Gold as reserve currency – Part 1

In the time of economic distress, Gold is often seemed as the last man standing. To help understand the role of gold we need to understand how is gold related to the fiat currencies and how it works now as compared to how it worked in the past.

It all started with IOUs being issued against the gold reserves. So in a classical sense the domestic gold supply is directly proportional to the country’s stock of gold. On the international trade front, the notes issued against the gold reserves would be constricted when a country experiences a deficit in trade in terms of gold due to the loss of gold while importing more than the exports.  This depresses the price levels and makes the exports more attractive to other countries while making the imports more expensive. This leads to an automatic correction of the country’s deficits.

What follows is sterilization under a gold standard where the exchange rates are fixed so there is no currency appreciation or depreciation. When a country has net surplus of gold in-flowing from deficit countries, the inflation of that country rises since people will have more gold to buy more imports. And over time since the imports will also increase due to the increased capacity of the nation’s citizens to buy more, the deficit will be corrected.  There will also be declines of export from deficit countries because of the higher prices. The deficit countries will also end up exporting instead of consuming part of their production to correct the deficit. Countries like US and France used the Sterilization in 1920s and 1930s with some success whilst stocking up piles of gold. Around early 1930s this model had detrimental effects on the global economy and was abandoned.

This classical gold model turned out badly in practice due to depletion of gold stocks in some countries while explosion in practice of hoarding gold.