indian monetary authority, the Reserve Bank of India, for this purpose. Thus, in getting the pound by way of exporting gold one has to bear only the cost of transferring gold from India to U.K., which is assumed to be 50 paise. People in India can thus, get any amount of pounds at the price of Rs. 20.50 per pound by exporting gold. This means that the supply curve of pound becomes perfectly elastic at this price.

Therefore, when the exchange rate rises upto Rs. 20.50 per pound in the foreign exchange market, it will not be allowed to rise further. Whatever, excess demand for the pound is there, it will be taken off at this rate from the foreign exchange market and will be shunted into the gold market, and the excess pounds will be made available through export of gold.

This point of foreign exchange rate is called the upper gold point or the gold export point (for India). It is the specific point of the foreign exchange rate beyond which any excess demand for pound (in India) is met by export of gold. Here, Rs. 20.50 to £ 1 is India’s gold export point and U.K.’s gold import point.

The reverse will be the case when the demand for rupee increases or the supply of pounds increases. In that case the value of rupee will rise or that of pound will fall. But here also the rate will not decline by more than 50 paise, the transfer cost of gold (from India to U.K. or from U.K. to India). Hence, the exchange rate will not fall below Rs. 19.50 per pound.

Any Englishman can get any amount of rupees at the rate of Rs. 19.50 per pound by importing gold into India. For, he can get 1 /5 th ounce of gold from the Bank of England for one pound, and transfer it by bearing the transfer cost of 50 paise, in return for which he can get Rs. 20 from the Reserve Bank of India.

This means, the supply of rupees against pounds (i.e., the demand for pounds against rupees) becomes completely elastic at the exchange rate of Rs. 19.50 per pound. Thus, the demand curve for pounds becomes perfectly elastic at this rate.

This exchange rate should be regarded as the lower gold point or the gold import point (for India). For, at this rate, any excess supply of pounds or any excess supply of demand for rupees, will be taken away from the foreign exchange market and will be shunted into« the gold market, and the excess rupees will be made available through the import of gold in India. Here, Rs. 19.50 to £ 1 is India’s import point of U.K.’s export point. These export and import points can be expressed diagrammatically as in.

In X-axis represents the quantity of pounds demanded and supplied. The foreign exchange rate (i.e., the price) of pound is measured along the Y-axis. DD curve is the demand curve for pounds and SS curve is the supply curve for pounds. Both these curves intersect at point P, so that PQ shows the equilibrium foreign exchange rate (as determined by the gold parities of Indian and British currencies), where OE is the amount of pounds demanded as well as supplied.

In our illustration, 0£’ = Rs. 20 per pound. The line ss’ shows how under international gold standard the supply curve of pounds becomes perfectly elastic at the exchange rate of OU (Rs. 20.50 per pound) which is the upper gold point or the gold export point (for India). Since the supply curve is perfectly elastic at the gold export point, a shift of the demand curve to the right has no further effect upon the price of pound.

Thus, the demand for pound raises the exchange rate from its equilibrium position towards the upper gold point limit only. The exchange rate cannot rise any further, and thus, loses its equilibrium function at the gold export point, because the differences in the amounts of foreign exchange (pound in our illustration) supplied and demanded at the upper gold point are made by gold exports.

Similarly, the line dd’ depicts how demand curve for pound becomes perfectly elastic at the exchange rate of OL which is the lower gold point or the gold import point (for India). Since the demand curve is perfectly elastic at the gold import point a shift of the supply curve to the right has no further effect upon the price of pound. That is, the increased supply of pound lowers its price (the exchange rate) from its equilibrium position upto the lower gold point limit only.

The exchange rate will not decline further, and thus, loses its equilibrium function at the gold import point, because the differences in the amounts of foreign currency supplied and demanded at the lower gold point are made up by the gold imports.

In when the demand curve DD is shifted to D₁ D₁ (indicating an increase in demand for pound) supply curve SS remaining the same, the equilibrium rate of exchange rises to OE ‘, i.e., price of pound in terms of rupees increases. But after point S when the demand curve shifts to D₂ D2, the equilibrium rate of exchange actually shows rise to OE’ but this will not happen as the supply curve SS has become perfectly elastic at point S due to gold export. The excess demand MN of pound is met by MN export of gold (by India).

In the original equilibrium rate of exchange is OE at which OQ is the amount of foreign exchange (Pound in our illustration) demanded as well as supplied. However, if the demand curve DD remaining constant, when the supply curve SS is shifted to S₁S₁ (indicating an increase in supply of pound), the equilibrium rate of exchange falls to OE”, i.e., price of pound in terms of rupee declines. This may happen till point d. After that the supply curve is shifted to S₂S₂ the exchange rate will not fall below OL as the demand has become perfectly elastic at point d (thus, demand curve is dd ‘ – a horizontal straight line) due to gold import. The excess supply of pound MN is being taken away from the foreign exchange market and shunted into the gold market through import of gold in India/or export of gold by U.K. to India to get Indian rupee.

The same logic is valid in case of decrease in demand and supply positions in their reverse effect. In this case the gold export point is a at which the demand curve becomes perfectly elastic as aU. Similarly, the gold import is b at which the supply curve becomes perfectly elastic as bL.

Thus, it may be observed that the exchange rate can at best change within the narrow limits set by the two specie points – upper gold point and lower gold point, determined by the transfer cost, since otherwise gold flows out to correct any deficit or surplus in the balance of payments. It is the outflow and inflow of gold which are responsible for the stability of the exchange rates under international gold standard.

It should be noted, however, that without free convertibility of currency into gold and of gold into currency, this mechanism of gold standard cannot function effectively to maintain exchange stability.