Why were exchange rates so stable under the Classic gold standard?

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Mr Ali R Allana: Historical Perspectives 1800-1939     Candidate no: Y1711748

Why were exchange rates so stable under the Classic gold standard?

The period known as the ‘Classic Gold Standard’ occurred between 1880 and 1914

and saw the rapid expansion of countries onto the gold standard. A country is

generally considered to be under a Gold standard when it ties its domestic currency to

a fixed amount of gold. To maintain this standard, a Government should aim to buy

and sell gold at the price chosen. The first gold standard era of Britain lasted from

 1821 to 1919. Gold was chosen because it completed the three properties of

commodity money needed (medium of exchange, a unit of account and a store of

 value). By 1900, a succession of countries had set Gold as the standard, including

Holland, Denmark, Sweden, France, Italy, the US, Russia and Japan with Germany

 initiating a trend away from silver in 1871.

Different countries accorded gold currency more importance than others.  However it

 is possible to identify the most regularly occurring features of the Gold standard

economies, though in reality few countries exhibited all the trends. The first and most

 basic requirement of the gold regime was Gold-convertibility – a unit of currency that

 can in theory be exchanged at a fixed rate to gold. This was not made a legal right in

 some countries. Austria-Hungary and Italy were two gold establishments

 where Gold-convertibility was not an official requirement. The second condition was

 money circulating as a ratio to gold reserves, also known as the ‘Gold content’. How

 much this ratio varied depended on the country. Britain, Finland, Japan, Norway and

 Russia were 100% backed with gold reserves while Belgium, Holland and

 Switzerland used a cover system that allowed some degree of flexibility in the

 reserves of gold held. There also seemed to be a lack of exchange control associated

 within the gold standard with currency conversion being regulation-free. Lastly, both

 people and money and hence gold were allowed to freely cross borders making

 monetary exchange and conversion easier for consumers and producers alike.

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Exchange rates have arguable never been as stable over a period of thirty-five years as

 

they were during the Gold standard. The long-run stability of exchange rates is all the

 more remarkable given the numerous financial downswings that occurred during this

 time. ‘Monetary disturbances associated with banking difficulties recurred in

 successive episodes centred on the years 1884, 1890, 1893, and 1907’. The handful

 of countries that decided to abandon the gold standard after joining left for other

 reasons such as substantial balance of payments deficits. The vast majority of the

 ‘gold establishments’ (main countries that were part of the gold standard) enjoyed the

 advantages that settled exchange rates brought. Greater specialisation during the era

 led to an unprecedented rise in trade and investment flows occurring without

 the capital and speculation risk involved with exchange rate fluctuations.

It is possible that exchange rate stability occurred because of stable balance of

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 payment positions among the ‘gold establishments.’ There are a number of

 reasons why so few balance of payment difficulties arose during the classic gold

 standard. Each will be in turn be given greater detail and analysed comprehensively

 before coming to a conclusion on the most significant factor contributing to stable

 exchange rates. The balance of payment adjustment is a process supposed to show

 trade imbalances cannot last indefinitely and will eventually return to equilibrium.

 The price-specie-flow model, David Hume (1752), provides a simplified explanation

 of how the adjustment process might have worked ...

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