The most important feature of the gold standard is that it is an automatic standard. It can operate automatically without interference from the monetary authority. In other words, under international gold standard, the equilibrium in the balance of payments of the gold standard countries is automatically achieved through gold movements.
The self adjusting mechanism of gold standard can be explained by the theory of gold movements. According to this theory, the country with relatively high cost-price structure loses gold, while the country with relatively low cost-price structure gains gold.
In other words, the country with deficit balance of payments (i.e., with excess of imports over exports) will experience gold outflow and the country with surplus balance of payments (i.e., excess of exports over imports) will experience gold inflow.
Suppose two countries A and B is on gold standard. Further suppose that country A experiences a deficit balance of payments, while country B a surplus balance of payments.
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The disequilibrium between these two countries will be automatically corrected through the mechanism involving the following steps:
1. Gold Movement:
Gold will flow out of country A with adverse balance of payments and will flow in country B with favourable balance of payments.
2. Changes in Money Supply:
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Given the gold reserve ratio in both the gold standard countries, the outflow of gold will lead to a contraction in the supply of money (i.e., of currency and credit) in country A. On the other hand, the inflow of gold will result in the expansion of money supply in country B.
3. Changes in Prices and Economic Activity:
Contraction in money supply will lead to a fall in the prices and the profit margins in country A. This will, in turn, reduce investment, income, output and employment in that country.
On the other hand, expansion of money supply will raise prices and profit margins and consequently investment, income, output and employment in country B.
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4. Changes in Imports and Exports:
Fall in prices in country A will encourage foreigners’ demand for its products. Moreover, decrease in incomes in country A will discourage demand for goods from other countries.
Thus, exports will increase and imports will decrease in country A. Similarly, rise in prices in country B will lead to an expansion of imports in that country.
5. Equilibrium in the Balance of Payments:
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Expansion of exports and contraction of imports will create conditions of favourable balance of payments in country A. On the other hand, Contraction of exports and expansion of imports will lead to an adverse balance of payments in country B.
As a result, gold will start flowing from country B to country A and this will ultimately remove disequilibrium in the balance of payments in both the countries.
Thus, the movements of gold as a consequence of disequilibrium in balance of payments will automatically create conditions for the removal of the disequilibrium and ultimately lead to equilibrium in the balance of payments in the gold-standard countries.